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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: And before we get into this episode, we wanted to speak a little about a project that we've been working on. And the purpose of this podcast is to provide free, accessible information and guidance to help investors. And in that spirit, we've also created a free educational course.

Jayamanne: And it's a foundational course on how to invest successfully. It covers a lot of the same concepts that we do in the podcast, but it is a self-paced course that focuses just on the basics. So we'll pop a link to it in the bio.

LaMonica: All right. So today's episode, we've spoken about Philip Morris before on Investing Compass. And it was based on research in Jeremy Siegel's book, Stocks for the Long Run. And the book takes a look at the best performing stock in the last eight decades up until when it was written.

Jayamanne: With dividends reinvested, Philip Morris was the best performer in the S&P 500 between 1925 and 2007.

LaMonica: And a $1,000 investment in 1925 would be worth a staggering $380 million in 2007. The position would be worth close to $1 billion today. So over the 82 year time period of the study, Philip Morris returned an average of 17% a year.

Jayamanne: So today, we're going to look at the factors behind the success of the stock and how it led to the incredible returns that the stock achieved.

LaMonica: Okay.The first factor is something that Philip Morris and I have in common, and that is low expectations. So Philip Morris is a cigarette company. So over that 82 year period reviewed by Siegel, there was a drastic decline in smoking. So smoking peaked in the U.S. in 1961 and declined significantly as health issues became widely known. Many investors don't consider a declining industry as a key ingredient in a recipe for investing success.

Jayamanne: And this was also a period when cigarette companies faced mammoth lawsuits and restrictions were introduced globally on advertising tobacco products. Warning labels were slapped on the boxes. A company facing all these dire challenges seems to be a poor candidate for strong returns.

LaMonica: And so in this book, Siegel refers back to the basic premise of investment returns to explain this contradiction. And he reminds readers that the long term return on a stock depends not on the actual growth of its earnings, but on the difference between its actual earnings growth and the growth that investors expected.

Jayamanne: Many investors lose sight of this fact. There is little benefit from purchasing an AI stock growing at 30% if that growth is already priced into the stock. It's better to buy a stock that grows at 7% if the market anticipates growth at 3%.

LaMonica: And many investors focus on the potential and somewhat obvious expected success stories for the future. We saw this with the captivating growth potential for lithium's use in electric car batteries, the blockchain revolution in banking and artificial intelligence. They all qualify as obvious growth opportunities.

Jayamanne: These industries have seen large scale interest from investors and many investors are hoping that they pick the hundred-bagger that capitalizes on the forecast of exponential growth. Investors believe this is a way to build wealth, buying a fast growing company. But ultimately, will you have the success with a fast growing company if everybody thinks it's a fast growing company? Likely not. And that's because expectations matter.

LaMonica: The second factor is a declining industry. Philip Morris was a company in a declining industry as we discussed. And this can have advantages for investors due to declining competition.

Jayamanne: So investors were not clamoring to fund startup tobacco companies. This lack of competition can be a significant advantage for existing industry leaders.

LaMonica: The reason the investors search for a company with a moat or sustainable competitive advantage is because competition can lead to bad outcomes for investors. Responding to competition causes companies to lower prices, invest in product innovation and spend more on marketing. All of these activities reduce profits.

Jayamanne: So there is a trade-off. A growing industry makes life a lot easier for a company even if it leads to more competition. And we'll talk about this trade-off a little later. But now the lesson is that investors shouldn't reflexively ignore industries that appear to be in decline. So why don't we have a look at two industries that investors are skeptical about for future growth?

LaMonica: Well, the first is commercial property. There are many doubts around commercial property as work from home continues to become a part of working life. So Dexus is an Australian share that our analysts believe is being unfairly punished due to negative investor sentiment against commercial property. Retail sales continue to decline as more consumers prefer online retail. There are several REITs focusing on retail property that are undervalued, such as Charter Hall and URW.

Jayamanne: While commercial property and retail property face headwinds, there is little risk that both will completely disappear. People will still go into the office and shop in shopping centers. The key is finding companies that are best placed to continue to thrive in this difficult environment.

LaMonica: All right, let's move on to the next factor. We see that continued investment in some resources and commodities are dwindling. Coal is an example where global efforts to reduce carbon emissions is restricting investments in new coal capability. Even as the world moves away from coal, there will be continued demand as the world is not yet prepared to meet energy needs through renewable sources.

