Friday, July 25, 2014

Altria: Timing Isn't Everything, Part II

A follow up to this post. To me, what's of interest when it comes to Altria (MO) isn't just that it has done very well over longer time horizons in terms of risk and reward, it's what can be learned from it and applied elsewhere.

In the earlier post I noted the following:

- $ 10,000 invested in Altria increased to $ 80 million (incl. reinvested dividends) over roughly fifty years ending in 2006.

- The stock, including the impact of reinvested dividends, has more than tripled since the end of 2006.

Quite an outcome. These results are unusual if for no other reason that the business itself has faced so many headwinds for so long.

That, to me, is what makes Altria worth better understanding.

Studying what doesn't quite fit expectations sometimes leads to useful insights.

"The thing that doesn't fit is the thing that's the most interesting, the part that doesn't go according to what you expected." - From The Pleasure of Finding Things Out by Nobel Prize winning physicist Richard Feynman

I mean, the kind of difficulties Altria has faced (and, to an extent, continues to face), at least on the surface, would seem to not be correlated with such an investment outcome.

As I also noted in the earlier post, the things working against Altria might eventually spell real trouble for investors. It's worth careful consideration. Even though things have worked out great investment-wise for a very long time, maybe owning shares of Altria will eventually become a dumb thing to continue doing.

My view is that time spent trying to prove that thinking is flawed beats trying to reinforce its correctness every time. Those seeking what's consistent with their own views tend to pay for it later in the form of much reduced returns. So read and think about what challenges and raises doubts about investing ideas; pay less attention to what seems to confirm.

Now, it's also possible that Altria's inherent business strengths mostly remain in place. In the past, those who've put too much weight in Altria's challenges (and mostly ignored the advantages) have greatly benefited continuing long-term shareholders. The "story" remains not very compelling. Why things have worked so well for investors long-term isn't terribly intuitive. The core product is still not at all good for its users. Volumes have been declining for a very long time and should continue to do so. There have been and remain many legal, tax, and regulatory challenges. 

Yet none of this is really new. These days, U.S. smokeable products is the biggest driver of value for Altria in its current form. With the two big spin-offs back in 2007 and 2008, that now IS a relatively new consideration. Smokeless products and the SABMiller (SBMRY) stake also make meaningful but much smaller contributions to value. Wine makes a very small contribution.

So, prior to the spin-offs, food products and international tobacco products were once a big part of the story. 

Well, that means Altria can no longer lean on those other businesses if the U.S. smokeable products business gets in trouble.

Altria's long-term results mostly comes down to pricing power, very high returns on capital, and a persistently low stock price relative to earning power (a discount to intrinsic value).*

The pricing power has, on average, at least up to now, more than made up for volume declines. Naturally, there are limits to pricing power, but those who can increase price successfully will see it mostly (if little or no marketing spending is required), if not entirely, fall to the bottom line. Revenue that comes via volume increases generally have a bunch of associated incremental cost of sales. So, for the business with pricing power, a 3% increase in revenue from additional volume is inferior to a 3% increase in price that mostly sticks.

It naturally may make sense for a particular business to pursue both, but available pricing power is sometimes an underutilized lever. Revenue generated from incremental volume is usually, by comparison, rather hard work (and not necessarily high return).

Sustainable pricing power in combination with low capital requirements usually creates attractive business economics. Well, Altria has both. The business of producing and selling small ticket consumer products (even after all the price increases over the years), with brand loyalty, strong distribution, and scale can come with not insignificant competitive advantages.

Now, growth is frequently thought of a desirable characteristic for a business. On the surface this makes sense. Well, if growth is such an important and wonderful thing, why has Altria done so well?

How many potential new competitors are going to be interested in competing in an arena with a shrinking pie, big legal, tax, and regulatory risks, where it's tough to build a new brand? Due to tobacco marketing restrictions, it's tough for a new entrant to the industry to build an alternative brand and gain significant market share.** Excise taxes alone make up a big part of the per unit cost. That makes its tougher to come in with a low cost alternative to take significant market share from established brands.

Does consumer behavior change for a few cents savings when it comes to something as personal as taste?

Probably not.

Even if it did change behavior, would the economics make it worthwhile for the new entrant?

Doubtful.

Reduced competitive pressures contributes to persistent pricing power.

