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My Favorite Tobacco Stock is…Intel?

By Charles Lewis Sizemore, CFA on January 8, 2013 in Investing, Most Popular

Yes, you read that correctly. My favorite “tobacco stock” is Intel Corp (Nasdaq:$INTC).

Lest you think I’ve lost my mind, I am aware that Intel does not sell or market cigarettes or other tobacco products. Intel is the world’s premier designer and manufacturer of computer processors.

But while Intel is not a tobacco company, it most certainly is a tobacco stock, or at least it shares many of their characteristics.

This requires a little explaining. If you’ve read some of my past posts, you are probably familiar with my reasons for liking tobacco stocks over the long haul, even if I recommend avoiding them at current prices (see “The Price of Sin” and “Time to Stop Bogarting Cigarette Stocks”). Because of the social stigma associated with vice investments like tobacco, alcohol and firearms, many institutional investors shun them, either by choice or by socially-responsible investment mandate. This causes sin stocks to be priced as perpetual value stocks, with the low valuations and fat dividends that this entails.

Well, I admit, in this particular respect Intel has nothing in common with tobacco stocks (even if it is priced like one at the moment). It’s hard to find a scale by which Intel would be considered socially irresponsible. But let’s take a look at some of the other characteristics that make tobacco stocks—and Intel—interesting.

Tobacco companies have gargantuan barriers to new competition—what Warren Buffett might call an unassailable moat. Given the legal and political risk and the size and scale needed to deal with both, it would be next to impossible to start a new tobacco company now. You would need infinitely deep pockets and decades’ worth of political connections. As a result, Big Tobacco has become an entrenched oligopoly in which a handful of players—such as Altria (NYSE: $MO), Reynolds American (NYSE:$RAI) and Lorillard (NYSE:$LO)—completely dominate.

But even if you could start a new tobacco company, why would you? It’s not exactly a business with a bright future. In the developed world, tobacco is a business in steady but terminal decline.

This brings me back to Intel. I’m actually in the minority among investors at the moment in that I see a bright future for Intel. No, they haven’t figured out mobile yet, but they will. As mobile devices become more and more sophisticated, they will need the power than only Intel can provide. And there is also the server business, which accounts for roughly a quarter of Intel’s revenues. Ironically, while Intel has yet to really break into mobile, its server business has benefitted handsomely as the mobile revolution has created greater demand for cloud services.

Yet this is not how the market views Intel right now. No, Intel is a company resigned to gentle decline, as its core PC market inevitably shrinks. From the way Intel bears talk, PC users are disappearing from polite company faster than smokers, forced to type on their physical keyboards in alleys behind buildings or in doorways.

For the sake of argument, let’s assume they’re right. Intel would still be a buy at current prices.

As the Big Tobacco has proven for decades, companies in declining industries can make excellent investments under the right conditions. If you have a dominant market position (think back to Warren Buffett’s “moats”), a conservative balance sheet, and have ample cash flow for share repurchases and dividends, you can do quite well by your investors even in a shrinking market. It’s worked for Big Tobacco investors, and it will work for Intel investors as well.

At just 9 times earnings, Intel is priced significantly cheaper than any major tobacco stock, and its dividend is competitive at 4.3%. I might add that Intel’s dividend has risen by over 40% in the past two years and that its dividend still only accounts for 37% of (depressed) earnings.

Buy Intel and reinvest your dividends. If I am right, Intel will regain its place among America’s most reputable growth stocks. But even if I’m wrong, Intel is positioned to offer “tobacco like” returns for the foreseeable future.

Note: The “Intel is a tobacco stock” concept was conceived during a podcast interview with InvestorPlace Editor Jeff Reeves in which we each discussed our picks in the 10 Best Stocks of 2013 contest. Jeff’s choice was Intel; mine was German luxury carmaker Daimler (OTC:DDAIF).

Disclosures: Sizemore Capital is long INTC and DDAIF

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Review of Nassim Taleb’s Antifragile

By Charles Lewis Sizemore, CFA on December 19, 2012 in Book Reviews, Most Popular

We all know what “fragile” means. But what is the opposite of fragile?

If you are like me, your instinctive response would be “robust” or perhaps “durable.” But you would be wrong.

Something that is fragile is damaged by an unexpected shock, whereas something that is robust or durable is able to withstand it. To be robust is to be neutral to shocks.

But what do you call the true opposite of fragile—something that actually benefits from shocks?

