It would seem that it has become almost impossible to discuss tobacco companies without also mentioning ethical investing. So far in 2014, the juxtaposition of ethical investing and investing in the tobacco industry has been in the spotlight. Some of this attention is the result of an analyst downgrading Philip Morris (NYSE:PM) for moral reasons. Occurring in early January, this downgrade sparked considerable discussion about ethical investing. As shown on the chart below, Philip Morris has seen its share price drop under $80 in recent weeks. However, it should be noted that a market wide decline took place over roughly the same time period, so the price decrease is not entirely the result of ethical concerns. While Philip Morris is the primary company mentioned in this article, much of this discussion is applicable to ethical investing in general. In the case of Philip Morris and many others, ethical investors are passing up profits.
An Ethics Free Evaluation of Philip Morris
When I look at Philip Morris, I see a company that is reasonably valued, pays a large dividend, and has a compelling macro story. I'm sure others share my sentiment. With a P/E slightly under 15, Philip Morris seems fairly valued, especially for a company with solid growth opportunities. Philip Morris is expanding into Asian markets where there are hundreds of millions of smokers. If a reasonable amount of these individuals make the switch to Marlboro or any other Philip Morris brand, shareholders will be well rewarded. Finally, Philip Morris has been popular among income investors for its dividend. Shares of PM currently yield around 4.8% and, as evidenced below, the company has a track record of sizeable dividend increases. Philip Morris is not the type of company that will double overnight, but it still offers investors the opportunity for quality returns over the long haul.
Like almost any other business, Philip Morris has some areas of concern. The primary issue surrounding the company is that it does not have enough free cash flow to pay its dividend and execute its buyback plan. Currently, management has taken advantage of low interest rates by using debt to make up for the gap in funding. In the future, as rates rise or their debt load becomes too high, this borrowing will likely end. Once this occurs, Philip Morris will need to reduce the amount of shares it repurchases or cut its dividend. The buyback will almost certainly be the expenditure that is cut because dividend cuts tend to generate significant backlash from income investors. Potential investors should also consider that Philip Morris has seen lower than expected shipping volumes recently. Based on Philip Morris' macro picture, these volume declines seem likely to reverse, but nonetheless some investors are concerned. Investors need to consider these and other concerns when deciding whether or not to purchase Philip Morris.
The two above paragraphs outline some basics about Philip Morris that should be considered before investing. The decision to invest should be based on the future profitability of the company. Those who believe that Philip Morris will expand its market share and increase profits should purchase the company. Individuals who should not invest include those who believe that Philip Morris will fail to succeed in emerging markets and those who think that a more attractively valued alternative exists. Notice that in the areas of concern, the health risks of smoking and morality of investing in tobacco was conspicuously absent. The risks of smoking have been known for over half a century, yet tobacco companies remain profitable.
The use of ethical criteria when selecting stocks is not likely to boost returns. Investopedia defines ethical investing as using one's ethical principals as the main filter for securities selection. This stands in stark contrast to fundamental investing, where financial information is the main filter for securities selection. Unethical companies do not always make great investments, but continuously ignoring attractively priced companies because of ones ethics will almost certainly lead to less than optimal returns over time. As mentioned earlier, an investment decision boils down to estimating future earnings potential and paying a fair price for these earnings. An investor who uses an ethical lens has already removed many potential investments before they even begin to look at fundamentals. Finding good investments can be difficult even without limiting the types of companies one can consider. At the end of the day, investors are in the business of purchasing profits while ethical investors intentionally avoid profits from certain industries.
There is also the question of where to draw the line when deciding what companies are ethical. It seems that tobacco companies draw the ire of ethical investors more so than any other industry. While Philip Morris produces products that kill, so do many other companies. Alcoholic beverages and fast food have also been linked to health problems and kill thousands of Americans each year, yet for some reason companies like Brown Forman (NYSE:BF.B), McDonald's (NYSE:MCD), and Anheuser Busch InBev (NYSE:BUD) are mentioned much less frequently by ethical investors. One must also consider whether companies that harm the environment are unethical. If anything, I believe these types companies are morally worse as they harm unsuspecting people. With Tobacco, Alcohol, and Fast Food, the individuals being harmed are typically people making a conscious decision to consume a product that they know is dangerous. Damaging the environment causes indiscriminate harm. The victims are not limited to patrons of the company responsible for the pollution. However, these names are seldom discussed with the same outrage that is directed towards the tobacco industry. Ethical investors who avoid Big Tobacco because of the deaths caused by smoking need to consider the impact of all the companies they are invested in.
Finally, if ethical investing has no effect on a company, should it be continued? I understand that many individuals simply do not want money that comes from activities they do not condone. This message is not intended for them, but it is instead directed towards those who believe that by not buying stock they can somehow harm a company. Somehow a subset of investors have gotten it into their heads that they can stop Philip Morris by not purchasing shares of its stock. It's quite difficult to harm a multinational corporation; difficult turns into impossible when your primary mode of action has no effect whatsoever. When one buys or sells PM, the only thing that changes for Philip Morris is the name in their shareholder registry. All the shares available for purchase on a daily basis have already been issued by Philip Morris. When buying Philip Morris stock, the money is not going to Philip Morris, but instead to the current owner. Public offerings are the only times that companies will benefit from the sale of their own securities. Those looking to hurt the tobacco industry are best served by not purchasing tobacco products and avoiding public offerings of tobacco companies. Ethical investors should evaluate whether their strategy is having the impact they intend.
Ethical investing interferes with the unbridled pursuit of profits. While ethical investors have noble intentions, many seem to focus their ire arbitrarily on certain industries such as tobacco. Further, many seem unaware of the futility of their actions. If one is strongly opposed to a particular company or industry, their best and likely only shot at hurting said company or industry is to boycott their products. Not buying a stock has no effect on the company and, in the case of Philip Morris and similar companies, ethical investors are missing out on substantial dividends. Investors should focus on companies' fundamentals and growth prospects when making investment decisions. Ethical investing seems like a good idea on the surface, but digging a little deeper reveals many unsatisfying truths.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.