Technology businesses deal with constant change. This creates big winners and, well, many losers.

Even those who can pick the winners beforehand too often pay a high price for the privilege.

That technology businesses overall tend to have lower long-term returns is likely, in part, due to lots of disruptive competition and the fact that the current winners are often priced for greatness.

Sector Returns (1963-2014)
Consumer Staples: 13.33%
Technology: 9.75%

Consumer staples had the highest returns among the ten sectors.

Yet they're routinely referred to as defensive. Well, thinking of them as defensive isn't wrong, it's just incomplete.

Technology had the lowest returns among the ten sectors.

The future may be very different, of course, but the point is that fierce competition and technology shifts can turn sound core business economics into something else altogether.

High returns on capital today; rather the opposite down the road.

New competitors and capital usually go where there's exciting growth prospects; where there's some new compelling territory to potentially dominate. One, maybe two, end up financially fattened along with lots who fail miserably trying.

A big part of the reason for Altria's long-term results was that the stock was often cheap. Over time, additional shares could be accumulated below per share intrinsic value through additional purchases, dividend reinvestments, and buybacks.

Now Altria's shares are currently somewhat more fully priced at 15-16x earnings. Not exceptionally expensive, but far too high to produce anything close to the compelling historic returns.
(That is, if the price to earnings were to mostly stay that high.)

So that mean forward long-term returns will be worse unless the stock gets cheaper and remains there long enough. I realize it's tough to convince someone to cheer when a truly cheap stock they just bought gets even cheaper. Yet it is, in fact, a good thing for the long-term owner. Obviously, it would be even better to buy the stock after it drops, but the point is if something was bought below intrinsic value in the first place -- and it proceeds to drop even further below intrinsic value -- the long-term investor should not really mind at all. Learning to ignore the annoying quotes isn't easy but it's also not impossible. Future purchases, dividend reinvestments, and buybacks will work to the long-term owners benefit. That's just how the math works. A long-term investor who buys shares of a good business at a fair or better price should view a further drop as a good thing.

It's also possible, of course, that the earnings multiple ends up going even go higher. Now, in the near-term, that higher multiple doesn't exactly seem like a terrible thing if it allows for a profitable sale, but keep in mind that something else attractive to buy must then be found.

Some taxes probably must also be paid on the gain.

That alone is tough to overcome. The exchange may work just fine, but it's easy to underestimate the possibility that, in the process, overall after-tax returns end up being reduced. Each move isn't just a chance to improve results; it's a chance to make misjudgments that reduce results.

My point is that the benefits of limiting activity are sometimes not fully appreciated. Once something sensible with attractive long-term prospects is bought at a good price, the threshold for making exchanges should be quite high.

In any case, this way of thinking will be of little relevance to those who actively trade stocks. Yet the logic and math behind this way of thinking should be very relevant for those with longer time horizons. For a comfortably financed business with sound economics, it is a drop in stock price -- or, at least a languishing stock price -- that will produce a much improved long-term result.

Over longer horizons, share prices roughly track per share intrinsic value. Over shorter horizons, that need not be the case.

Near-term (and even longer) anything can happen as far as price action goes.

This will work just fine as long as intrinsic value and how it will likely change over time -- within a range -- has been judged reasonably well.

It's when someone pays a price well in excess of value -- maybe on a speculative basis or due to misjudgment -- and it drops that there's a potential problem.

Permanent loss of capital.

What's somewhat bewildering is the fact that Altria's smokeable products volumes continue to shrink as they have for a very long time.

In general, domestic cigarette consumption has been in decline since the early 1980s.

I noted in the prior post that those who happen to buy Altria when the S&P 500 reached its pre-crisis peak on October 11th, 2007 -- hardly the ideal time -- actually experienced a very nice result.

In fact, Altria's annualized total return was roughly 17% since that peak.

Yet, since back in 2007, Altria's smokeable products volume declines have been anything but small.

Volume was 175.1 billion in 2007.

Last year it was 130.5 billion.

The number was more like 230 billion during the mid-1990s.

Despite these volume declines, Altria's equity returns -- mostly due to pricing power, high return on capital, and mostly low equity prices compared to intrinsic value -- ended up being roughly 17%. That's with the stock being purchased at the pre-crisis peak! Those returns are well above average, of course, and would naturally be improved with just slightly less inopportune purchases.

