Odd Lots - How Tobacco Became One Of The Greatest Investments In History

Episode Date: October 15, 2020

For over a century, tobacco stocks have been among the greatest investments in history, consistently outperforming other sectors decade after decade. But what is it about tobacco companies specifically that has led to this incredible performance? On this episode, we speak with financial advisor Lawrence Hamtil along with Gene Hoots, a financial advisor and the author of “Going Down Tobacco Road”, to discuss the extraordinary performance of this sector.See omnystudio.com/listener for privacy information.

I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets, from corporate law to constitutional law, and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars and policy experts to break down what the rulings really mean. We do this every weekday,

then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start your day, and on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. Oh, and welcome to another episode of the Oddlots podcast. I'm Joe Wisenthall. And I'm Tracy Allo. Tracy, you know, one thing that sort of characterizes the stock market these days is just this incredible dominance of a handful of gigantic tech companies.

I mean, you pointed out today, I think you tweeted a chart this morning just showing how like if you exclude. just a handful of like five companies or whatever, the S&P 500 is basically going nowhere. Yeah, that's exactly right. So I think it's if you exclude Facebook, Amazon, Apple, Microsoft, and Google, and just look at the remaining 495 companies in the S&P 500, the index is actually down 1% so far this year. And if you only look at those five tech stocks, those are up 40 or almost 40% this year, which is phenomenal. And because they're such a huge part of the index, of course, they've pulled the whole thing up to about 6% year to date.

What do you think about those articles, I mean, you're a journalist. What do you think about those articles that are like, oh, if you had invested? You say that like you're not. Oh, you're a journalist. No, we both are. I know. Okay. What do you think about those articles that are like, oh, if you had invested like $100 at Apple's IPO,

you would be like this rich by now? Would you ever commission a story like that? I don't think I'd commission them, but I can see why people keep writing them. I mean, hindsight articles are often a draw. And I think there are quite a few things that you could find where you could say, oh, well, had you invested a dollar in this, you'd now be a millionaire or even a billionaire. And some of them are really surprising. So I think we spoke about Domino's Pizza once. I mean, there are stocks like that that's a good one that you wouldn't necessarily expect to.

outperform in that way. Right. Here's a crazy stat. If you had invested $1 in tobacco stocks in the year 1900, which, you know, no one alive today, I don't think we could have done that. Do you know how much it would be worth today? I do not. One dollar, supposedly, according to this thing I'm reading right here, $6.3 million if you had invested in tobacco stocks in 1900. Oh, darn. I miss that opportunity. But, yeah. I mean, tobacco stocks, tobacco stocks kind of fits under the Domino's pizza model of unexpected outperformance. Because when you think about tobacco stocks, you think about all these pressures and headwinds that have been on the business model for for decades now, right? Yeah, I mean, basically since we've been alive or since, you know, yeah, since we've been alive, we've mostly known tobacco as the sort of vilified industry, all sorts of public health efforts to get people to stop smoking, taxes on cigarettes to discourage consumption, lawsuits, and so forth. And yet, you know, sure, you have some noise here and there.

And I think maybe in the last couple of years they haven't done as well. But by and large, tobacco companies, cigarette companies have just been extraordinary winners for years and years and years, even with all of these sort of efforts to slow. them down. Yeah. So I think this is a really interesting industry to focus on at the moment, even though we're talking about things that happened to tobacco over the past 100 years or so, you can see there's definitely parallels between tech and cigarette makers, I guess, because government policy played such a role in the tobacco industry. And we're starting to see, I think, the beginnings of government policy really come into play for the big tech companies. as well. And I think people even called like, I've seen people say things like, oh, Facebook is the new tobacco or whatever. They usually mean that negatively. But if you took it literally from an investment standpoint, that's like, oh, that I should definitely buy that. Yeah, there's definitely tension there between it being a complete moneymaker and also people saying it's negative for society. Right. So anyway, today we're going to talk about tobacco stocks in general.

and why they've done so well, and not just tobacco stocks, but tobacco companies and what it is sort of unique about this industry, that for decade after decade after decade, year after year, and despite all these headwinds, they've just been extraordinary moneymakers, very hard to disrupt them, bring them down in any way. We're going to be talking with two guests today, Gene Hoots, he's an investment advisor, and he's the author of a book going down Tobacco Road, R.J. Reynolds, Tobacco, Empire, the Gold Leaf in North Carolina, and Lawrence Hamtel. He's also an investment advisor and follow him on Twitter. He's talked a lot over the years about tobacco stocks and about what makes them unique. And Gene and Lawrence, they did a Q&A on their, on Lawrence's blog a few weeks ago about the industry. I thought it was super interesting and I thought we should expand on it here. So very excited to learn more about these, about tobacco companies. with these two. So let me bring them in one of the time. Lawrence, thank you very much for joining us.

