Jeremy Siegel’s book, ‘Stocks for the Long-run’ takes a look at the best performing stock in the last 8 decades. When dividends were reinvested Philip Morris (NYSE: PM) was the best performer in the S&P 500 between 1925 and 2007.

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. Over the 82-year period of the study Phillip Morris returned an average of 17% a year.

An exploration of the factors that led to these incredible returns offers lessons for investors today.

Low expectations

Philip Morris is a cigarette company. Over that 82-year period reviewed by Siegel there was a drastic decline in smoking. Smoking peaked in the US 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.

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.

To explain this apparent contradiction, Siegel refers back to the basic premise of investment returns. 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.”

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 is better to buy a stock that grows 7% if the market anticipates growth at 3%.

Many investors focus on the potential – and somewhat obvious – expected success stories for the future. Captivating growth potential for lithium’s use in electric car batteries, the blockchain revolution in banking and artificial intelligence all qualify as obvious growth opportunities.

These industries have seen large scale interest. Undoubtedly many investors are hoping they pick the 100-bagger that capitalises on the forecast of exponential growth. Investors believe this is the way to build wealth – buying a fast-growing company. However, will you have success with a fast-growing company if everybody thinks it is a fast-growing company? Likely not. Expectations matter.

A declining industry can have advantages for investors

Philip Morris was a company in a declining industry. It is little surprise this led to declining competition. Investors were not clamouring to fund start-up tobacco companies. This lack of competition can be a significant advantage for existing industry leaders.

The reason that 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 these activities reduce profits.

There is a trade-off. A growing industry makes life a lot easier for a company even if it leads to more competition. I will explore this trade-off further later. For now, the lesson is that investors shouldn’t reflexively ignore industries that appear to be in decline. We can explore two industries that investors currently have misgivings about.

There are many doubts around commercial property expectations as work-from-home continues to become a part of working life. Dexus is an Aussie stock 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 (ASX: CQR) and Unibail-Rodamco Westfield (ASX: URW).

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

In these declining industries there are companies that will prosper with reduced competition and a lack of new entrants. Peter Lynch speaks about this in his book, ‘One up on Wall Street’. He 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 favour and with major players are that can survive negative growth in the overall industry.

If we look at revenue CAGR (compound annual growth rate) over three years, it narrows the industries down to two in Australia – Energy Services and Forestry. However, 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 capitalise on the ‘reverse monopoly’.

Companies with moats, or moat-like characteristics

The stocks that I’ve mentioned (CQR and URW) are currently undervalued, but the key to successfully finding ‘reverse monopolies’ is focusing on companies with wide moats. These companies may not always be at attractive prices.

A company 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 growth their earnings for at least the next 10 years.

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

The market dynamics were essentially frozen in place. And Phillip Morris had an established brand with consumers with little risk of competitors building comparable brands.

They were also selling a product that was addictive. A recognisable brand and an addictive product led to pricing power. The smoking population was shrinking, but existing smokers were willing to pay more. This allowed Phillip Morris to continue to grow earnings over the long term.

Companies can gain their competitive advantage from five sources that Morningstar has identified:

Network effect: A 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, the more consumers who use Visa V credit cards, the more attractive that payment network becomes for merchants, which in turn makes it more attractive for consumers, and so on.

Intangible assets: Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products or allow the company to charge higher prices. For example, patents protect the excess returns of many pharmaceutical manufacturers, such as Novartis NVS. When patents expire, generic competition can quickly push the prices of drugs down 80% or more.

Cost advantage: Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, Cigna CI controls such a large percentage of U.S. pharmaceutical spending that it can negotiate favorable terms with suppliers like drug manufacturers and retail pharmacies.

Switching costs: When it would be too expensive or troublesome to stop using a company’s products, that indicates pricing power. Architects, engineers, and designers spend their entire careers mastering Autodesk's ADSK software packages, which creates very high switching costs.

Efficient scale: When a niche market is effectively served by one or only a handful of companies, efficient scale may be present. For example, midstream energy companies such as Enterprise Products Partners EPD enjoy a natural geographic monopoly. It would be too expensive to build a second set of pipes to serve the same routes; if a competitor tried this, it would cause returns for all participants to fall well below the cost of capital.

Cash, and healthy balance sheets

Financial strength plays a role in long term returns. Philip Morris was in part successful due to their healthy cashflow and low debt levels. Cashflow and profit are important. It is what allows companies to invest in growth related activities, or to issue dividends.

Philip Morris was an extremely well-run business. However, there were restrictions on growth activities such as marketing, and there was no use for R&D or expanding production. Although we have vapes, e-cigarettes and the like now, there was no market for these innovations for the period Siegel explored.

Without needing to use capital expenditures 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. However sometimes an adjacent expansion can make sense.

The other use of capital expenditures is to return cash to shareholders. And this was an area of focus for Phillip Morris. Dividends became a key source of shareholder returns.

When Siegel did the research for his book, he assumed dividends were reinvested. I previously mentioned the low investor expectations for Phillip Morris. As more regulation was introduced, more rounds of lawsuits were filled and continued declines in smokers those expectation continued to shrink.

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.

A future declining industry?

Ultimately, it is not just looking for a ‘reverse monopoly’ in a declining industry. It is matching this with the right stock in this 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.

A strong company can strengthen their hold on an industry even as it declines. The tobacco industry in the US 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.

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 hypothesised to be in the same position as the tobacco/cigarette industry.

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 a product that cannot be recreated or replaced in the short or medium term.

High grade coal burns cleaner than poor quality cool. 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. Rightfully so. Yet if there is a long timeframe until the world weans itself off of coal there is undoubtedly an advantage to having a higher quality product.

Economic growth in developing countries will require larger energy supplies 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.

Coal is a declining industry, but Australian 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 cashflows for coal producers as regulations prevent investment in new supply.

Dividends may be the only option left for coal companies. The industry may not be in favour with investors which will keep valuations low. Much of this is a hypothesis. Yet on the surface there are some similarities to tobacco.

Conclusion

Picking individual shares is not easy. And it is not an approach for everyone. If an investor is going to select individual shares, it is 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 leads to can have negative impacts on long-term returns.

We encourage investors to keep a ‘wish list’. Companies that they believe align with their investment strategy, and that they hope to invest in when the price is attractive. Mark has spoken about his wishlist before on Investing Compass.

Being a contrarian has been rewarded in the past by taking a different view to the market. It is the case with Philip Morris. I’ve written about it maybe being the case with Japan. I’ve also speculated about where contrarians are going now. Investing in companies with strong prospects that have fallen out of favour will reduce the overall risk in your portfolio.

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