Barron's Streetwise - Smoke Break for Ethical Investors

Episode Date: July 24, 2020

As cash pours into do-good investments, Philip Morris is trying to clean up its image. Can a cigarette maker go ESG? Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because if you don't invest in cigarettes, cigarettes will exist. So I think exclusion is not addressing the issue. Welcome to the Barron Streetwise podcast. I'm Jack Howe. The voice you just heard, that's Andre Kalanzopoulos. He's the CEO of Philip Morris International, one of the world's largest cigarette companies. He wants investors to view his company not just as a source of significant cash flow and big dividends, but as a corporate citizen of high

moral standing? Should ethics-minded investors buy Philip Morris shares? Or does the fact that even a cigarette maker wants to qualify as a do-gooder suggest that the ethical investing movement is phony baloney? Listening in, as always, is our audio producer, Metta. Hi, Metta. Hi, Jack. I want to talk about cigarettes and ethics at a time when people in general just seem angrier at each other than they've ever been. How do you think it's going to go for me?

Great. I think you should light up on air. No, no. Smoke a pack while we record. Well, I like your confidence, but I'm not smoking. I smoked for years, although in my mind I was quitting smoking for years. Not long after my first child was born, I decided my smoking had to stop. The World Health Organization says 8 million people die worldwide

each year from smoking. That's 8 million out of 57 million deaths from all causes. Now to quit, I tried an electronic cigarette called Blue, B-L-U. That delivers nicotine through vapor, not smoke. But it turned into something that I did in addition to smoking, not instead of smoking. I needed some new ideas, so I bought a book called Alan Carr's Easy Way to Stop Smoking. It was first published in 1985, so maybe the ideas weren't quite new, but the book said to go ahead and smoke while reading it, which I liked. Kind of like your advice, Metta. That's right. I bought a fresh pack of American Spirits and took a smoke break after each chapter. The book laid out all the things that were unpleasant about being a smoker, and it gave a timeline of how quickly health improves for people who quit.

And then, and this is the part that was key for me, it argued that the main thing that makes someone crave a cigarette is the most recent cigarette they had. It said that people imagine nicotine addiction to be more powerful than it really is. Forget patches, gums, or other quitting aids, the book said. Just stop smoking for a few days and quitting will become much easier after that. Stop for a few weeks and you'll be done for good. As long as you don't have a cigarette from then on, you won't want one. I did what the book told me and I haven't smoked or vaped for many years.

I don't have anything to do with the book, by the way. I mentioned it in a column once and the publisher emailed me to say thanks. I figure I've saved $20,000 maybe on cigarettes since I quit, so you're welcome. And I'm not saying what worked for me will work for everyone. I have no idea. But it does make me skeptical about whether smokers who want to quit need what are called modified risk tobacco products. There are two of these that have received permission from the U.S. Food and Drug Administration

to be marketed as less harmful than smoking. Last October, the FDA gave the nod to something called General Snooze. That's made by a Stockholm-based company called Swedish Match. It's a powder made from tobacco and other ingredients that gets put into pouches that look like little tea bags, and those are placed between the lips and gums. Snus is different from what Americans call snuff or dip. For one thing, there's no spitting. Amanda, before we go any further, have you ever either smoked or snused? I have done both. Were you a heavy smoker or not too much? I didn't smoke that much. I only smoked a couple once in a while.

Have you ever snoozed while smoking? Oh no, I think that would make anyone pretty sick. That would be a lot. Is there a term for snoozing while smoking? I don't know. Snoking. Done. The FDA's second authorization to market a tobacco product as safer than cigarettes came

just this July, and it was given to Philip Morris for IQOS. That's I-Q-O-S. A couple of years ago, there was a newspaper story that said the name stands for I Quit Original Smoking, but Philip Morris says that's not true and that the name isn't an acronym. It's just meant to denote innovation and technology. Now, Icos consists of a rechargeable device that heats but doesn't burn proprietary tobacco-filled sticks. The company calls these sticks HEETS.