Altria does also have a solid smokeless products business and a valuable stake in SABMiller, but the vast majority of the company's value these days comes from a business that's in decline.

So exciting growth prospects can be one of the ingredients in an attractive investment.

It's just not a necessary ingredient.

"Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor." - Warren Buffett in his 1992 letter

Still, ideally the volumes wouldn't be declining so much.

Will the declines accelerate at some point?

Will it stabilize at some lower but still very lucrative level or not?

Will the environment around litigation, taxation, and regulation eventually change in a very negative and unforeseeable way?

These are tough things to figure out.

Taxation alone can have a big impact on volumes; these things interact.

I happen to NOT think Altria is such a wonderful investment if bought at or near current prices.***

Margin of safety matters with all investments. The price paid upfront is the best way to balance the investment specific risks against potential rewards.

Still, there's no need to own Altria's stock to learn something useful from it.

The current market valuation is a bit too high for my taste, but this doesn't mean I'll be selling my shares anytime soon. An attractive long-term investment, that's understandable (to the owner), and bought at a nice discount to value in the first place, shouldn't be sold just because it has become more fully valued. That's a recipe for making unnecessary mistakes.

My inclination is generally to not sell what I understand and have been fortunate enough to get at a good price. Increases to intrinsic value -- benefiting from long-term compounding effects -- should be the dominant factor in investing; clever trading in and out of positions should not. There's only so many things one investor can truly understand well. Those who think they can master many things are likely to end up operating outside of their comfort zone.

Still, inevitably, some selling ends up being warranted:

- when the stock price represents a significant premium to conservatively estimated per share value

- when prospects and core economics materially deteriorate (i.e. not just temporary but fixable difficulties)

- when prospects and core economics, in the context of the price initially paid, turn out to have been poorly judged

- when opportunity costs are high

A sound investment approach should be built upon thoughtful yet straightforward principles.

Additional complexity is sometimes necessary and warranted; more often it's not.

Simple, but not too simple, often works best.

It's a balance that isn't easy to figure out.

The right preparation in advance should enable decisive action when others are fearful.

Adam

Long position in MO established at much lower than recent prices. No intent to buy or sell near current prices.

Other related posts:
Aesop's Investment Axiom Revisited - Jul 2014
Altria: Timing Isn't Everything - Jul 2014
The Growth Trap: IBM vs Standard Oil - Jun 2014
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Boring Stocks - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Defensive Stocks Revisited - Mar 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Altria Outperforms...Again - Oct 2010
Altria vs Coca-Cola - Jul 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
GM vs Philip Morris (Altria) - Apr 2009
Defensive Stocks? - Apr 2009

* As highlighted in the previous post, this effectively creates a mechanism for intrinsic value transfer. The ongoing purchases that are made at a discount to value -- whether incremental, dividend reinvestments, or buybacks -- benefit continuing long-term owners at the expense of those with a shorter horizon (that are willing to sell at a discount to value).
** Some might view e-cigarettes as a growth opportunity. I view it as a new risk for an investor even if it might turn out to be a very good thing for the world (if it reduces smoking). Even if the growth were to occur, there's no way to now judge whether it will be of the high return variety. Growth invites in new competition. The rules of the new e-cig game has many unknowns. Maybe it turns out to be wonderful for long-term shareholders; maybe not. I certainly have no way of usefully gauging such things.
*** It's worth mentioning that I certainly can understand why some won't own shares of Altria for non-economic reasons.
----
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, July 18, 2014

Aesop's Investment Axiom Revisited

In this prior post, I included the following excerpt from the 2000 Berkshire Hathaway (BRKa) shareholder letter:

"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? "

Aesop's Investment Axiom

Warren Buffett adds that, if the investor can answer these questions, then both the value and the number of "birds" that should be offered can be understood.

"And, of course, don't literally think birds. Think dollars."

Buffett also writes that the difference between investing and speculating may never be "bright and clear" but the differences do matter. Here's one simple attempt, if limited imperfect way, to make a distinction.

The speculator would be generally troubled if the price of an asset dropped substantially -- even if temporarily -- after purchase. We're talking about necessarily rather short time horizons. So the emphasis is not only on price action going in the right direction, but as soon as possible. When dealing with such short time frames, the reason for the drop ends up mattering not much at all.