Jayamanne: In these declining industries, there are companies that will prosper with reduced competition and a lack of new entrants.

LaMonica: And Peter Lynch writes about this in his book, One Up on Wall Street. Points out that industries with reducing competition and negative growth become reverse monopolies. He encourages investors to look at industries that have fallen out of favor and with major players that can survive negative growth in the overall industry.

Jayamanne: Let's look at some Aussie-specific examples backed by data. So if we look at revenue CAGR, so compound annual growth rate over three years, it narrows the industries down to two in Australia, energy services and forestry. However, you can't just stop there and look for companies in these industries and invest in them. There are multiple factors to Philip Morris' success that must be considered. You need to find the right stock and in the right declining industry to capitalize on the reverse monopoly. And that leads us to moats or moat-like characteristics.

LaMonica: We've spoken about Charter Hall and URW. They're currently undervalued. The key to successfully finding reverse monopolies is focusing on companies with wide moats, and that's certainly something I try to do in my own investing.

Jayamanne: Mark speaks about purchasing American Tower. It has been on his wish list for a very long time, but unfortunately, it hasn't really been at an attractive price. He ended up purchasing the stock when it was fairly valued.

LaMonica: So these companies may not always be wildly undervalued. Companies with a wide moat can protect and grow their earnings for at least the next 20 years. Companies with a narrow moat can protect and grow their earnings for at least the next 10 years.

Jayamanne: With Philip Morris, it was in an industry with tightening regulations around advertising and marketing. Prior to this tightening, Philip Morris had arguably been the most recognizable and established cigarette brand in Marlboro. With marketing frozen, this became a moat source.

LaMonica: The market dynamics were centrally frozen in place, and Philip Morris had an established brand with consumers with little risk of competitors building comparable brands. They were also selling a product that was addictive. So a recognizable brand and an addictive product led to pricing power. Smoking population was shrinking, but existing smokers were willing to pay more. So, it allowed Philip Morris to continue to grow earnings over the long term.

Jayamanne: So we speak about moat sources when relevant during our shared deep dives, but we will go through an overview of the five that Morningstar has identified.

LaMonica: So the first is network effect. Network effect occurs when the value of a company's service increases for both new and existing users as more people use the service. For example, social media. More people that use Instagram, the more likely that you're going to sign up for that social media platform. There isn't really much point in a social media platform without your friends on it.

Jayamanne: The next is intangible assets. Patents, brands, and regulatory licenses are examples of intangible assets. Marlboro is an intangible asset as a brand. It can prevent competitors from duplicating a company's products or allow the company to charge higher prices. Another example is patent protection for pharmaceutical companies. When patents expire, generic competition can quickly push the prices of drugs down by 80% or more.

LaMonica: And we have cost advantage. Firms with a structural cost advantage can either undercut competitors on price while earning smaller margins, or they can charge market level prices while earning a relatively high margin. An example of this would be the big four banks. Due to their scale, they're able to access cheaper wholesale rates. It makes it difficult for smaller banks to compete.

Jayamanne: Switching costs is our next moat. This is when it would be too expensive or troublesome to stop using a company's product that indicates pricing power. A great example of this is Apple. Once you're in their ecosystem, it is extremely difficult to get people to leave. We've done a share deep dive on Apple as a stock if you're interested in learning more.

LaMonica: And during that deep dive, Shani, you said walled garden.

Jayamanne: Yes.

LaMonica: A lot

Jayamanne: Walled garden approach. That's what they've got.

LaMonica: Exactly. All right. The last moat source is efficient scale. So when a niche market is effectively served by one, or only a handful of companies, efficient scale may be present. And Telstra's a good example of this. It would be too expensive to build another network to serve the same routes. But competitor tried this. It would cause returns for all participants to fall well below the cost of capital.

Jayamanne: So as investors, understand whether the companies you are interested in hold any of these characteristics.

LaMonica: All right. So we're going to move on to the next factor that helped Philip Morris achieve those phenomenal returns. That is cash and a healthy balance sheet.

Jayamanne: Financial strength plays a role in long-term returns. Philip Morris was in part successful due to their healthy cash flow and low debt levels. And cash flow and profit are important. It's what allows companies to invest in growth-related activities or to issue dividends.