As Nassim Taleb points out, there is no word in English (or in any other language, ancient or modern) that conveys this idea. So he invented one—antifragile—and wrote an entertaining and enlightening book around the concept.

Taleb is at times playful and even self-effacing in his writing and at other times insufferably arrogant (“non-meek” in his words). But he is always—and I mean always—thought provoking.

Years ago, before Taleb become something of a celebrity, I picked up his original Fooled by Randomness and had something of a “eureka” moment. Taleb put into words (and numbers) many of the abstract ideas about risk and randomness that I instinctively felt yet couldn’t articulate (he had that effect on a lot of people, it would turn out). In particular, I had always mistrusted the Value-at-Risk metric and its offshoots that had been crammed down my throat as an undergraduate finance student. It registered on my “bulls_t detector”, to borrow one of Taleb’s earthy phrases, and history would vindicate this gut reflex with implosion of the financial system in 2008.

I still consider Fooled to be his best book, and if you have never read Taleb’s work that is where I would recommend you start. But Antifragile: Things That Gain From Disorder expands on the concepts in Fooled and its follow-up The Black Swan and goes far beyond financial markets into a more general theory of randomness and volatility and their importance in life and nature. “Living things are long volatility,” he emphasizes often.

Perhaps Taleb’s greatest gift as a writer is his ability to speak in metaphors, the best of which is his analogy of the Procrustean Bed (see my review of Taleb’s The Bed of Procrustes).

Procrustes was a nasty little fellow from Greek mythology who would invite guests into his home and then either stretch or amputate parts of their legs to make them fit just right in his guest bed. In Taleb’s analogy, much of the modern world is a Procrustean bed of sorts. People, markets, and economic systems are contorted to fit tidy theories.

But in Antifragile, Taleb goes beyond this “square peg in a round hole” argument to a larger critique of “soccer moms” (both figurative and literal) who naively attempt to make the world safer by “sucking randomness out to the last drop.” Doing this provides the illusion of safety while actually making us less resilient and more fragile. In other words, not only are scraped knees and bruises ok, they are an essential part of growth.

Many readers misunderstand Taleb’s core message. They assume that because Taleb writes about unseen and improperly calculated risks, his objective must be to reduce or eliminate risk. Nothing could be further from the truth.

If anything, Antifragile is a celebration of risk and randomness and a call to arms to recognize and embrace antifragility. Rather than reduce risk, organize your life, your business or your society in such a way that it benefits from randomness and the occasional Black Swan event.

Taleb’s own life is a case in point. He had the free time to write Fooled, The Black Swan and Antifragile because—in his own words—he made “F___ you money” during the greatest Black Swan event of our lifetimes, the 1987 stock market crash. And to demonstrate that Taleb’s trading style is antifragile, had the 1987 crash never happened, Taleb would not have been materially hurt. His trading style puts little at risk but allows for outsized returns.

In what may seem somewhat disturbing to some readers (and Taleb himself is disturbed by it as well), what makes a system antifragile is that its individual pieces are perishable. Natural selection—the survival of the fittest—requires that the unfit are allowed to fail.

Using the example of restaurants, the restaurant sector is robust because the failure of any one restaurant does not affect the others. And the restaurant sector is antifragile because the remaining players actually learn and grow from witnessing the mistakes made by the failed restaurant.

Now, compare this to the banking system. The world banking system is inherently fragile because the failure of one bank leads to contagion that can cause the failure of other banks and of the system itself.

The importance of failure to an antifragile system is a recurring theme to the book. As individuals and as a collective, we learn more from mistakes than from successes. In a capitalist system, you need a replenishable supply of entrepreneurs willing to take risks. For every failed business idea, our knowledge base expands.

Taleb goes so far as to advocate we treat ruined entrepreneurs in the same way we honor dead soldiers, “perhaps not with as much honor, but using the same logic.”

As Taleb explains, just as “there is no such thing as a failed soldier, dead or alive (unless he acted in a cowardly manner), likewise there is no such thing as a failed entrepreneur or failed scientific researcher.” Their sacrifice makes the system stronger.

I commend Taleb on another book well written, and I recommend Antifragile along with Fooled by Randomness and The Black Swan.

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Investing Lessons: Avoiding the Peter Lynch Bias

By Charles Lewis Sizemore, CFA on November 8, 2012 in Behavioral Investing, Investing, Most Popular

The single most important lesson I’ve learned about being a successful investor is the need to maintain emotional detachment. Any feelings you may have towards a stock are unrequited. If you love a stock, it will not love you back. And if you hate a stock, it will not give you the satisfaction of responding in kind. (As tragic as unanswered love may be, unanswered hate is often more damaging to your pride.)

