As long-term shareholders of Altria (MO) dating back to the old Philip Morris know, one of the reasons why the company has performed phenomenally well (turning $10,000 in January 1980 into $4.21 million today if you count the Kraft (KRFT), Mondelez (MDLZ), and Philip Morris International (PM) spinoffs) is because investors were able to benefit from two simultaneous forces that are rare for a company to enjoy over the long-term: high earnings and dividend growth coupled with decades of undervaluation (for a case study on this lollapalooza effect, be sure to read Dr. Jeremy Siegel's book Stocks For the Long Run).
The reason why Altria was so successful in the past is because the danger of government regulation and tax policy has always threatened to undermine the tobacco company in a permanent way that never materialized. Cognitively, this has created quite the challenge for those that desire to actively monitor their holding in Altria stock: because a large part of the company's long-term success is due to the fact that seemingly severe smoking restrictions have yet to destroy the tobacco company's profits, it can be easy to fall into the trap of dismissing all threats to the company's business model because the past threats have been overblown.
This creates a complicated dilemma for those monitoring their Altria stock: because the previous tax and regulatory threats failed to stop Altria's dividend engine, a false sense of security may exist in evaluating future threats. The news that brings this to my mind, of course, is the latest gambit out of Mayor Bloomberg's office to curtail cigarette smoking in New York, as the The New York Daily News reports:
Undeterred by the collapse of his big-soda ban, Mayor Bloomberg launched a new health crusade Monday, proposing a law to forbid stores from publicly displaying cigarettes and other tobacco products. New York would be the first city in the nation to impose such a ban, which Bloomberg framed as a way to reduce teen smoking. Under the proposal, tobacco products would have to be under counters, in cabinets, behind curtains - anywhere but in public view. Stores would still be able to advertise that they sell cigarettes, and could display prices.
While it is unclear if this ban will come to pass, and while the laws of New York are but one out of fifty, this news story highlights what may turn out to be an uncomfortable truth for long-term tobacco investors: government agents will always find yet another way to restrict tobacco access. This may eventually cause permanent damage to Altria's long-term earnings power. Click here to check out a timeline of increasing tobacco restrictions over the past fifty years.
We see this all the time. Campuses are banning smoking. Heck, most restaurants and bars now ban smoking. President Obama gave the DFA the authority to regulate the tobacco industry, further decreasing Altria management's autonomy in selling its product to customers. To cope with budget deficits, most states turn to cigarette tax increases as the default fix. Smoking rates are down. To continue with the New York example, the number of adult smokers has decreased by 35% since 2002. And lastly (and this is the kicker that deters me from investing in Altria), the volume shipment of Altria's cigarettes have been declining by 3% annually since the late 1980s. Altria has thus far been able to compensate for this difficulty by increasing the price of cigarettes, but with Altria management noting the difficulty of raising prices over the next few years, the option to raise prices may not provide as much ballast in the future as it did in the past (word to the wise: Philip Morris International is different from Altria in this regard, and has thus far managed to increase volume shipments as it has penetrated international markets).
If I were an Altria shareholder, there are two things I would do:
1. First, I would place a sharp limit on the percentage of my net worth that I would expose to tobacco companies, most likely in the 5-10% range. There are simply certain sectors of the economy where diversification is more important than others. Recently, I wrote about how the financial sector tends to blow up every generation or so, and for that reason, I would place a 10% limit on the amount of my wealth that I would allow to be in the banking sector. I hold the tobacco industry in similar regard.
The funny thing, of course, is that Altria is one of those stocks that investors tend to hold in large amounts. Jeremy Siegel once wrote an excellent piece documenting the fact that Ben Bernanke's only individual stock holding was Altria at the time he became Chairman of the Fed. Because the old Philip Morris facilitated the purchase of its stock among employees, Altria has become one of those stocks that gets passed down from generation to generation within families. And lastly, Altria has historically satisfied the holiest of niches for income growth investors: it has offered both high current yield and high dividend growth. For that reason, it can become easy for investors to bend their maximum allocation rules and allow Altria to become a heavy position in one's portfolio.
2. I would not tolerate much dividend or earnings declines before selling. I'd keep the company on a short leash. If the normalized earnings declined for three straight years, I'd be out. Likewise, if the dividend got cut, I'd be out. The risk of this approach is that a lot of other investors might think the same thing (particularly with a dividend cut), and the stock price could be diving at the moment you're selling.
I do not want you to read this article as me encouraging you to sell your Altria stock right now. Nor I am predicting an imminent decline in either the earnings or dividend. Rather, I am trying to advocate caution against allowing Altria's excellent past in overcoming tax and regulatory risk to allow investors to be dismissive of all future risks that could impair earnings quality. This is a special dilemma for Altria shareholders because of the fact that the risks have historically been overblown is the very same thing that has allowed investors to achieve superior returns. This creates a potentially harmful form of cognitive dissonance that Altria shareholders need to guard against if they aim to protect their long-term wealth.