Whether the drop is caused by emotions, perceptions, technical factors, the market environment as a whole, or real company specific problems just isn't relevant. With speculation, it's the price action that rules.

The investor should be generally troubled, instead, only if the intrinsic value of something went down substantially after purchase. The emphasis is on price versus value; it's on the stream of cash flows that an asset can produce over the long haul; it's on Aesop's investment axiom. With investment, it's the value that rules.

A drop in what something is intrinsically worth (or if value was misjudged in the first place) is when there's a real chance of permanent capital loss. Otherwise, for the investor, a price dropping against well-judged value can be a very good thing.

Buffett explained it the following way back in 2009:

"When I do invest, I don't care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2."

If the investor pays a discount to what that future stream of income is worth in present terms, why should a further drop in price be a problem? Of course an investor wants market prices to reflect the actual business economics in the long run. Yet, the participant with a true emphasis on investment should know that a near-term (or even longer) drop in price is a good thing if it represents an increasingly large discount to estimated value.

Some might correctly make the point that the speculator (with a long position) also likes to see value going up. While this is true, the speculator is not concerned with whether there was an actual change in value, or whether emotions, perceptions, or something else has temporarily moved the market price.

The price needs to increase, for whatever reason, just long enough to sell; enduring value is of little concern.

Now, it's not like non-fundamental forces don't potentially help the investor as well. If, for example, the shares happen to temporarily sell at a bigger discount because of psychological factors that can serve the long-term oriented owner very well. Still, favorable investment outcomes mostly come down to what the business itself produces long-term.

It mostly comes down to whether enduring value is created over time.

Prices from time to time in capital markets will go to extremes.*

From an interview with Buffett:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return."

He adds:

"On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."

For the investor it's about the long run core economics of the business.

For the speculator it's the price.

It may not be black and white -- and there's surely plenty of overlap -- but the differences do matter.

Ben Graham long ago expressed concerns that the two distinct activities were becoming blurred.

Also, John Maynard Keynes once wrote:

"If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase."

Keynes understood that investing was mostly about what an enterprise could produce over time.
(Apparently, for Keynes, the word enterprise and investment were equivalent.)

John Bogle certainly seems to think that speculation and investment has unfortunately become nearly equivalent in the minds of too many.

Keep in mind I'm not suggesting there's something inherently wrong with speculation. Both investment and speculation can be useful in the right proportion. I'd argue the whole system has evolved to overemphasize the latter. Capital markets might just end up functioning in a way that better serves us if the distinction was more broadly appreciated. Considering where we are today, some sensible changes that encourage greater engagement in true investment activities by more participants seems in order.

These days, instead, stock "rental" dwarfs ownership.**

Meaningful improvements to the situation appear very unlikely unless it also occurs at a cultural level. How many today associate the stock market with the convenient ownership of businesses for the long run? I think it's fair to say that many think of it, first and foremost, as a place to speculate on stocks. Change how that question is generally answered and maybe, albeit no doubt slowly, behavioral norms might just change. The emphasis may become more about long-term effects and outcomes; it may become more about wise capital formation and allocation.

Nothing about the current situation is inevitable. That doesn't mean improvements will come easily. Even some modest enhancements in this regard would be a healthy development.

Also, for those who see stocks for what they are -- convenient partial business ownership -- and can resist the temptation to trade frenetically, the fact is it has never been more straightforward and low cost to invest for the long haul.

It's not a good thing that these two distinct activities are now so often viewed as being nearly one and the same. That's not to say there isn't a place for speculation. Trading with an emphasis on the short-term is a necessary and useful element in the capital markets. At least, it is up a point. Just because a certain amount of something is useful doesn't logically mean more of it is even more wonderful. With systems, even relatively simple ones, the right proportion matters.

I mean,take something like a petrol engine. It works just fine with the right amount of air and fuel. Well, at least it does if the ratio remains within a narrow range. Yet, step outside that range and it just doesn't work. So the right amount of fuel is a good thing but, eventually, too much of it begins hurting engine performance.

This is just one less than perfect, but possibly useful, way to think about the implications of excessive speculation.

More from the 2000 Berkshire letter:

"...there are many times when the most brilliant of investors can't muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money."

There is nothing inherently wrong with speculation but each participant should know where their own true emphasis lies.