That's H-E-E-T-S. It says Icos is safer than smoking because the riskiest part of smoking isn't the nicotine, it's burning organic matter and inhaling the smoke, which can have thousands of chemicals. I believe that. I think if you made cigarettes from carrot leaves and smoked them for 20 years, it would be terrible for you. I don't recommend anyone smoke or snooze carrot leaves, by the way. recommend anyone smoke or snooze carrot leaves, by the way. Anyhow, Philip Morris piloted Icos in Italy and Japan in 2014, and two years later announced a new goal of, quote, delivering a

smoke-free future. This past Tuesday, it reported second quarter financial results. Earnings fell from a year ago, but beat estimates. Cigarette volumes were down almost 18%, but heated tobacco volumes jumped 24%. Shares rose 4% on the news. After the report, I had a chance to talk with Andre Kalantzopoulos. Andre? Yeah, hi. Hi, it's Jack Howe from Barron's. How are you?

Very good. Andre is the CEO of Philip Morris, whose cigarette brands include Marlboro, Parliament, and Virginia Slims. When I say Philip Morris, I mean Philip Morris International. The ticker symbol is PM, and it sells cigarettes outside the United States. There used to be a company called Philip Morris Companies, which sold cigarettes everywhere. It was renamed Altria in 2003, and it spun off its international business in 2008. Today, Altria trades under the ticker symbol MO and sells its cigarettes inside the U.S. One goal of the spinoff was to bring the relatively fast-growing international business out from under the legal

and regulatory constraints of the U.S. business. Recently, there was talk of recombining the companies, but the talks fell apart last year. I know that's complicated. The only thing you really need to remember is that Andre runs the company that sells cigarettes and Icos outside the U.S., but it also licenses Icos to Altria so that it can sell the device inside the U.S. I asked Andre how the pandemic has affected his business. He said cigarette declines weren't as big as expected considering so many stores and restaurants were shut down. Some people confined to their houses might have smoked more, but Andre suspects that was true more of singles than family members. You can say as people are not in the office, but in the houses, they may consume more.

That's probably for single individuals. But if you're with a family and sometimes parents and children, obviously people refrain much more from smoking, which is a very good thing. Andre also says cigarette volumes picked up in June, which counts toward the second quarter, but might give an indication of what to expect during the third quarter. And he says he was particularly pleased with ICOS results. In the U.S., ICOS is similar in price to premium cigarettes like Marlboro, but in some countries, ICOS is taxed at lower rates than cigarettes to acknowledge its lower risk for users. Some American states might reduce ICOS

taxes now that the FDA is weighed in on safety. I asked Andre how ICOS profitability compares with cigarettes. He said that changing the business is expensive for now, but that eventually, as volumes rise, he expects marginal ICOS profitability to be better than that for cigarettes. I asked what makes IQOS better than vaping. Andre says his research shows that a much higher percentage of IQOS users get off cigarettes for good, which he attributes to a more enjoyable experience. It's much closer to the taste of a cigarette. You know, if a cigarette is like a fully bodied red wine, Icos would be something like wine with ice cubes, a few ice cubes. And any vapor product is water in which you put alcohol

and you add some flavoring to give it taste. Now, for the record, when I have wine at home, I almost always add ice. I know that doesn't sound classy, but I make sure to hold the glass by the stem, often with a pinky extended, which is super classy. So I'm pretty sure those two offset each other. I didn't ask Andre if he drinks wine on ice, but I did ask whether he smokes. I smoked and I've been using Iqos since it became the first prototype. So I have switched fully out of cigarettes.

Cigarette stocks used to be called sin stocks, a group that historically included alcohol, gambling, and pornography. I'm not sure how those rank from best to worst, but cigarettes, those seem pretty unambiguous. The products kill the customers, which isn't ideal. But the business was lucrative despite regulatory efforts, and in some cases, maybe because of those efforts. Cigarette companies have been banned from advertising on television since the year before I was born, and that's left them with low marketing costs and lots of extra cash flow. Speaking of which, Meta, you think it's time for a word from our sponsor?

Ain't it the truth? When you smoke true, you get all the flavor and the filter too. Ain't it the truth? When you smoke true, you get all the flavor and the filter too. Mm-mm. Four out of five doctors agree that's not really a sponsor of ours. It's a TV commercial from the beginning of the 70s, judging by the width of the collars. Then there's high taxes.

High taxes should have hurt cigarette companies, but they might have inadvertently helped. New York City is an extreme case. The federal government gets just over a buck a pack. The state gets $4.35, and the city gets $1.50, bringing the total to almost $7 a pack. And there was a proposal earlier this year to add nearly $2 a pack more to state taxes. The flip side of all that tax is that if cigarette makers want to raise their prices by, let's say, 25 cents a pack, their customers hardly notice. So cigarette companies have used price hikes to offset volume declines for years.