LaMonica: And Philip Morris was an extremely well-run business. But there are restrictions on growth activities such as marketing, and there is no use for R&D or expanding production. Although we have vapes and e-cigarettes now, there is no market for these types of products for the period that Siegel explored.

Jayamanne: Without needing to use capital expenditure on growth activities, Philip Morris was able to focus their efforts elsewhere. The first was diversification. Philip Morris purchased Kraft. They weren't the only cigarette company to diversify. RJR acquired Nabisco. Investors should be wary of these efforts as a pivot into a new industry can be difficult, but sometimes an adjacent expansion can make sense.

LaMonica: And the other use of capital is to return cash to shareholders. And this was an area of focus for Philip Morris. Dividends became a key source of shareholder returns. When Siegel did the research for his book, he assumed dividends were reinvested. We previously mentioned the low investor expectations for Philip Morris as one of these factors. As more regulations introduced, more rounds of lawsuits were filed, and continued declines in smokers, those expectations continued to shrink.

Jayamanne: Dividends were reinvested at low valuations, which meant that more and more shares were purchased over time. At the same time, the dividend was growing as long-term investors acquired more and more shares. This combination compounded the impact of dividend growth.

LaMonica: Ultimately, it's not just looking for a reverse monopoly in a declining industry. It is matching this with the right stock in that industry. The right stock will have a strong moat. In the case of Philip Morris, it was a combination of a declining industry, excellent management, pricing power, and low expectations.

Jayamanne: Okay, so those are the factors. Low expectations, declining industry, a moat, healthy balance sheets. Where can we look to now for potential opportunities?

LaMonica: Well, a strong company can strengthen their hold on an industry even as it declines. The tobacco industry in the U.S. became more concentrated as smoking rates declined. Marlboro was the beneficiary as the brand went from a 5% market share in 1957 to 30% by 1995.

Jayamanne: Ultimately, you want a strong company that still does very well for shareholders regardless of how the industry is doing. The coal industry may be hypothesized to be in the same position as tobacco and cigarette industries.

LaMonica: And Australia produces some of the highest quality coal in the world. Many Australian coal producers in our equity analyst coverage do not have a moat as they produce commodities. However, it can be argued that Australian coal does have protection due to the quality of the product that cannot be recreated or replaced in the shorter medium term.

Jayamanne: High-grade coal burns cleaner than poor quality coal. It is also sought after because it has a smaller environmental footprint than lower grades. Much of the focus is the difference between carbon emissions from coal and clean energy sources, and rightfully so. Yet, if there is a long time frame until the world weans itself off of coal, there is undoubtedly an advantage in having a higher quality product.

LaMonica: An economic growth in developing countries will require larger energy sources to power larger economies and higher standards of living. Renewable energy will not be able to meet this requirement. Coal-fired power stations using Australian coal may be one of the answers to meet emissions reduction targets and ambitious growth in power generation.

Jayamanne: Coal is a declining industry, but Aussie coal is a preferred option. Although there is limited pricing power, there may be a longer runway of production than some investors expect. There are limited options for the cash flows for coal producers as regulations prevent investment in new supply.

LaMonica: And dividends may be the only option left for coal companies. Industry may not be in favor with investors which will keep valuations low. And much of this of course is a hypothesis, yet on the surface there are some similarities to tobacco.

Jayamanne: Picking individual shares is not easy and it is not a approach for everyone. If an investor is going to select individual shares, it's worth considering that doing what everyone else does is not a strategy for success. What most investors do is chase growth. Industry growth and the relentless competition it can lead to can have negative impacts on long-term returns.

LaMonica: And as I alluded to earlier, you should have a wish list and act upon that wish list when the price is right. You've always encouraged investors to keep a wish list. Companies that they believe align with their investment strategy that they hope to invest in when the price is attractive.

Jayamanne: And lastly, being a contrarian has been rewarded in the past by taking a different view to the market. It is the case with Philip Morris. Investing in companies with strong prospects that have fallen out of favor will reduce the overall risk in your portfolio.

LaMonica: And that is our episode for today. And Shani, I think it's safe to say we're not going to win any ESG awards for talking about tobacco and coal. But we hope that you found it interesting anyway. We, of course, would love your feedback and a rating in your podcast app. So thank you very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)