Pour Beam Down the Drain and Pick Up Some Diageo Instead

In case you had any doubts, it’s official. Diageo (DEO), the world’s largest spirits maker, will not be buying Beam, Inc. (BEAM) for its bourbon portfolio.

CEO Ivan Menezes said this week that Diageo would be expanding its existing portfolio of whiskeys and launching new ones, and adding for emphasis that “we don’t need to” buy Beam.

I told you so.

Late last year, Diageo had recently lost its distribution deal with Jose Cuervo, leading to wild rumors that DEO would buy Beam for its tequila assets. Beam’s Sauza is the No. 2 global tequila brand by sales.

Apart from the obviously backward logic of buying a large bourbon distiller to get a relatively small tequila brand, Diageo would have a hard time swallowing an acquisition of Beam’s size. Beam has a market cap of $11 billion (Diageo’s is more than $80 billion), and after years of pricey purchases, DEO and its shareholders have acquisition fatigue.

Purists will point out that Diageo is still very weak in bourbon and that acquiring Beam — and its Jim Beam, Maker’s Mark and Knob Creek brands — would fill that gap. Diageo currently only has one bourbon brand, Bulleit, and it is a relatively small player.

All of this is true, but there are a couple points to keep in mind:

  1. Bourbon is a very small market outside of the United States.
  2. Most drinkers make litter distinction between Kentucky straight bourbon, Tennessee whiskey and Canadian whisky.

Per the first issue: Yes, the United States is the single most important market to be in globally. That’s not changing anytime soon. But it’s also a mature market and one where demographics are not necessarily moving in the right direction. Younger drinkers tend to prefer vodka cocktails, not whiskey.

And in any event, DEO is focusing its expansion efforts in emerging markets, where it plans to get more than half of its revenues by 2015.

Diageo’s scotch brands, such as Johnnie Walker, tend to be far more popular overseas. Most emerging-market consumers have literally never heard of bourbon. Try ordering one in a bar in South America or the Middle East and observe the confused look on the bartender’s face.

This brings me to point No. 2.

There are plenty of aficionados out there who take the distinctions between Kentucky straight bourbon, Tennessee whiskey and Canadian whisky seriously. In Kentucky, you might be required to give satisfaction in a duel for confusing bourbon with neighboring Tennessee whiskey. (I’m joking … Sort of. )

But all three whiskeys have a sweet flavor (as opposed to scotch’s smoky flavor) due to their use of corn as a major ingredient. And most drinkers are only vaguely aware that they are different products. I have no stats to confirm this, but anecdotal experience has shown me that 95% of the patrons in any bar in America wouldn’t know that Jack Daniel’s (a Tennessee whiskey), Jim Beam (a bourbon) and Crown Royal (a Canadian whisky) are different types of whiskey.

And on top of all that, Diageo is planning on expanding its bourbon offerings anyway.

This is a long way of saying that Diageo CEO Menezes is absolutely right.

Diageo doesn’t need Beam.

And that causes a little problem here. You see, Beam has had an elevated valuation for years in the belief that it would be acquired by Diageo or Pernod Ricard (PDRDY). Beam trades for nearly 30 times earnings, compared to 20 times for the larger and better diversified Diageo.

My advice? Pour BEAM down the drain and stock up on DEO.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long DEO. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar, but also which stocks will deliver the highest returns. This series starts Nov. 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.

Investing in All Things Naughty

It’s so good to be bad—at least when it comes to investing.

Vice stocks are a corner of the market where many investors—and particularly professionals—are afraid to venture.  But this reluctance by many investors to embrace vice stocks is precisely what makes them such profitable investments (seeThe Price of Sin).  Because professional investors like to avoid being associated with merchants of death and peddlers of peccadillo, these companies tend to trade at discounts to the broader market and often pay substantial dividends.

Some areas of the vice world—in particular tobacco and firearms—have moats around their businesses that mafia dons or drug lords would envy.  Government regulation and a hostile legal regime make it almost impossible for new company to set up shop in these businesses.  The compliance costs would prevent them from ever getting off the ground…and the first lawsuit would bury them.

Today, we’re going to take a look at five high-profile vice stocks and evaluate their investment merits.

We’ll start with Diageo ($DEO), the London-based premium spirits giant.   Diageo just reported earnings growth of 28% year over year, helped along by rising U.S. booze consumption.

