Do You Want To Invest In America's Most Profitable Industry?

Summary

• Looking for an alternative to tech stocks?
• It’s a largely forgotten industry except among institutional investors.
• It’s an old industry but is all about technology and innovation.

By Dan Ahrens, chief operating officer of AdvisorShares and portfolio manager of the AdvisorShares Vice ETF (Ticker: ACT)

This should be an easy question. But it’s rather complicated. In recent years, the equity markets have been on a terrific bull run – particularly in the U.S. It’s been widely publicized that the current market is dominated by just a smaller number of technology-related names that now make up a huge percentage of most stock market averages. Some of these tech stocks related to social media aren’t profitable. Others have just recently turned profitable after years with high flying stock prices while they were still unprofitable. Many online retailers that are finally showing good profits, have much of their profit due to advertising sales. The profits they make through goods and services derive from extremely large volumes with thin profit margins per sale.

So – what is the world’s most profitable industry? Tobacco. It’s largely a forgotten industry – except among institutional investors that understand its profits and performance. Many individual investors assume it must be a poor investment with declines in smoking, known health risks, high taxes, and constant legislative pressures. The opposite is true. Total revenues for U.S. tobacco companies reached $117 billion in 2016, up from less than $80 billion in 2001. At the same time, tobacco companies have consolidated through mergers and cut costs. Fewer and fewer people are smoking, but tobacco revenues have soared through years of steady price increases. With a large portion of cigarette sales going to taxes, it's easy for tobacco companies to tack on extra profit margin for themselves. A pack of cigarettes costs very little to produce.

There are many sources and metrics for company or industry data including profitability. Some of the most complete and useful information can be found at Damodaran Online Data. Last updated January 5 of this year, they show U.S. net profit margin for Tobacco at 43.37% – far out in front of any other industry (various industries including Financial Services, Banks, REITs, Software, and Beverages followed in the twenties). A number of other measures of pre-tax or after tax adjusted operating margins also showed Tobacco as the top industry.

As tobacco companies are rich with cash, how does all this translate to stock performance?

Through the end of 2017, the Dow Jones US Tobacco Index (Total Return) averaged 16.51% over the last 5 years and 17.33% over the past 10 years. For the same periods, the S&P 500 (Total Return) averaged 15.79% and 8.63%.

I must say, the performance shocks most people – even me. The stock market news is dominated by high flying technology stocks. Discussions of tobacco stocks seem mostly limited to health risks and smoking bans.

What does the future look like? In my opinion, it looks very profitable, but different. Tobacco is a very old industry, but the modern tobacco industry is all about technology and innovation. New “heat not burn” tobacco devices have already been approved in at least 29 other countries. The largest, or most widely used is called iQOS. Heat-not-burn products only heat tobacco. There is no combustion. The heating process generates a tobacco flavored nicotine-containing vapor. According to the industry, since the tobacco does not burn, the levels of harmful chemicals are significantly reduced compared to cigarette smoke. At this point in the United States, the FDA doesn’t want to say it agrees. In January, a panel gave a non-binding recommendation to NOT allow these products to be marketed as “safer”. It’s expected that the FDA wants more data before there will be any type of formal U.S. approval. I think that approval will come in only a matter of time. Just this month, the FDA announced a major initiative to reduce nicotine levels. Heat-not-burn should play right into that. (Perhaps they just wanted it to sound like their idea, rather than the Tobacco Industry’s).

Japan is one country where iQOS is already thriving. And iQOS is profitable! From 2015 to 2017, iQOS market share grew from 0.4% of the combined cigarette/heat market to 14.1%. It’s been reported that 75% of people using iQOS have quit smoking. Between decreased cigarette sales but added iQOS business, combined national market share for the company behind iQOS increased from approximately 25% to more than 32%. (Goldman Sachs, in a March 5, 2018 report, claims that company doubled its profits in Japan with the increased market share).

At this point in 2018, many large tobacco companies are trading near their 52-week lows. It’s obvious that delayed FDA approval combined with declining smoking rates and continued legislative risk do continue to weigh on tobacco stocks. I think it’s quite possible that these cash-rich companies may be a great buy at current prices.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.