If you own shares of the original Philip Morris, now Altria, over the 30 years that ran through June 2017, you made almost 19% a year including dividends versus 10% a year for the S&P 500 index. The outperformance stopped after that. An e-cigarette brand called Juul took off in the U. the US and so did vaping more broadly. What's up vapers thanks for checking out Daily Vape TV. My name is Nick and today we're going to be trying out some Juul pods. So I have the mango flavor that they have and then the three other flavors that came with the Juul kit which are Cool Mint, Fruit Medley, and Creme Brulee. So the Juul by Pax has definitely made a huge bang in the industry

because whether or not you're a smoker or a vaper, you've definitely heard of it. Don't Jill Scarrini. Altria bought a stake in Juul in 2018, but that's backfired because some states have sued Juul for marketing to the young. That's not a good look. To be clear, we're talking about vaping, not Icos. Andre at Philip Morris points out that the average Icos user is over 35. Anyhow, cigarette stocks have sharply underperformed over the past few years, and that includes Philip Morris. Concerns over falling volumes might be partly to blame.

So might an explosion in demand for ethics-themed investments. Seems like everybody's been hopping on the ESG bandwagon lately. Environmental, social, and governance has been another hot topic at this year's Inside ETF Conference. Problem is everyone has a different idea about how precisely to define it. I know we've talked about this many times. Here's where I'd normally define ESG investing, although I'm not sure I really can. I can tell you what it stands for. Environmental, social, and governance. And I can tell you generally it's an effort among investors to nudge companies into doing good.

What's clear is that it's a hot trend right now. What's clear is that it's a hot trend right now. Morningstar says that ESG funds took in a net $20.6 billion last year. That's four times what they took in the year before. And unsurprisingly, 500 mutual funds added ESG criteria to their prospectuses last year. That's 10 times the number that did so the year before. There might be some greenwashing going on. That's a term for when a mutual fund or company adds token ESG language to try to attract some of that incoming investor cash. Philip Morris seems to be all in on ESG. In June, the company reported its 2019 ESG performance in the first of what it calls integrated reports. It covers farmer pay, workplace safety, diversity, forest protection, cigarette butt littering,

data privacy. There's a section on housing for tobacco workers in South Africa and another on mental health workshops for employees in Switzerland. The report is 192 pages. That's 54 pages more than the company's annual financial report to shareholders. I asked Andre if he focuses so much on ESG issues to compensate for the fact that cigarettes are so harmful. He says the company faces heavier scrutiny than other companies, so it needs to be better. He also says that ESG investors should consider that not all tobacco companies are the same

and that his company is innovating to try to reduce the harm its products cause. He says the old approach of excluding sin stocks from portfolios isn't helpful. The simplistic way of saying, well, I'm not going to invest in this company. I'm going to resolve the problem. We don't resolve any problem because if you don't invest in cigarettes, cigarettes will exist. So I think exclusion is not addressing the issue. I think looking at what companies are indeed doing and how they try to change their impact, it's important for ESG investors. But I think we need maturity also in the ESG investing to get to this stage. So should ethics-focused investors

buy Philip Morris shares? The truth is that isn't much of a moral dilemma for me. I think the risks of smoking are well communicated at this point. And I think that buying shares of a company once they're listed isn't the same as, let's say, directly financing cigarette sales. You might feel differently on the matter, and that's fine. Frankly, I have mixed feelings about this new era of corporations endlessly marketing their morality. I'm happy to see customers and investors use their influence to push companies to be kinder and fairer. But I'm put off by the number of studies I see coming from Wall Street saying that different measures of morality predict superior stock returns. Really? It's difficult enough to agree on measures that have been clearly reported for decades, like share prices relative to the

book value of company assets and what those mean for stock returns. All of a sudden, we're sure that a new and shifting way of measuring goodness is the key to beating the market. I'm skeptical. But if morality is a market beater, we'll increasingly need an industry of independent arbiters that can certify which companies are good on behalf of money managers. Call it the ethical industrial complex. And I'm not sure we'll all agree on the same stuff being good. I mean, I eat cheeseburgers, but I compost my veggie scraps. Do those two offset each other?