Hey, thanks, guys. Thanks. I appreciate the opportunity. And Gene, I really appreciate you coming here as well and talk about your book. Thank you. It's a pleasure to be here. I guess one of you will be talking about your literal book and one of you will be talking your book, so to speak. But seriously, you know, let's kick it off. I mean, Lawrence, I've followed you for a long time. I know you sort of regularly point out what an extraordinary industry. This has been from a sort of investment standpoint. When did you sort of start paying attention to tobacco stocks as sort of like their own, almost their own asset class? What got you interested in them? I think when I started in the industry in 2002 and started to manage other people's money in 2005 and sort of a contrarian.

by nature and I was heavily influenced by people like David Dreamin and Peter Lynch and both of those guys talked at length about tobacco stocks and what was seemingly their perpetually cheap valuations. And at that point in time, in the early 2000s, it was really sort of a contrarian play. They were just coming out of the master settlement agreement, the lawsuits, things like that. valuations were depressed, dividend yields were in the double digits, and they really were facing kind of a bankruptcy threat at that point in time. And so if you really looked at the businesses, you could see they were still making money despite all the negative headlines. And if you dig a little deeper, you understand the dynamics of the industry or almost unlike any other.

If you look at Ken French's website, he has industry data going back to the 20s. And as far as I can tell, there's never been a negative 10-year period in total return for the tobacco industry. That's unlike just about any other. You talk with Tracy about this hypothetical time machine of going back and investing money and some big winner. And if you look at it, Microsoft, all these big tech companies, I think at some point, Apple, they suffered through fairly long periods in the wilderness, so to speak. but tobacco, for the most part, really hasn't. I mean, if you had invested that money at any point in time over the past 100 years, you probably would have had a decent outcome over the subsequent decade.

So it's really been a fascinating industry, and I followed it for a long time. I think our clients have been invested in it for 15, 16 years, something like that. So Lawrence has been following the industry, and Gene, you are actually in the tobacco industry, and, of course, you've written this book about your experience. Can you maybe, in a nutshell, tell us what exactly you were doing at tobacco firms? And do you agree with Lawrence that the business is special in many ways? First of all, I certainly agree with that. It has been a special industry.

And thinking about that industry is what prompted me to write the book. I grew up in tobacco country. I'm a native North Carolinian and didn't realize. how much tobacco had always been a part of my life until I started this book. But I worked 20 years, 21 years for R.J. Reynolds in Winston-Salem. I was in the financial area one way or another, mergers and acquisitions for a while. And in the last 10 years, I ran the pension and profit sharing and 401K plans worldwide, managing those monies. So I was of the tobacco industry, but not in it. I looked at the company as more or less an analyst would from outside so often and dealt with

the tobacco analysts and talked with them about it. So that gave me a little different perspective than most people in the company. And after 30 years, I decided to sit down and write this book. The key event in the life of R.J. Reynolds and in Winston-Salem as well, the home of J. Reynolds, was the leverage buyout by KKR in 1988, early 18. That was a seminal event in the life of the company, and I built my story around that. Why did that happen? Why was there a buyout?

What led up to it, and then what followed it? And I was interested to see, just as Lawrence has already mentioned, through all of those good times in bed of corporate raiders, mistakes and acquisitions that Reynolds made that were misdirected, perhaps. the tobacco industry just rolled right along, generating a return on equity of somewhere between pick a number, 14 and a half and 19 percent, year after year after year. There's a lot to dig into, and the question, of course, is why has the industry been able to continue to create this return on equity for so long? We'll get to these sort of legal headwinds

and the other attempts to slow down the industry that public health officials have undertaken. taken over the years. But, you know, just sort of that aside, you're like, look at the ROE of the industry. And you're like, well, okay, why didn't haven't more competitors come in and squeezed those results out? Why haven't margins come down? Why hasn't there been a price war? Let's start with that question. Either one of you could take it or both of you. Why hasn't this extraordinary outperformance resulted in more competition and that, therefore, poor performance? One simple explanation is the performance has been great, but the industry has been losing customers all along. And Peter Lynch in one of his books talks about the comparison between Philip Morris and Xerox.