Most of the chatter today revolves around improving U.S. sales, but the real story is in emerging markets, where Diageo already gets 40% of its revenues and soon expects to get more than half.  Diageo sees “soft spots” in some of its key emerging markets, most notably in Brazil and China, but this is a short-term, cyclical cooling.  Diageo’s future lies in the developing world, and the long-term secular trend towards rising consumer incomes is here to stay.

Diageo is also a serial dividend raiser, boosting its dividend every year since 1999 (Note: dividends are paid in British pounds, and the gains can be masked when translated into dollars.)  Diageo raised its dividend by 9% this quarter and currently yields 2.6%.

Diageo’s core scotch whisky business has some of the best competitive moats I’ve seen.  Scotch isn’t even technically “scotch” until it been aged by 3 years, and you can’t command premium pricing until it has been aged by at least 12 years…if not 25.  Few would-be competitors have the patience or the bankroll to sink large sums of money today into a project that won’t be profitable for a decade or more. (SeeDiageo: The Ultimate 12- to 18-Year Investment”)

Diageo currently trades for 18 times earnings, making it a little on the pricey side.  This is a stock that should trade at a premium to the broader market and one that I expect to outperform the market over time.  But you might want drip into this one slowly or, better, wait for a pullback before making any large new purchases.

Next on the list is one of my very favorite long-term holdings, Dutch megabrewer Heineken ($HEINY).  Heineken, along with Anheuser-Busch InBev ($BUD) and SABMiller ($SBMRY), is a global enterprise with a portfolio of beer brands that covers every inhabited continent.

You might be surprised to see me this bullish on Big Beer.  After all, beer is a mature industry in the United States and Europe and growth—where there is growth at all—tends to be centered on smaller “micro brew” brands, not the big names you see advertised at the Super Bowl.

This is where Heineken’s geographic reach comes into play.  Heineken already gets about a quarter of its profits from Africa.  Think about this for a moment.  Africa is the least developed region of the world, and the last real “frontier” market of any size.  It also happens to be a rare pocket of growth in an otherwise moribund global economy and a region where incomes are still rising.

Topping it off, a disproportionate amount of alcohol consumed in Africa is of the homemade moonshine variety; in some countries the number is more than half.  As incomes rise, these drinkers will trade up to branded beer and spirits.

As Africa moves up the income ladder, the 25% of profits that Heineken already earns there will explode.  Consider Heineken a long-term investment in the rise of the African consumer.

Heineken is considerably cheaper than its Big Beer peers, trading for just 10 times trailing earnings and 1.7 times sales.  As a point of comparison, AB InBev trades for 20 times trailing earnings and at 3.6 times sales…and also lacks Heineken’s exposure to Africa.

No list of prominent vice stocks would be complete without mention of cigarettes.  Big Tobacco is a true pariah industry and the quintessential vice investment.  Unless prohibited for religious reasons—as is common with Islamic investment funds—many socially-responsible investors will give alcohol a free pass.  Not so with tobacco.

This is precisely why Big Tobacco has been such a profitable investment over the decades.  Because they have limited potential for growth and are largely forbidden to advertise, tobacco companies have huge piles of cash to distribute as dividends.  And because many investors shun the sector, the cheap valuations push the yield higher.  With dividends reinvested and compounded, Altria ($MO) is the most profitable company of the past half century, as Jeremy Siegel laid out in The Future for Investors.

Unfortunately, investors seem to have caught on, and much of what made Altria such a fantastic investment in years past no longer holds true.

At current prices, Altria yields 4.9% in dividends, which still makes it one of the biggest payers among large-cap American stocks.  But this is significantly cheaper than its five-year average of 6.5%, and it no longer trades at a discount to the broader market.  In fact, most Big Tobacco stocks trade at a slight premium to the market.

Tobacco stocks were fantastic investments for virtually the entire investing lifetime of anyone trading today.  But they were great investments precisely because they weren’t popular…and today, they are.

As compelling as the vice story is, Big Tobacco is best avoided at this time.

Next on the list is…ahem…”gentlemen’s club” operator Rick’s Cabaret International ($RICK).   The adult sphere is an interesting subset of the vice universe in that the economics are very different from the rest.  As I wrote earlier this year, adult media businesses like Playboy Enterprises have had a hard time competing with free and abundant competition on the internet and have had to change their business models.  Playboy is no longer a “publisher” but a brand management firm focused on selling its image and its bunny logo.  The jury is still out as to whether this transformation will be a monetary success.