Keep in mind that both speculation and investment may utilize fundamental factors to guide their decisions.

So the difference does not necessarily come down to whether the fundamentals influence decision-making. Occasionally, I'll hear or read that someone is a "fundamental investor". Yet their typical holding period will be very short.

Well, that's still mostly speculation in my book. The fact that fundamentals are taken into account does not turn the activity into investment.

There's nothing inherently wrong with speculation but it shouldn't be confused with investment; they're, in fact, two rather distinct activities.

The real problem with speculation is that, for too many, it creates high levels of activity and frictional costs instead of high returns. Lots of effort; modest rewards or losses.

There's nothing wrong with speculation until the vast proportion of market participants are engaged in it.

There's nothing wrong with speculation unless the scale becomes so large that it absorbs lots of capable people who could, instead, be engaged in something more productive and useful.

Come to think of it, there's plenty wrong with amount of speculation these days.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:

Munger: "Cognitive Failure" In Economics
Ignore The Noise: John Bogle on Market Fluctuations
Aesop's Investment Axiom
Margin of Safety & Mr. Market's Mood
On Speculation and Investment
John Bogle: The Clash of the Cultures
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I
Buffett: "Two Types of Assets"
Munger: "Separate Derivatives from the Basic Bridges of Civilization"
Bogle: History and the Classics
"Stock Renters"
Buffett on Aesop's Formula for Value
Michael Porter on Business and Investing

* This inherent moodiness should either be ignored or turned into an advantage. A temporary drop in price even further below well-judged value provides a chance to buy more shares at a discount. The other extreme might offer the opportunity to sell. The tough part is avoid being tempted toward excessive amounts of activity. Otherwise, investment will quickly morph into speculation even with the best intentions. Excessive activity can lead to lots of unnecessary mistakes and frictional costs. Also, equities will always become mispriced, but that doesn't make attempts to reduce the damage these huge distortions can do not worthwhile. The current system seems, at times, a capital misallocation machine. The compounded effect of such things is almost certainly harmful.
** How many drive a rental car with the idea they want to make sure it remains a useful asset for as long as possible? Well, when speculation and short-term oriented traders -- the "renters" -- dominate, maybe some valuable business assets end up being treated much like that rental car. When the intent is to own something for minutes, days, weeks, months, or even a few years, the long-term implications of decisions being made today can take a back seat. Well, even the best businesses face unique challenges and opportunities. More true "owners" would be welcome. The average public company may then just end up with improved governance and executive leadership. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, July 11, 2014

Altria: Timing Isn't Everything

On October 11th, 2007, the S&P 500 reached its intraday pre-crisis peak.

The market as a whole certainly has been on a wild ride since then.

Now, let's consider a stock like Altria (MO).

It also had quite a ride since then -- I mean, few stocks were completely immune to the volatility -- even if it was somewhat less intense than the market as a whole.

Yet let's look at the overall results if Altria had been bought, rather unfortunately, at the peak on October 11th, 2007.

Well, those who purchased Altria's stock on October 11th and hung in there actually experienced a very nice result.

In fact, shares of Altria bought on that far from ideal date produced -- including the substantial reinvested dividends -- an annualized total return of roughly 17%.*

At that rate of return, and over that time frame, the value would have increased to nearly 3x the original investment.

Not a bad result considering that the starting point was on what was a very inopportune day. Naturally, some additional buying as the crisis unfolded -- as the stock price was getting cheaper -- could have only improved the result.

Of course, Altria's stock wasn't going to be immune to the nasty market price action that arose during the financial crisis, but the increasingly cheap shares were an ally to the long-term oriented owner. In fact, it was beneficial to continuing shareholders even if -- other than dividend reinvestments and buybacks -- no incremental purchases were made as the shares became cheaper.

Additional purchases by a continuing shareholder, at the temporarily reduced prices, would naturally also have been beneficial.

The point is that the lower prices can be a benefit, through the wise use of a company's excess capital, even if the shareholder decides to NOT purchase incremental shares.
(A dividend, of course, is excess capital produced by the company that's distributed to the owners but, unlike excess capital used for buybacks, the decision to invest in more shares must be made by each individual shareholder.)

The key is that market prices became reduced but per share intrinsic value did not. That's a very good combination for long-term owners. It is a permanent and substantial drop in per share intrinsic value that creates a real problem for investors.