And Xerox was kind of the sexy growth stock in the 60s, and that was kind of the point at which smoking started to fall out of favor when the health risks became well known. And so Xerox ended up attracting a lot of competitors. And on the other hand, tobacco, which started to lose clients, I think smoking's down 50%. And percentage terms over the last 50 years, why would you want to get into that industry? It's a declining industry, a melting ice cube, so to speak. So like Peter Lynch said, a shrinking industry doesn't attract much competition. and it's better to be sort of the dominant player in a slow growth or no growth industry and customer terms.

Looking back long term, I think there's a number of things that brought the tobacco industry to a few key players today. It took a long time to get there. And the industry doesn't want to talk about it, but I truly believe the basic thing that brought all this largest of the tobacco companies was the tobacco companies are setting an addictive product. It's fairly inexpensive or has been relatively so throughout history. There's just a great interest and desire to have nicotine in one

form or another. So they had a product that was marketable. It really developed customers that were addicted to it over time. And the industry did not want to face that for a long time. I've talked to executives today and some of them said, we wished we'd have faced up to it and avoided the controversy years before we did. We still could have been in the business. So that's the first thing. I think that was an advantage that most businesses do not have. I would imagine that people are not addicted to Facebook to the point that they couldn't find a competitive product to go to or a different website if they needed to. The tobacco industry, part of that was chance with the product they had.

policies along the way over decades led to the fact that there were only a few people participating in the business. As Lawrence said, there's not a real interest in joining it now, but government policies. But one of the major ones was when the advertising of tobacco was outlawed, first on television, then from billboards, that made it almost impossible for new entrants to come in, no matter how profitable. the business was, you just couldn't afford to build a cigarette plant and there was no way to mount a marketing and distribution campaign for a new cigarette. A new cigarette would have been quite profitable for anybody who could do it, but it just wasn't worth the risk. Smokers are very, very loyal to the brand and it's very hard to get them to change. Could I give you one brief anecdotal

example of that? Of course. Yeah, of course. I just had this conversation the other day. with a young man, I'd never met him, and his grandfather was a major executive with R.J. Reynolds, and he said that his grandmother, who ultimately died of lung cancer, was a devoted camel smoker. And when she found that Reynolds was going to make a filtered product, she declared that a filter would never touch her lips. And she went out and bought all, they did not discontinue the manufacturer of camel's 60 millimeter regulars. but she thought they might. She went out and bought as many camels as she could, build her freezer with them so that she would have a lifetime supply.

Because she didn't want to switch brand. And that's how loyal to their product. The Marlborough Cowboy people just as loyal to Marlboroughs, believe me. All right. So you have an addictive product where brand loyalty really matters, but advertising is also, well, is important because of the brand loyalty aspect, you need to build up that following. Once you have it, you're basically guaranteed to keep those customers. Could you maybe describe in a bit more detail how the industry whittled down to just a handful of major players?

Because I imagine in the 1900s when you could have invested that $1 in a tobacco firm, it wouldn't have been clear which, tobacco firm you should invest in. There'd probably be quite a few around, right? What was the industry like back then? And how did it evolve exactly to the point where we have two or three major players? Well, let's look at 1900 or thereabouts. There were hundreds of chewing tobacco products. There were very few cigarettes sold at the turn of the last century. Cigarettes did not become nationally popular until about the time of World War I. People had chewing tobacco, they had snuff, smokeless tobaccos, and pipe tobaccos. But the thing that changed things was primarily around the turn of the century, James Buck Duke created the American Tobacco Trust. And that was the consolidation

of the industry. So that alone consolidated most of the tobacco companies into three or four major companies. You had American tobacco, you had Liggett Myers, RJ Reynolds, and that was about it. Philip Morris had a piddling market share at that point. So the breakup of the tobacco