Rick’s is a different animal altogether in that—as an operator of strip clubs—its economics are closer to those of nightclubs, bars, and restaurants.  Unlike booze and cigarette sales—which tend to hold up well during economic downturns—strip clubs are more sensitive to the health of the economy and to the permissiveness of corporate expense accounts.  That said, Rick’s revenues held up remarkably well throughout the lean years of 2008 and 2009 and have been growing steadily for the past several years.

Rick’s is also reasonably cheap at 10 times earnings and 0.8 times sales.  And the company is reportedly considering spinning off its clubs into a REIT, which, if successful, could give a nice jolt to the stock price.

Alas, Rick’s is not going to be investable for most people reading this.  Rick’s has a market cap of just $84 million and average trading volume of just 33,000 shares per day.  This is a tiny small-cap stock that few investors are going to be comfortable owning.  That said, the company does have some big-name institutional buyers, including CALPERS (California-Public Employees Retirement System) and Dimensional Fund Advisors.

And finally, we come to “merchant of death” Northrop Grumman ($NOC), a defense firm perhaps best known for its unmanned drones.

Of course, Northrop Grumman does more than just drones.  The company builds an array of defense systems and even offers logistical support and “cyber defense” systems.

I come across Northrop Grumman regularly, as it has popped up on the Magic Formula screen off and on for the past several years.  For those unfamiliar with it, the Magic Formula was a screen devised by hedge fund legend Joel Greenblatt to find highly-profitable companies trading at temporarily low valuations.  I’ve used the screen as a “fishing pond” for years and have found some real gems.

Northrop Grumman’s dependence on government contracts at a time when the government is broke and looking to downsize has dampened investor enthusiasm for the stock.  It trades for just 11 times earnings and 0.8 times sales.

Yet the company has managed to navigate a difficult political environment deftly and has kept its net income stable even while revenues have been slightly down.

Northrop Grumman recently hiked its dividend by 11% and has raised its dividend for 10 consecutive years.  The company also has ambitious plans to buy back about 25% of its outstanding shares by 2015, making Northrop Grumman a model of shareholder friendliness.  At current prices, the stock yields an attractive 2.7%.

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Plain Packaging: An Assault on Big Tobacco Branding

Last month, I wrote that Australia’s plain-packaging law was one of the worst setbacks for Big Tobacco in decades because it attacked the companies’ single most valuable asset: their brands.

Big Tobacco has strong enough moats to survive high taxes, punishing lawsuits, and an aging and declining customer base intact.  But plain packaging threatens the industry at its very core, and this is something underappreciated by investors in the sector.

James Dean
Cigarette Marketing 101

Long-time chain smokers light up for one very obvious reason—they are addicted to the nicotine.  But for casual smokers—those who may light up while drinking, for example—the experience matter too.  I call it the Rebel Without a Cause effect”; the devil-may-care image that goes along with smoking is part of what makes it pleasurable.

There is a certain appeal to Altria’s ($MO) familiar Marlboro logo.  But there is most certainly no romance in a plain white box with a picture of a diseased lung on the flipside.

If you think I’m making this up, consider the recent grumbles coming out of Australia.  Following the implementation of the plain packaging law at the beginning of this year, Aussie smokers  have complained that their cigarettes taste different.

The Australian health minister, quoted by the New York Times, insisted that there had been no change to the cigarettes themselves but that “people being confronted with the ugly packaging made the psychological leap to disgusting taste.”

I’m not a cigarette smoker, though I do enjoy the occasional cigar.  And I would insist that a cigar does indeed taste better when the smoker is wearing a suit and sitting in a comfortable leather chair surrounded by wall-to-wall shelves of old books.  The very same cigar smoked in a plastic lawn chair while wearing Crocs just isn’t the same (and shame on any grown man for wearing Crocs outside of the pool, but I digress).

Rational?  No.  But nonetheless true.

It remains to be seen whether plain packaging laws spread outside of Australia; they are being considered in Canada, India, the UK and in the European Union as a whole.  Big Tobacco wll argue that the ban violates their trademarks and seizes their intellectual property, and they may find a few sympathetic judges.  But given the history of the anti-tobacco movement, it’s a lot more likely that Big Tobacco will fight a rearguard action for years before ultimately losing.

So, if the future is bleak, does this mean that you should avoid tobacco stocks like Altria, Reynolds American ($RAI) or Lorillard ($LO)?