More on this in a bit.

First, some context is in order.

Altria produced a 19.88% annual return (incl. reinvested dividends) over a roughly fifty year period that ended in 2006.

A 19.88% return over such a time horizon will turn a $ 10,000 initial investment into over $ 80 million.

The stock, including the impact of reinvested dividends, has -- much like what happened since October 2007 though not surprisingly somewhat better -- more than tripled since the end of 2006.

So that would put the tally on the initial $ 10,000 investment at something close to ~ $ 280 million. The power of compounding and a long time horizon.

There are, in my view, reasons why future results likely won't be nearly as favorable for Altria. Some of this comes down to whether the shares will again sell at a low earnings multiple. As it stands now, that's not the case. The stock often has sold at a low multiple over the decades and that had a lot to do with the investment outcome.
(While I intend to remain a long-term Altria shareholder, additional shares in the company are of little to no interest near current prices.)

Still, lots of useful investment lessons can be learned from Altria -- some of them counterintuitive -- then applied elsewhere if the opportunity arises.

Even if the stock itself happens to be of little interest, it can serve as a useful investment case study.

At least that is my view.

Some will argue, maybe correctly, that eventually all the things working against Altria (legal and regulatory risks, taxation, volume declines etc.) are finally going to catch up with the company and its investors.

It's also possible, however, that many of the inherent business strengths continue to at least mostly be there.

Now, lets get back to market prices, intrinsic values, and the implications for long-term investors. A big part of the explanation for Altria's high returns over the decades is that the stock was often rather cheap (price < intrinsic value). That resulted in per share intrinsic value growing faster than the overall intrinsic business value. How? Well, in effect, the less patient -- shorter term oriented -- owners and traders were transferring a portion of the per share intrinsic value to continuing owners over time. This intrinsic value transfer happened because they were consistently selling their shares at a discount to value. This meant, over time, that additional shares could be accumulated below -- maybe even far below -- per share intrinsic value through corporate buyback activity as well as dividend reinvestments.
(Buybacks can make sense when both more than sufficient funds are available to meet all operational/liquidity needs of a business AND the stock is cheap. The decision to pay a dividend -- by the board/management -- should come down to whether the business needs are covered while the decision to reinvest that dividend -- by the investor -- should be based on whether shares sell at a discount to value.)

Well, that transferred value doesn't just disappear, it ends up in the hands of continuing owners, and boosts total return.

Again, as noted above, the long-term investor in Altria could also decide from time to time to accumulate additional shares whenever they became cheap and it made sense in the context of the overall portfolio.

Yet, lacking incremental purchases, the dividend reinvestments and buybacks alone can benefit the long-term oriented owner greatly if the stock often sells nicely below per share intrinsic value.

This is how per share performance can exceed business performance, and sometimes to a substantial degree. Altria's businesses did just fine; its shares did even better.

The compounded effect is not at all a small one. It does allow per share intrinsic business value to outrun overall intrinsic business value. The power of this dynamic is, at least at times, more than a little underappreciated. It at least begins to explain the gap that can exist between business performance and stock price performance.

So, for long-term owners, the low prices that came about as a result of the financial crisis were a very good thing. Returns since 2007 were enhanced greatly by that drop in the stock price. This is why the price declines were actually an "ally" to those in it for the long haul. At the very least, something to consider the next time a sound long-term investment goes up in price in the near-term (or even intermediate-term).

Most end up feeling pretty good when they see their stock going up.

That's actually not the logical reaction unless one is, in fact, selling soon.

Unfortunately, Altria's shares are much more fully priced these days. If this situation were to persist going forward -- or worse, become priced even more highly relative to per share intrinsic business value -- it would lead to, all else equal, reduced future returns.

It's understandably tough to convince traders to think this way.

It should be easier to convince those with much longer time horizons but, well, it's just not.

Beyond the often low stock price relative to earnings power (and intrinsic value), these high equity returns also came down to the company's historic competitive advantages, and attractive core economics, across many of its businesses.
(Which, of course, once included food products and international tobacco products.)

These advantages contributed to pricing power and high returns on capital.