trust by Teddy Roosevelt's antitrust measures created four or five major players in that era. That was partly a result of government policy that created just

that group. And then the tobacco industry really took off in 1913, and that is the cigarette part of it. Again, there were no real national brands. R.J. Reynolds introduced the first national brand, Campbell, in 1913. He was a, he was a genius at advertising and promotion, and he had a good product. So he brought that out. The two other tobacco companies, Ligott Myers, in America and realized they had to have a competitive product. So they brought out Chesterfield and Lucky Strike. Those three dominated the market. Then what really propelled the market forward was World War I.

The Doe Boys went overseas. Pershing declared that they needed cigarettes in order to win the war. And so we developed, through gift of cigarettes to the World War I boys overseas, we developed a national market. When they came home, we had a whole generation of people who now smoke cigarettes and were loyal to those three brands. And that was the beginning. This was repeated in World War II all over again. And so you've built a market that way.

And that's how you, by chance as well as design, you were limited to three or four or five major players. Philip Morris was a special case. They were people who came later with a. stroke of genius with the Marlboro Cowboy. I think that was partly genius and partly luck. They were there at the right time. And they undoubtedly used that opportunity to build their market share and grow like crazy. And they were well rewarded for it. The stockholders were. It's been the premier cigarette company ever since about 1995 when they took off. Hi, I'm PJ Vote. My podcast Search Engine has a new two-part

series for you. Of all the new technologies coming out of AI, the most transformative one might be driverless cars. They're already on the road in 10 American cities, and they're quickly coming to more. We tell the story of how we got here. The secret team at Google that spent 15 years building what might be the safest vehicle on the road, and we cover the fights brewing in blue cities, where unions and politicians are working to keep those cars off the streets. Listen to search engine wherever you get your podcasts. So, you know, it's interesting. You mentioned the, you know, how many ways people consume tobacco a hundred years ago and cigarettes weren't as big. Obviously, these days, there are a plethora of other alternatives. And so we don't really see new cigarette startups,

per se, but we have seen a lot of companies come into other delivery mechanisms, most notably vaping. Jewel was extremely big, although I think they've run into some trouble in recent years. We also see states taking a more liberal attitude towards consuming cannabis, pretty much all over the country. How do these factor into thinking about the competitive risks? Is this a new phase where there actually are sort of new entrants that could theoretically compete for, you know, mouth share? I guess, I don't know what term you use, in a way that we haven't really seen before. I would just say, I think there's that possibility. the threat to those things that always seems to be hanging over them is, is FDA regulation.

Jules having to go through that process now to get approved. I think Philip Morris International with IQOS is the only device that has FDA approval for marketing their product as kind of a safer alternative, if I'm not mistaken. and it's still a very difficult market to break into in a big way. There certainly are a lot of new methods. A Swedish Match has a new nicotine product that's a kind of an oral product that is kind of another competitor to chewing tobacco and smoking and so forth. There are a few things that are coming in, but almost with the brand loyalty,

people still have their preferences. And I think there are also some cultural differences. What appeals to smokers in Japan as an alternative, for example, may not necessarily appeal to Americans. So it remains to be seen just how popular vaping gets to be. It certainly does present a little bit of competition. But on the other hand, a lot of these companies, have their own vaping products.

So it just seems to me the most likely outcome is that they will continue to dominate the nicotine space for lack of a better term, whether it's through combustibles, oral or vaping in some fashion or another, simply because it's just very difficult to get your product there, get it approved. You've seen different states take different laws against vaping, but of course they, for the most part, still allow combustibles, but tax them heavily. I just think it's going to be a very tough nut to crack for a lot of these alternative delivery mechanisms to take a very big share of the nicotine market. I'm curious, we talked about how tobacco stocks would have been a really good buy 100 years ago. Would either of you recommend them as an investment now? And I'm going to add a disclaimer here that, you know, no one on All Lots is officially recommending any stocks to buy.

I'm curious. Would you say they are a good investment given some of the headwinds in competition that you just described? Well, I would just say that in full disclosure, both personally and client portfolios, we do have positions in the major tobacco names. So obviously we do think that they have rewarding or potential going forward. The last few years have definitely been tough, although I would argue almost all of that share price underperformance has been multiple contraction. You've seen Altria's, which is the domestic Philip Morris.