Not necessarily.  As I’ve written before, industries in decline can be fantastically profitable investments under the right set of conditions.  But the most important condition is price, and on this count Big Tobacco looks far from attractive.  Altria, Reynolds American and Lorillard trade for 17, 19, and 15 times earnings, respectively.  Their dividends, while high by broad market standards, are all lower than 5%, and all are trading near their 52-week highs.

Dividend income is a major consideration in my investment process, but I am avoiding Big Tobacco at this time.  I can get higher yields with comparable dividend growth rates in select REITs and MLPs, and I can get a much higher dividend growth rate in Big Tech names like Microsoft ($MSFT), Intel ($INTC) and Cisco Systems ($CSCO).

Do I expect Big Tobacco stocks to take a nosedive in the immediate future?

No, I don’t.  I expect the sector to more or less track the market in the short term.  But Big Tobacco investors should be aware that the single biggest factor in the sector’s outperformance of recent years—price—is no longer in their favor.

Sizemore Capital is long MSFT, INTC, and CSCO.

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Big Tobacco Botches the E-Cig Name Game

Back in April, I asked if E-Cigarettes would relight Big Tobacco’s prospects.   I had my doubts.

bogart_casablancaE-cigs seemed to be a more pleasurable version of a nicotine patch: something that an existing smoker might switch to for health reasons but not exactly an attractive or glamorous product for someone who doesn’t already smoke.  (Humphrey Bogart would not have been as cool in Casablanca with an e-cig dangling between his lips.  This is an indisputable fact, not an opinion.)

It certainly made sense for Altria ($MO), Reynolds American ($RAI) and the rest of Big Tobacco to get in on the action; it’s better to extract a little more revenue from defecting cigarette smokers than to lose them altogether.

But investors should be realistic about the potential for e-cigs to make Big Tobacco a growth industry again.  It’s not going to happen.  Though there are hundreds of millions of tobacco users worldwide (the World Health Organization puts the number of tobacco users at over 1 billion), public health campaigns, legal restrictions, and changing consumer tastes have put cigarette smoking in terminal decline in the developed world.  As a sobering (no pun intended) case in point, American teenagers are more likely to use illegal drugs than to light up a cigarette.

Perhaps most damaging, new “plain packaging” rules are directly assaulting the single most valuable assets of Big Tobacco companies: their brands.

In Australia, all cigarette boxes look identical, regardless of brand: plain white boxes with the brand name written in a uniform font, size, and placement.  Oh, and the same graphic photos of people dying of lung cancer on the back.

Similar rules are being considered in Canada, India, the UK and the European Union.  Big Tobacco is fighting it tooth and nail on trademark and intellectual property grounds, and I consider their objections valid.  But the assault on branding seems to be the next front in the ongoing war of attrition between public health advocates and Big Tobacco, and if history is any guide, the public health advocates will win.

This brings me back to e-cigarettes.  Altria is jumping into the e-cig market with a new product under the brand name Mark Ten.  Nowhere on the packaging will there be any prominent mention of Altria or its best-known brand, Marlboro.

I’m left scratching my head here.  There are over 250 e-cigarette brands currently on the market.  While I don’t see a smoker paying a large premium for a Marlboro-branded e-cig, I would certainly expect them to gravitate to a brand they already know.  In failing to use the Marlboro name, Altria seems to be neutralizing its single biggest strength: a consumer brand that is behind only Coca-Cola ($KO) and Anheuser-Busch InBev’s ($BUD) Budweiser in name recognition.

This would be tantamount to calling Diet Coke “Healthy Pop” and leaving all mention of the Coke brand off the can.  It’s madness.

If Big Tobacco is wanting to start fresh with new branding because of the toxic association between the existing brands and those filthy, old traditional cigarettes, they are wide off the mark.  Their market is existing smokers, not nonsmokers.  Unless they brand e-cigs as “portable flavored hookahs” or something with novelty appeal, it’s hard to imagine this product appealing to a young, unbiased consumer.

And this actually brings me to a related topic.  I noted last month that marijuana stocks were a terrible investment.  The companies engaged in legal production and marketing are small, poorly capitalized, and not likely to still be in business five years from now.

But as the legal regime surrounding their product continues to be relaxed, there may be room for a large, well-capitalized company to sweep in and take over the market.  Big Tobacco’s massive production and distribution machine could be easily tweaked to sell packaged marijuana cigarettes—which could be branded under familiar brand names such as Marlboro or Camel.

A lot of Americans would be put off by this, of course.  Fully 49% of Americans are against marijuana legalization for very valid reasons.  But the question Big Tobacco needs to ask is this: can their reputation get any worse than it already is?