A stock is like that unattainable cheerleader you had a crush on in high school. She neither loved you nor hated you; she was completely unaware you existed.

No matter how much you love a stock (and write favorably about it in MarketWatch) it will not reward your loyalty by rising in price. And heaven help you if you allow your emotions to cloud your judgment in a short position. I know of no surer way of losing your investment nest egg than to short a stock or other investment you hate. Alas, I know from experience; I shorted the Nasdaq 100 in the fall of 2003. In an outbreak of moral high-horsing that has (thankfully) now been purged out of me, I decided that tech stocks were overpriced and needed to fall further. The Nasdaq had very different ideas, and I was forced to cover that short at a 20% loss with my tail tucked between my legs.

A closely-related investment mistake is succumbing to what I call the “Peter Lynch bias.”

Peter Lynch ran the Fidelity Magellan fund from 1977 to 1990 and had one of the best performance records in history for a mutual fund manager—an annualized return of over 29% per year.

Unfortunately, he also offered some of the worst advice in history when he recommended that investors “invest in what they know.”

On the surface, it seems like decent enough advice. If you stumble across a product you like—say, a particular brand of mobile phone or a new restaurant chain—then it might be reasonable to assume that others will feel the same way. If the stock is reasonably priced, it might make a good investment opportunity.

Unfortunately, “investing in what you know” tends to create muddled, emotionally baggaged thinking. The fact that you like Chipotle (NYSE:$CMG) burritos and are intimately aware of every ingredient used in the red salsa does not automatically make Chipotle a good investment any more than your liking of Frappuccino makes Starbucks (Nasdaq:$SBUX) a good investment. Rather than give you an insightful edge, liking the product causes you to lose perspective and see only what you want to see in the stock.

How do we mitigate our emotional impulses?

In a prior article, I noted that “brain damage can create superior investment results.” But short of physically re-wiring our brains, what can we actually do?

I try to follow these basic guidelines and recommend them:

If you like a company’s products, try using one of their competitors before seriously considering purchasing the stock. If I had really taken the time to learn how to use an Apple (Nasdaq:$AAPL) iPhone or Google (Nasdaq:$GOOG) Android device, I probably wouldn’t have gotten sucked into the Research in Motion (Nasdaq:$RIMM) value trap. Yes, RIMM was one of the cheapest stock in the world when I recommended it last year. But I cannot deny that my decision to recommend it was biased by my ownership of a BlackBerry phone. Likewise, many iPhone owners are probably buying Apple for similar reasons today.
To the best extent you can, try to follow trading rules and use stop losses. What works for one investor will be very different than what works for another. Perhaps you use a hard stop loss of, say, 10% below your purchase price. Or perhaps you use a trailing stop or 20-25%. If you are a value investor, perhaps you base your sell decision on valuation or fundamentals rather than market price. But in any event, my point stands. Lay out the conditions under which you intend to sell and stick to them. Stock ownership is a marriage of convenience with quick, no-fault divorce if your situation changes. Don’t make the mistake of falling in love.
Unleash your inner Spock. For readers who are not Star Trek fans, Spock is an alien from the planet Vulcan who is incapable of feeling emotions. When talking about a stock or watching its price fluctuate gets your heart racing, take a step back and try to look at the investment through Spock’s eyes. Is it logical? Do the numbers make sense? Are the growth projections based on reasonable facts or on optimistic hope? Would you buy a different company if it were trading at the same price multiple?

Admittedly, these are not precise guidelines. But then, another lesson I learned is that it is a mistake to try to be too precise in this business. Follow the lead of great value investors like Benjamin Graham and Warren Buffett by making sure you have a wide margin of safety in your assumptions.

Disclosures: Charles Sizemore has no positions in any securities mentioned. This article first appeared on MarketWatch.

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It’s Time to Stop Bogarting Cigarette Stocks

By Charles Lewis Sizemore, CFA on October 23, 2012 in Investing, Most Popular

You know you have reached a certain level of immortality when your name becomes a verb, and I can think of no better example than the American actor Humphrey Bogart, perhaps best known for his role in that all-time classic Casablanca.

“To Bogart” a cigarette is to leave it dangling sloppily in your mouth, even when speaking, rather than engaging in proper smoking etiquette by giving it a few puffs at a time and then removing it. Over the years, the word has also come to mean to greedily hog something.