That pricing power, at least up to now, has generally made up for long-standing volume declines in Altria's core smokeable products business.**

Volume declines that have been substantial since 2007 alone, and, well, are generally expected to continue. For Altria in its current form, only U.S. volumes have been relevant since the Philip Morris International (PM) spin-off.

In any case, exciting growth is mostly not at all behind these results; it's just not a big part of the story.

Quite the opposite.

The question is whether Altria still possesses inherent advantages that will mostly persist going forward. The volume declines likely aren't going away anytime soon. The company -- other than the SABMiller (SBMRY) stake -- no longer has meaningful exposure to international markets. At some point will these things hurt investors? Will technology (e-cigarettes) change the competitive landscape and, more importantly, the business economics? A new technology can be an opportunity but doesn't only offer economic upside. Fundamental change can just as easily cut the other way; it can upset what had previously been excellent and sustainable business economics. So the future could offer a very different set of circumstances for Altria. As with any investment these kind of things must be considered. Of course, the future need not be quite as favorable as the past for the risk versus reward to still make sense.

At least if the price is right; if the value can still be estimated within a narrow enough range; if, going forward, the stock often sells at a discount to value so continuing owners can benefit from the intrinsic value transfer.

Altria's long-term past performance promises nothing about the future, of course. Still, the dynamics and factors that created the outcome, at the very least, seem well worth understanding.

So the assumption that growth is a required ingredient for high returns just isn't correct. For investors, this mistaken assumption can be costly.

How could growth not be a good thing? Well, sometimes growth is a very good thing. It's just not always a good thing.

Some seem to assume that all growth is of the high return variety.

Some seem to assume that the only road to high returns comes in the form of high growth.

Neither assumption is necessarily correct.

It's also clearly not about the timing; it's about how price compares to well-judged value, and how that value is likely to change -- considering the specific risks -- over the longer run; it's about identifying businesses that can maintain attractive core economics.

In other words, getting the price versus value judgment mostly right is difficult enough. Attempting to also time things consistently well can lead to unnecessary mistakes. The addition of timing to the equation is a distraction that's easy to do mostly in theory. Even if there surely are exceptions, it seems that more talk (or write) about timing things well than actually get results this way. Well, building an approach based upon the exception seems hardly wise. I'm guessing some who tried to cleverly time things -- who were given many chances to own sensible things at big discounts -- might now be having a rather difficult time finding stocks to buy. In fact, they may now be chasing things that are no longer selling with a sufficient margin of safety (or worse).

At a minimum, some skepticism is more than a little warranted when it comes to those who claim they can time things in a consistently effective way.

On the other hand, it is possible to turn the market dynamics -- sometimes driven by cognitive and emotional factors but barely related to economic value -- that tend to move prices near-term into an advantage. When something that was already cheap gets temporarily even cheaper this is hardly a disaster. The same goes for something originally bought cheap that goes to the other extreme.

Otherwise, better to ignore the near-term noise.

More in a follow-up.

Adam

Long positions in MO and PM established at much lower than recent market prices. As noted above, no intent to buy or sell near current prices. 

Other related posts:
Altria: Timing Isn't Everything, Part II - Jul 2014 (follow-up)
The Growth Trap: IBM vs Standard Oil - Jun 2014
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Boring Stocks - Jun 2013
Aesop's Investment Axiom - February 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Defensive Stocks Revisited - Mar 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Altria Outperforms...Again - Oct 2010
Altria vs Coca-Cola - Jul 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
GM vs Philip Morris (Altria) - Apr 2009
Defensive Stocks? - Apr 2009

* The Philip Morris International (PM) spin-off needs to be accounted for the get the return calculation correct. In other words, actual returns would naturally depend on whether or not the Philip Morris International shares were sold after the spin-off. It actually did work out somewhat better so far -- excluding tax implications -- if Philip Morris International shares had been sold and the proceeds were used to buy more Altria shares. Yet, either way, the investment outcome worked out just fine. Also, the two stocks have different risks that have to be considered. Keep in mind that these return numbers don't account for tax considerations.
** Smokeable products is the biggest driver of value for Altria in its current form. Smokeless products and the SABMiller (SBMRY) stake also make meaningful contributions to value. Wine is a very small contributor. Before the Kraft and Philip Morris International spin-offs, food products and international tobacco products were once a big part of the story.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, July 4, 2014

Buffett & Munger on Compensation - Part II

A follow up to this post. In this CNBC interview, Warren Buffett helps explain why less than optimal compensation systems come to exist in the first place:

"...once a board has delegated to a committee and they've spent hours working on something, and then they report it and there's 20 other items on the agenda and the Chairman calls on the comp committee to give his report and gives it in about 30 seconds, it never gets voted against. And it would be regarded as sort of usurping the power of the committee to all of a sudden say I've got a better idea. I haven't talked to the compensation consultants, I haven't looked at the figures, but I still have a better idea. It doesn't happen."

