A realist in a world filled with optimists & pessimists
From Tobacco to Latin American Oil …
Value investors buy stocks from pessimist and sell them to optimists, because they are realists (Ben Graham). It’s a principle that is key to investing. Over the course of time we have had many stories, myths and legends that covered humans, which tried to fly to close to the sun, because they fell in love with the felling of achieving superhuman things.
The most well known story in this regard is the myth of Icarus and Daedalus.
“Flying too near the ocean would dampen the wings and make them too heavy to use. Flying too near the sun, the heat would melt the wax and wings would disintegrate. In either case, they surely would die. Therefore the key to [success] would be in keeping to the middle. Icarus was overwhelmed with the ecstasy of flight and overcome with the felling of power that came with it. Icarus ascended higher and higher. When the heat from the sun melted the wax on his wings, Icarus fell from the sky.”
— The Myth of Icarus and Daedalus (TED-ED on YouTube)
Often times this story is just told in one way. Icarus flew to high and the sun melted the wax on his wings. But the part that is often forgotten is, that Daedalus advised him, to not fly to low, since this would dampen the wings and make them to heavy. The importance of this sentence is not to be underestimated, since it has a direct lesson for all the optimists/pessimists out there.
If you fly too high and expect a “new paradigm”, gravity will push you back to earth. If you fly too low though, you’ll not be able to fly. Both pessimists and optimists will suffer. Realists are the ones that are able to balance both views on a topic and look at it in a balanced way.
Don’t get me wrong, some kind of optimism is required in investing (and in life!), because else you will never pull the trigger and never believe that success is possible. But we need realism to realize when we are in a bubble, when expectations and forecast have run ahead of themselves, etc.
There are many examples of situations in which realists have been able to buy shares cheaply from pessimist and selling them later to optimists. That’s why we love it when crises in a specific industry occur. It gives us opportunities, that happen rarely.
2] Tobacco - Fallen Angels
For decades, tobacco producers have been among the best performing stocks out there. Divided growth in combination with predictable cash flows were among the main reasons for the great performance. These cash flows were supported by an addicted customer base and very low CAPEX requirements to sustain the business. The total return for Altria from 1968 - 2015 has been 20.6% p.a. or a combined 6638x!
As we know today, the music slowed down and with it, the shares of the beloved tobacco stocks. Expensive Acquisitions and increased regulation lead to increasing leverage, revenue slowdown and fears regarding the ability to still return capital to shareholders. Dividend investors turned into bag holders and over time most of them sold their shares at a significantly lower price then they bought them for (the dividends helped them to some extend, but they are still frustrated). Many tobacco stocks are down 70%+ from there all time highs!
Today we are confronted with a situation in which the pessimist point out the following:
Volumes in the tobacco industry are declining and the business is a melting ice cube.
Regulation will crack down on the business by enforcing new laws.
Debt is too high and with declining cash flows tobacco companies will face massive difficulties serving their debt.
Capital won’t get returned to shareholders and therefore it’s just dead money.
The optimists have the following arguments:
Cash flow will grow, because traditional cigarettes will dominate the market for decades to come.
Vaping and all kinds of new tobacco free products will result in revenue growth and margin expansion.
Regulation won’t be able to stop smokers, as more regulation is a long and difficult process.
The valuation for British American Tobacco, Imperial Brands, etc, is way to low.
Dividends are massive and sustainable.
I as a realist understand both sides of the argument. If I just look at the facts, then cigarette volumes are declining, which is a trend that is to some extent being compensated by price increases. Nevertheless, the market for tobacco products is expected to grow at a 2.5% CAGR till 2030 globally, and at a 3.5% CAGR in the U.S.
Cash flow will remain very substantial over the coming years, as tobacco won’t simply go away. Regarding regulation, regulators will try to crack down on tobacco companies (because of health issues). But as we all know, this is an issue that has been the case for decades, and nothing has been able to break the rebelliousness of young people, from getting their hands on these products. Furthermore, there are still many lobbyists that will make it very difficult and time consuming to pass new laws.