Big Tobacco is already a pariah industry under constant attack.  What would they have to lose by marketing marijuana cigarettes in Colorado and Washington?  It’s hard to see a loyal cigarette smoker kicking the habit because “their” brand has now been tarnished by tie-dye wearing hippies.

At any rate, if Big Tobacco is going to continue to be a good investment for its shareholders, management needs to focus on leveraging their core brands.  The alternative is to slowly fade away.

Marijuana Stocks: You Would Have to be High to Buy Them at Current Prices

I’ve been a big believer in vice investing—and particularly tobacco stock investing—for a long time.  I turned bearish on tobacco stocks late last year, but this was based purely on price.  In my view, tobacco stocks had simply gotten too expensive relative to other dividend-paying options—and I would reiterate that view today.

But if ol’ tobacky stocks are unattractive at current prices, what about wacky tobacky stocks?

With marijuana slowly becoming legalized in the United States (at least on a state-by-state basis), manufacturers and vendors of cannabis are evolving from enterprises of dubious legality into mainstream and regulated purveyors of vice.

So, if Big Tobacco has been a profitable investment despite its social stigma, might Big Weed get a haircut and get to work for investors?

Maybe, but I wouldn’t count on it.

To start with, there is no “Big Weed.”  All of the players are small companies with names that few investors have ever heard of.  Tobacco and marijuana are also vastly different industries with vastly different competitive dynamics.  Yes, both could be lumped into the category of “sin stocks,” but not all sin stocks are created equal.  This requires a little explaining.

I recently wrote that Coca-Cola and Pepsi were the “New Big Tobacco.” By this I meant that sugary drinks were evolving into a stigmatized industry that is regulated in the interests of public health in the same way that cigarettes are.  But I also noted that the stocks of companies operating under that kind of scrutiny can still be wildly profitable to own under the right set of conditions:

  1. There should be substantial barriers to entry for new competitors (what Warren Buffett likes to call “moats.”)
  2. The company should be financially healthy (strong balance sheet, manageable debt, etc.)
  3. Management should be committed to rewarding shareholders with rising cash dividends and, to a lesser extent, share repurchases.
  4. The stock must be cheap.

Big Tobacco names like Altria (NYSE:MO), Philip Morris International (NYSE:PM), and Reynolds American (NYSE:RAI) easily pass the first three criteria. They just happen to bomb the fourth.

So, how do marijuana stocks look in comparison?

The first point is in a state of limbo.  There were arguably barriers to entry under the old medical marijuana regime due to the legal hoops that growers and vendors had to jump through.  But none of the existing players were big enough to crush new competition, and none had any real name recognition.

Virtually every human being alive today is familiar with Altria’s Marlboro brand or Anheuser-Busch InBev’s  (NYSE:BUD) Bud Light, regardless of whether they smoke tobacco or drink alcohol.  But how many have heard of Medical Marijuana Inc (Pink sheets: MJNA), one of the largest suppliers of medical marijuana? Or Cannabis Science (Pink sheets: CBIS), one of its biggest competitors? Or for that matter, how many have heard of Growlife (Pink sheets: PHOT), a leading seller of hydroponic equipment?

I’m betting the answer is not too many.  At this stage in the game, there is no real brand recognition to speak of.

What about the other criteria?  Are these companies at least financially sound, and do they reward shareholders via dividends and share buybacks?

Not exactly.  All three companies are high-risk penny stocks, and none pay a dividend.  Of the three, Medical Marijuana, Inc., the “blue chip” of the group, has the healthiest balance sheet, but you’re talking about a company that generated only $5 million in revenue last quarter.

And price?  Medical Marijuana, Inc. trades for 14 times book value and 24 times sales.  To pay those prices for any stock…well, let’s just say you’d have to be heavily under the influence of the company’s products.

At time of writing, Medical Marijuana, Inc., Cannabis Science, and Growlife trade for $0.17, $0.05 and $0.04 per share, respectively.  But a young analyst I interviewed on the matter told me he had a price target of $4.20 on all three.

I think there was a joke in there somewhere at my expense.

Bottom line: while marijuana stocks may indeed be vice investments, they have none of the qualities that have helped tobacco generate such fantastic returns over the past 50 years.  Treat them as a risky speculation and nothing more.

Sizemore Capital has no positions in any stock mentioned. This article first appeared on InvestorPlace

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.