Today, I would say both meanings of the word are accurate descriptions of investors in tobacco stocks. Investors are “Bogarting” cigarette stocks by continuing to hold them at current prices.

First, a little disclosure is needed. I have been a major fan of sin stocks in general and cigarette stocks in particular for years (see “Not All Sin Stocks are Created Equal” and “Delightfully Sinful Dividend Stocks” as recent examples.

But my enthusiasm for Big Tobacco rested on two big assumptions:

They are largely despised by both individual and institutional investors due to their pariah status as politically incorrect merchants of death—making them perpetual contrarian value investments.
They pay high and growing dividends that are significantly better than what can be found elsewhere among mainstream large-cap stocks.

Unfortunately, I cannot credibly say that either of these conditions still hold. Cigarette stocks have become downright trendy of late as investors have taken to chasing yield in a low-interest-rate world.

Let’s take a look at Philip Morris International (NYSE:$PM), the seller of the iconic Marlboro brand among many others.

For years Philip Morris appeared to be the perfect stock. It had access to emerging market growth (roughly half its sales) while benefitting from an American listing and top-notch management. It also paid a dividend far higher than the norm among stable U.S. blue-chip stocks, and that dividend was growing every year.

There’s one little problem here: Philip Morris International is still a tobacco company. Its sales may be enjoying a multi-year boost as emerging market smokers trade up from cheaper local competitors to premium Western cigarettes, but worldwide demand for their products is shrinking, and fast.

In its most recent quarterly release, Philip Morris International saw its profits fall 6% on lower volume sales.

And perhaps worse, the regulatory noose continues to be tightened. Consider Australia’s new plain packaging law. All cigarette boxes for all brands now look identical in Australia. Cigarettes must now be sold in logo-free boxes featuring nothing more than graphic pictures of people dying of smoke-related illness. It’s hard to enjoy taking a drag on that cigarette when you’re looking at a picture of a gangrenous foot on the package.

This does not at all bode well for premium brands like Marlboro. Given that tobacco companies are all but prohibited from advertising, how can a premium brand differentiate itself from the cheaper competition when it sells its cigarettes in an identical box?

Australia has adopted the most aggressively anti-tobacco regime in the world in taking this approach, but other countries are catching up in a hurry. Russia, the world’s second-largest tobacco market after China, is starting to take tobacco’s health risks seriously. Russian prime minister Dmitry Medvedev recently said that a ban on public smoking and cigarette advertising t were “just the beginning” of his efforts to stamp out cigarette smoking in his country. Several countries in Latin America have joined this bandwagon as well.

Meanwhile, Philip Morris International’s dividend yield, now 3.9%, is not the great selling point it used to be. It’s lower than that of the 4.2% offered by blue chip semiconductor maker Intel (Nasdaq:$INTC) and significantly lower than that of most telecom stocks, MLPs and REITs.

Again, unlike the rest of these industries—which are still growing—Philip Morris faces a shrinking market for its wares. And its stock valuation of 17 times is ludicrous given that Intel trades for just 9 times earnings.

Taking a look at other Big Tobacco giants, the story isn’t much better. I have a special fondness for Lorillard (NYSE:$LO) because it was one of my most successful trades in history. I made 40% in all of two weeks (see “Insider Edge in Practice: Lorillard”).

But I wouldn’t be particularly enthusiastic about buying Lorillard today. Based on current earnings, it actually trades at a slight premium to the broader S&P 500. Yes, the juicy 5.3% dividend is appealing. But Lorillard is still a cigarette company selling primarily to a shrinking U.S. market, and it’s hard to justify buying it at a premium P/E ratio.

The same is true of Reynolds American (NYSE:$RAI) and Altria (NYSE:$MO), the granddaddy of all Big Tobacco stocks. Reynolds trades for a ridiculous 17 times earnings and Altria trades for 15. Both enjoy yields over 5%. (In the interests of full disclosure, MO is currently rated a “Hold” in the Sizemore Investment Letter; it’s been a holding of the portfolio for two years, and I’ve been reluctant to pull the trigger and sell because of the taxable gains it would generate. But I have tightened my stops in MO and am not advising that investors put new money into it.)

Investors have enjoyed a fantastic ride in Big Tobacco stocks, but like a good cigarette (or cigar if you prefer), they will eventually burn out. This long-time tobacco bull recommends discarding Philip Morris International like a soggy cigarette butt and viewing the rest of the sector with skepticism. There are better income opportunities elsewhere.

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