There was a popular game show in the 1950s called “I’ve Got a Secret.” A celebrity panel received clues, then they tried to guess a contestant’s “secret.”

Let’s play a similar game.

Using these clues, try to guess the stock being referenced: 

• I was the best performing stock in the second-half of the 20^th century
• I’ve averaged a 20% annual return since 2000 
• I used to sponsor television shows but not anymore

Who am I?

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If you guessed Altria (the company formerly known as Philip Morris), you’re correct!

The Marlboro Man may be a controversial fellow, but he’s treated shareholders extremely well.

Credit Suisse published a report in 2015 chronicling the performance of every major American industry from 1900 to 2010. Tobacco blew the other industries away. A single dollar invested in tobacco stocks in 1900 was worth $6.3 million by 2010—a startling 165 times greater than the average American industry!

Altria has continued to deliver smoking returns in the new millennium, returning 21.8% annually since 2000—trouncing the S&P 500’s average return of 4.5%. 

You may be thinking:

• Wait… isn’t public smoking banned just about everywhere?
• Aren’t tobacco companies being sued… like all the time?
• Why would anyone invest in companies that poison their customers?

Such assertions are reflected in broad industry data. Total cigarette consumption peaked in 1981 and has been declining ever since. By unit sales, tobacco is actually one of the worst industries of the last thirty years.

So why has Altria compounded such high returns? 

Several factors are at play. And here’s the best part—you can apply these insights to stocks outside the realm of tobacco.

Boring is Beautiful

Humans value novelty. It’s part of our cognitive hardwiring.

The caveman part of our brain also likes shiny things. Slick features and benefits are appealing.

Altria isn’t new or shiny. It’s an old company fraught with persistent headline risk.

Yet Altria has been able to overcome declining unit sales, because it consistently raises prices. Addicted customers make for a price inelastic, loyal following, which also happens to be very lucrative. For years, tobacco firms have earned among the highest returns on capital of any industry.

Tobacco firms also benefit from low capital requirements. In other words, they don't have to reinvest a high proportion of profit into maintaining fixed assets, such as plants and equipment, to continue producing sales. That results in a high free cash flow conversion rate, which is one reason Altria investors have enjoyed spectacular returns. 

The other main reason has to do with valuation.

"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 expect."  - Jeremy Siegel, The Future For Investors 

Tobacco stocks are consistently underestimated by consensus, which has helped garner higher returns. 

In a 2005 study, Professor Jeremy Siegel found Philip Morris delivered annual earnings growth of 14.8% between 1957 – 2003. This growth rate was well higher than the 9.7% average of S&P 500 companies.

Despite superior growth, Philip Morris' stock traded at a discount to the market over this period, resulting in an above-average dividend yield. Reinvesting a healthy flow of dividends allowed investors to accrue a lot more stock. Accumulating more and more shares, whose prices were gradually being pushed higher by earnings growth, produced unique exponential compounding.

What if there were not negative headlines, or moral concerns surrounding Altria? The expectations hurdle would have no doubt been steeper. That would mean fewer dividends per share (i.e. lower dividend yield). Less reinvestment opportunity means less shares owned, and ultimately—lower long-term returns.

Capitalizing on this insight does not require you to confine your portfolio to so-called ‘sin stocks.’ Anything that causes investors to overlook business quality can create a lucrative investment opportunity.

You can hunt for bargains in areas people might find boring. Take self-storage REITs, for example. There is nothing glamorous about that business. People rent space to store belongings. That’s it.

However, this “boring” sector has crushed the stock market over the last two decades. From December 1993 to June 2017, the self-storage industry returned 15.8% per annum, eclipsing all other REIT categories.

Public Storage (PSA) is the ‘best of breed’ player. Their portfolio of over 2,000 facilities is bigger than the next two competitors combined, providing meaningful scale advantage. Since PSA only occupies 6% of the fragmented U.S. self-storage market, there is still plenty of room for growth.  

The company has a pristine balance sheet and peer-leading rent and occupancy rates. Almost 60% of tenants rent for longer than a year and regularly accept renewal rent hikes of 8-10%.

Over the last twenty years, PSA has averaged earnings growth of 9.4%, while sporting an above-average dividend yield of 3.8%. These stats compare favorably to the S&P 500’s 5.2% earnings growth rate and 2.0% average dividend yield (9/30/1997 – 6/30/2017, source: Bloomberg). 

Remember Altria’s magic return elixir? Attractive growth combined with high dividends.

Similar ingredients have handsomely rewarded PSA shareholders. Since 1997, PSA’s cumulative return is a jaw dropping 1,382%! 

Not bad for a company whose business probably strikes most people as simple and mundane.

 

Hindsight is 20/20

As it turns out, the real secret to investing—buy low, sell high—isn’t much of a secret at all. But while this mantra may be easy to recite, it often proves much more difficult to execute.

A cruel irony is that it often pays best to do the hard things. Like reducing exposure at a market high, putting cash to work in a cascading market, or owning stocks that don’t seem appealing at first glance.

With the benefit of hindsight, it’s easy to diagnose trends. The challenge is finding the next winner in the present.  In the moment, we have perceptions about the world we inhabit, but those perceptions are not always congruent with reality.

For example, below is a clip from an episode of “I’ve Got a Secret.” An elderly gentleman recounts seeing a man fall from a balcony to a theater stage. In the moment, he had no idea he was witnessing one of the most monumental events in American history.

There is no guarantee Altria or Public Storage will continue to be strong investments in the future. But by studying the cause/effect relationships of these outperformers, we can at least better contextualize present opportunities and hopefully make better decisions as a result.

 

 

 

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Sources: Bloomberg, The Future For Investors: Why The Tried And The True Triumph Over The Bold And The New,  by Jeremy Siegel

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.