Debt is high for most of the companies, as acquisitions in the past were very costly. On the positive side, many companies have been deleveraging for years and importantly, most companies have debt with maturities that are far in the future (2030, 2040, etc). Regarding capital allocation, a lot of companies have announced share buyback programs and are paying huge dividends. While capital allocation is in many ways not perfect, it’s far from terrible with most companies in the industry.
The bottom line is, that at these levels BAT & Imperial look attractive for a trade. The combination of buybacks (7% in the case of Imperial), dividends (8-10% for both stocks) and consistently high cash flow, will likely have positive effects on these stocks.
Looking at the chart above this doesn’t look like a dying business. Rather like a business that will have stable cash flows and return them to shareholders. Nonetheless, this is artificially created by raising prices. The question how long this can continue is very difficult to answer, but for a few month trade this looks not to bad. The key here is sentiment. The reason why I love Twitter/X so much is because you can get a pretty good idea of current sentiment. Many of the tobacco bag holders have sold there positions, which is always a signal of flushing out the fearful, in an attempt to balance the market.
While these businesses certainly are not growth stocks and while these businesses certainly face headwinds, every business has a price at which it is attractive.
[Im not long any of the names mentioned until here and just choose this industry as a good example for my thoughts regarding Realism, Pessimism & Optimism.]
2] Latin American Oil - A balance of politics and cash flows
In the chapter of realism, Latin American Oil stocks can’t be not mentioned. Volatility, politics, dividends and uncertainty belong to these stocks, like the sun rise every morning. This is exactly the reason why investors in the west, who only know MAG7 and some “compounder stocks”, will not touch these stocks. But as a realist, price and critical thinking will solve most questions that will come up in the research process.
My 2 bets in this sector include Petrobras and Geopark. I have written up my thesis on both of them on this blog, so feel free to check them out, if you haven’t already.
Petrobras is the perfect example of realism, since the stock had countless instances in which the stock dropped >10% in a day. Most recently after the Q4 earnings report. The pessimists believed, that Petrobras would be nationalized by the state, investors would lose everything and dividends would be cut to 0. The underlying report has painted a vastly different picture. It was clear, that Petrobras cut its dividend because of political pressure. But does this mean, that it would drop to 0?Absolutely not! Looking at the big picture, we could see that the company was crushing it operationally.
It was a common overreaction by fearful pessimistic investors. Since then, the stock has been silently working on a bottom and is in an uptrend again.
[Original article from below 👇]
The second Latin American stock in my portfolio is Geopark, a stock that has performed fantastically in an operational way and good in terms of share price appreciation since the write up [February 2024]. At the time, fears surrounding the Colombian attorney general were high and protests erupted in the country. Here we had a similar situation of pessimists missing the big picture.
The fears were, that Colombian president Petro, who basically has close to zero power (since the senate is against him), would go full out Venezuela mode (in regards to politics and crackdowns on protesters). Simply put, this was a crazy exaggeration, as he has incredibly low support by voters and the senate. At the same time, Geopark (Colombian oil producer) was trading at a very low price, while buying back 20% of shares outstanding!
[Original thesis 👇]
3] Conclusion
All in all, realism and a look at the big picture is highly underrated, although it can help us to improve our performance massively. Especially is situations that come unexpected, we should remain calm and logically think about the pessimistic and optimistic arguments that exist.
Yours sincerely,
MODERN INVESTING
This is not financial advice and shouldn’t be threaded like it. Everyone has a different risk tolerance, which is why I don’t want and can’t give anyone financial or investing advise. Everyone has to make his on mistakes :)
Good write-up, you are most likely right about the tobacco industry, however, I couldn't ever buy tobacco stocks for moral reasons. I hate the product so much, the smoke, the smell, the cigarette buds on the streets, and of course the health consequences. I also "think" that taxes on tobacco don't cover all of the cost of the consequences on society. I would be curious to see a study about it.
Do you still hold Odfjell Technology?