I drive a gasoline-burning minivan, but I'm hybrid curious, and I own the Tesla of weed whackers. Am I an okay person? Sometimes I feel like our civic discourse in America has become so angry, hateful, and frustrating that we're trying to make up for it by demanding impossible levels of piety in our professional and commercial relationships. I'd call it hyper-judgmentalism, but I'm afraid I'd offend someone. UBS, the investment bank, says investors should buy Philip Morris shares, in part because ICOS is a hedge against increased quitting, but also because

during the Great Recession just over a decade ago, cigarette sales held up better than sales of other consumer staples. That suggests once life gets back to normal, even if the economy is weak, That suggests once life gets back to normal, even if the economy is weak, cigarettes could do well. The stock trades at 15 times this year's projected earnings, and Philip Morris is expected to increase earnings per share by 8% to 10% over the next several years. The stock's dividend yield is gigantic, over 6%. I do have one big concern about Philip Morris, though. Remember, I'm not a fan of kicking cigarettes by finding other ways to get nicotine. If Icos is safer than smoking, it's surely not safer than quitting nicotine altogether.

If Philip Morris is successful in switching its cigarette smokers to Icos, and if it really wants to be a moral actor, won't the next step be switching its IQOS users to nothing? I asked Andre, and he basically said, we shouldn't let the perfect be the enemy of the good. Of course, the best thing they can do is to quit completely use of nicotine. And that has been the objective of all the efforts in public health. Now, if the risk of cigarettes is 100. Icosin evapour products are between 95% and 99% reduction. I'm not suggesting this means automatically the same reduction in morbidity and mortality. But now the objective, I think, of all of us should be to convince people to switch out if they don't quit. Meta, I know we have loads of questions.

Do you think we have time to answer two of them if I keep the answer short? And do you think I'm capable of keeping the answer short? Yes and yes. So we've got a question from Jonathan, who is 24 years old. Hi, Jack and Meta. Big fan. I'm in my early 20s and getting ready to go into law school. I have a Roth IRA for retirement, but was wondering if there are any recommendations

for investments in stocks or funds that I can see some growth by the time I leave law school in approximately three years. I want to be able to have some of my savings grow to help pay for school or other necessities by the time I graduate. Thanks, and I look forward to your response. Thank you for your question, Jonathan. And the answer is no. There's and I look forward to your response. Thank you for your question, Jonathan, and the answer is no. There's nothing I can recommend that will grow your money meaningfully if the goal is to spend it on necessities in three years. Stocks are the best vehicle for growing money, but over short time periods, their returns can vary widely. And if we're talking about true necessities, you can't take a chance. I'll give you two choices.

First, you can put the money in a bank money market account paying maybe one percent and change right now. Keep it there for the next three years and then spend the money. Or the second choice is change your definition of necessity. Maybe you don't really need to spend that money or all that money. Maybe you'll be working by then and you can spend your income. If you can figure out a way to keep that money invested for at least 10 years, then put it in a low fee S&P 500 index fund. That was like record time, Meta. Who else do we have? All right. So next up is Mike from Brooklyn. Hi, Jack and Meta. The IMF has forecast that for many of the advanced global economies outside the United States, real GDP will be greater for those countries than it will be for the United States in 2021.

I think this has much to do with the fact that a lot of the European and international developed countries, including China, have their coronavirus situation under control. My question is, is it time to overweight my international holdings in my retirement account, or at least go from 67.33, which is my current allocation, domestic to foreign, to market weight, which is approximately 56 domestic, 44% foreign. Love the show. Look forward to your response. Thank you, Mike from Brooklyn. You know, several weeks ago on this podcast, I asked Mohamed Al-Aryan that question. He basically said that while stock prices look more attractive overseas, stocks look safer in the U.S. and that the time to shift money from the U.S. to overseas would be when we're on the verge of a major global economic recovery. I'm not sure

whether the latest rise in U.S. virus cases and deaths changes his view. I'd say that if you already have one-third of your stock money outside the US, that might be enough. Keep in mind the big US companies typically operate worldwide. S&P 500 companies get more than 40% of their revenue from outside the US. So Mike, you probably already have more overseas exposure than you're indicating. I think you're doing just fine. Thank you, Mike. Thank you, Jonathan, for sending in those questions. And everyone, please keep the questions coming. Just tape on your phone, use the voice memo app, send an email to jack.how, that's H-O-U-G-H, atron's dot com. Send comments, too. Maybe we'll play them on a future episode.

Thank you for listening. Meta Lutzhoft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. Follow me on Twitter to find out about stories and new podcast episodes. That's at Jack Howe, H-O-U-G-H. See you next week.