You've seen there multiple go from the low 20s to the high single digits, although they've continued to raise their dividend year after year and increase their earnings. In my mind, that's just, and that really stemmed from, I think, in 2017, when the FDA sort of threatened to limit the amount of nicotine and cigarettes. And so far, really nothing has happened in that space, but it certainly sort of returned to investors' minds the idea of heightened regulation, which really hadn't been there in a while. Certainly, I think that even though it is a shrinking industry, the potential for the overall nicotine market is still relatively large.

And I do think there will be some things that will happen going forward. But yes, I do think that they will eventually return to favor. But as you pointed out earlier, everybody is kind of on the tech side of things. some of these other industries are out of favor, but that tends to happen in cycles, and I do think they'll eventually come back in favor. I took my analyst hat off years ago, so I'm not about to try to add anything to what Lawrence has said on that, but let me give you a little historical perspective on the so-called nicotine delivery system.

That was a term that was coined by a dear friend of mine, Dr. Claude Teague, who was in research at RJR. He wrote an internal memo about that that was strictly an academic or research product. It made it to a congressional investigation and became a buzzword from that point on. But there has been a desire for a nicotine delivery system since about the late 1500s. And it picked up steam in England and all over Europe when Sir Walter Raleigh introduced it throughout Europe. There's been a love-hate relationship between governments and nicotine ever since. It's interesting that the first anti-smoking campaign was waged by Tsar Alexis in Russia in the mid-1600s. He had fairly severe fines.

The first offense for smoking was a slit nose and transferred to Siberia. The second time they caught you smoking, it was the death penalty. he still wasn't able to stamp out the tobacco purge that people had. And what governments and kings and queens and czars learned after that was, look, we can make a lot better deal here by taxing this product than we can trying to stop it. And that's been going on ever since. Bringing that all the way through to the master settlement agreement, I was aware of the agreement I knew something about it,

but I was dumbfounded when I looked at the numbers. When you go through the settlement agreement that was made, there were a number of stakeholders that now become vested interest holders in the continuation of the cigarette business. And you have federal excise taxes, state excise taxes, payments to the FDA, payments to the farmers, payments of billions of dollars to the lawyers who brought those class action suits. when you add it all up and from from the time that it started about 19 i guess that was what

89 i think 99 whichever 50 projecting those numbers 15 50 years forward the tobacco industry was on the hook for 1.7 trillion dollars of payments over that period of time how did they address this this if you looked at that outside and looked at that astounding number you'd say My heavens, this is going to break the industry. You know what they did? They said, we can cover this. We'll raise cigarettes, 45 cents a pack. That covered their bills to all these outside people and gave a little increased profit margin beside.

That's the nature of the business. Talk about, I'm fascinated by that because, you know, I mentioned, like, my whole life I've been feeling the public health and lawyers and everyone going after this industry. So the master settlement agreement was in the late 90s. Talk a little bit more about how that came about. And then that point you made about the stakeholders, how suddenly there are a lot of interested parties, not just tobacco company shareholders who want to see this industry continue. Talk about sort of how that all came about.

Well, it came about primarily through the instigator and the leader in it to give them credit for their creativity was a group of lawyers down in Mississippi, They had successfully sued the asbestos manufacturers and gotten something of a war chest together and that gave them an opportunity to go after other industries. And the tobacco industry was ripe for this. So they approached the state's attorneys general of all of the states. And I'll simplify it because there were a few little side deals here. But basically they went through this suit and had a class action representing all the attorneys

General, and it fell apart in Congress. They then came back and finally got together with the tobacco companies and made disagreement. That's how it happened. There was a really interesting part of the settlement that I had not realized before. In all of the machinations within RJR, after the buyout, CEOs changed, a number of people came in and tried their hand at ring tobacco company and weren't successful. Of all the unlikely people that they brought in as the CEO was Steve Goldstone, who was an attorney with RJR's outside counsel, Davis Polk Wardwell. He came in as the CEO. He knew, I can't say he knew nothing about the tobacco industry, but he had never worked in the tobacco industry. Goldstone in my book turned out to be one of the

few really great heroes within a story that had a mixed message from success. And he recognized finally as probably only an attorney could, this ship is sale of trying to stonewall and say, there's no connection between cigarettes and cancer. He went to the other majors and said, look, if you continue this approach, the government is going to run us out of business. We've got to come to terms here. And that's what led to the master settlement agreement was him bringing the industry to the table and some rationality, I think, and willingness to compromise. They recognized they were going to have to do something along those lines. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every