Becky Quick -- the CNBC interviewer -- brought up the idea that corporate boards might become rather clubby at times. Buffett responded by saying he finds it "always interesting...to read academic discussions of boards." Some have a tendency to overestimate the likelihood that corporate board actions will be primarily about "business maximization" and underestimate the social component.

"...boards are in part business organizations and in part social organizations. People walk into those with their behavior formed by dozens of — usually your people have achieved some standing, perhaps, in the community. So they've learned how to get along with other people. And they don't suddenly change their stripes when they come into a board meeting. So there's a great tendency to behave in a socially acceptable way and not necessarily in a business maximization way. The motives are good; the behavior is formed by decades earlier."

That comment about boards being social organizations -- and the implications for owners -- deserves some attention. In the real world, corporate board behavior isn't, as some might like to imagine, necessarily all about what's best for the business and owners. During the same interview, Andrew Ross Sorkin later asked:

"I hear you saying this is what happens. My question is should it happen this way?"

Buffett's response:

"Well, no, obviously you know everybody would speak freely and all of that sort of thing, and dialogue would be encouraged and the chairman would love to hear reasons why his ideas were no good, but it isn't quite that way."

Buffett later goes on to explains another important dynamic at work:

"There are a number of directors at any company that are making two or three hundred thousand dollars a year, and that money is important to them. And what they really hope is they get invited to go on other boards.

Now if a CEO comes to another CEO and says I hear you've got so-and-so on the board, we need another woman or whatever it may be, oh, she will behave.

If they say she raises hell at every meeting, she's not going to be on the next board. On the other hand, if they say she's constructive, her compensation committee recommendations have been spot on, et cetera, she's got another $300,000 a year job. That's the real world."

These are, at least in some ways, remarkably blunt comments that reveals just how social -- and not surprisingly a bit self-serving -- things end up being on at least some boards. The idea that "business maximization" is what boards are about is an invented version of how humans -- even very capable ones -- are likely to behave in groups. The error of expecting otherwise seems similar to the error of assuming that market participants will mostly act in a cold and rational manner.

There are, of course, some very good boards. That doesn't mean many boards are not susceptible to some of these adverse dynamics.

It's worth noting that, unlike many other companies, non-executive board members at Berkshire Hathaway (BRKado not get paid.

Here's Charlie Munger's take:

"You start paying directors of corporations two or three hundred thousand dollars a year, it creates a daisy chain of reciprocity where they keep raising the CEO and he keeps recommending more pay for the directors..."

He also said the following when asked about the unconventional view that lots of disclosure regarding executive compensation is not necessarily the best thing for shareholders:

"I think envy is one of the major problems of the human condition... And so I think this race to have high compensation because other people do, has been fomented by all this publicity about higher earnings. I think it's quite counterproductive for the nation. There's a natural reaction to all this disclosure because everybody wants to match the highest."

Buffett followed with this:

"It's very natural to think if you're a director of the ABC Corp. and the CEO of the XYZ Corp is getting more, well, our guy is at least as good as theirs. And it goes on and on and on.

So publication of the top salaries has cost the American shareholder money. Maybe disclosure is the great disinfectant, all of that, sunshine is the great disinfectant. Sunshine has cost American shareholders money when it comes to paying their managers."

Munger then quipped that it's "a peculiarity of ours, but we're right".

Basically, publishing the information creates envy that leads to higher pay packages. They think people will generally expect to earn more when they see what others are earning.

In the 2006 letter, Buffett offers some thoughts on Berkshire's board (page 18) and compensation practices (starting at the bottom of page 19).

Also, for some additional thoughts on compensation -- including the misalignment of interests that can occur with stock options -- check out the Compensation section of the 1994 letter.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Buffett & Munger on Compensation - Part I
The Illusion of Consensus
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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