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I'm curious, in recent years, we've seen another trend, I guess, or awareness, which is the ESG movement in capital markets. So the idea that people should be investing in sustainable debt and equity. Do either of you feel that ESG has yet had an impact on the tobacco industry or is maybe limiting capital or affecting the cost of capital in some way? I'll just offer my thoughts on that. It's very hard to quantify in any way. I mean, you can always look at the share price and whether some major institutions are forced to divest their shares. Of course, somebody has to buy those shares for the market to clear. So somebody will end up owning them. The trouble is at what price. And it's, it's, It's very hard to say that that movement has raised their cost of capital in any material way. For example, Altria pays out something like 80% of its profits every year. So I'm not sure they need anybody's capital because they're too busy returning cash to their shareholders. And the same thing for, I think, BAT and most of the other players.

on the fixed income side, which is maybe they have access, the debt market in recent years, there's really no evidence that their interest rates are any higher than anybody else's of a similar balance sheet quality. So to me, it's a little bit tricky to try to say that ESG is really pressuring them in a financial way. Certainly they're aware of it. If you read through their commentaries, they are trying to get ahead of this movement and sort of market themselves. Philip Morris International talks about a smoke-free future and what they're doing to try to get their customers to pivot from combustibles to heat, not burn, and lower-risk products. And so in a way, it's sort of funny how they're appealing to the ESG credit. by saying that they're actually trying to do what's best for their customers by getting them to pivot to these other products.

So I think they're aware of it, whether or not ESG actually matters to their bottom line. I don't know. It probably matters more in terms of who ends up owning the shares. But that's about all I can make of it from what I've seen over the last few years of this movement, sort of becoming sort of niche to more mainstream. Let me ask a sort of follow-up question to Lawrence. ESG aside, I'm just curious about the sort of conversations you might have with clients. They're probably people who just feel uncomfortable investing in tobacco stocks,

worried about owning a part of an industry that does lead to all sorts of adverse health effects and so forth. What are those conversations like as a financial advisor dealing with that aspect of it? Sure. So we give our clients the ability to identify what they want to own, of course, and also what they don't want to own. And more than a few say that they would prefer not to own tobacco directly. And that's fine. We can work around that. The vast majority simply look at it from a more pragmatic standpoint, which is where do you draw the line? So are you going to own shares of Walmart or some sort of retailer that sells these products? Are you going to look at it in a

different standpoint that what's acceptable? If you own an index fund, they own these shares. So really, there's what are you doing other than making yourself sort of feel a little bit not, I wouldn't say morally superior, but making yourself feel a little more comfortable in how you're invested just by not owning those shares directly. And I think, most people recognize that they just want to invest in a way that that makes the money, gives them an opportunity to achieve the returns that they need for their retirement. And so they end up sort of concluding that they're okay with owning a small stake in a business. And they're not on a secondary market, they're not giving the money directly to the company.

They're simply receiving their share of the profits via dividends. or what have you, and they're free to take that money and do with it what they want, whether it's donating to an anti-smoking campaign or whatever. So we have those conversations. We sort of lay it out in a certain fashion that says, okay, well, if you exclude these, here's the reason why, here's what you may consider, and if they still decide to exclude it, that's certainly fine. But we just want to make sure that they understand all the different angles

and see it through that way. This attitude on tobacco, I think, comes and goes. I think this is right. I remember not being directly related to it, but reading an article about it. CalPERS, the big pension fund in California, divested themselves of tobaccos for some period of time. And then I think I read an article in the journal that they had decided they had made a mistake and they were going to reinvest in tobacco stocks after tobacco stocks had,

at such a great performance for four or five years. I have a slightly weird question, and I'm not sure either of you will be able to answer it. But we mentioned cannabis earlier in this episode. To what extent do the economics of the cannabis industry resemble the economics of the tobacco industry, in the sense that, you know, you have a product that people really like? you have, you're growing a crop essentially, which is similar to tobacco. Could you see the cannabis industry following along the lines of the tobacco industry if, for instance, you know, tomorrow the federal government decided to legalize marijuana across the United States?

Would it take off and would it resemble tobacco? I'll just offer some thoughts on that, which is, and this is just pure conjecture on my part, I actually think, and this is just based on my conversations with people who know a little bit more, is that I almost wonder if the cannabis industry will not more closely resemble the alcohol industry and not tobacco in the sense that the side effects of excess alcohol consumption more closely resemble cannabis consumption in some ways. And I think that some alcohol companies have identified cannabis as a thing. threat to their bottom line. And I want to say that a few companies have actually made

investments in cannabis to sort of hedge that risk. To me, at this point, it seems a little more fragmented. There's not too many established players. It's not at all clear how profitable their operations have become. I want to say that maybe Gene can correct me that the tobacco companies were profitable from day one and really had, there wasn't much speculation in that space. To me, it seems like there's quite a bit of speculation in cannabis. So I don't know if that helps at all, but I would say maybe the better comp is the alcohol industry for cannabis, not tobacco. Historically, you're right.

The tobacco industry was amazingly profitable from the very beginning, way back in the just post-Civil War. It started with chewing and smoking, the pipe-smoking tobaccos, and it was profitable from the very beginning and has continued to be so. If I could just offer my take on what an investor should look for going forward, and I don't know what the companies are going to do, but the thing I would be looking for from the cigarette companies is to face the reality, and I've made this analogy before, the cigarette business with this declining base of customers is not unlike an oil-producing company,

a company that's got oil wells and you're on a decline curve here of some dimension. The business is going away. The best thing I think that those companies can do is if they can find substitute tobacco products or tobacco products, that's fine. otherwise take that money that's being pumped out of the ground, if you will, in my analogy, give it back to the shareholders. Don't try to reinvest it. As Lawrence has said, the cigarette companies don't need any more capital.

They've got plant in place. They may need to modernize occasionally, but the need for more fixed investment is not large. It simply is an enormous cash cow. What they do with that cash is going to determine, I think, how successful they will be as investments for the stockholders. This is where, looking back, RJR went down one path. Philip Morris went down another. Philip Morris was successful. They said they had a more abiding faith in tobacco than Reynolds did, and they stayed mostly in the tobacco business.

They made a side venture into the foods business, which was pretty successful when they spun it off. RJR had an enormous number, eight different industries, most of which did not work out very well. The reality was, I was stunned when I went through the numbers, over a 26-year period, we invested $19 billion in non-tobacco industries. We got back $18 billion. Our return was minus 1.5% of year compounded. Tobacco's profits hid all of those problems. They masked all of it.

And the company continued to deliver about a 13 and a half to 14% a year compounded return. That's super interesting, that analogy to the oil well and declining, even throwing off tons of cash. You know, before we go to wrap up, I want to go back. It's interesting comparing cannabis to alcohol because I want to ask, A, why haven't the economics of the alcohol industry been as strong as tobacco. Why hasn't it been this multi-decade money printer in the same way in your view? And either one of you can answer. And then, you know, just thinking about industries going forward, we sort of teased it when I mentioned, you know, Facebook and some of the big tech companies. Lawrence, you mentioned Peter Lynch. And, you know, you have this idea of like,

okay, companies you know is sort of a thing that we associate with Peter Lynch. But what are the things that you would look for to say, okay, this has economics that might over a long time be similar to what we saw in tobacco? Well, I would say just first of all on the alcohol industry question, it is interesting. And my understanding is they sort of went the opposite way of tobacco with Jimmy Carter deregulating the beer industry in the 70s. It became very fragmented. You had the rise of a lot of craft brewers. Some of the big breweries started to lose market share and pricing power and so forth. One other interesting dynamic I think you've seen play out in this pandemic,

although it hasn't helped the shares at all. Because of the restrictions on public smoking, there's not a lot of waste that goes into it, whereas you're seeing a drop in alcohol consumption because of the loss of public venues, of sporting events and concerts and so forth. So in a way, there's just not a lot of waste in the tobacco industry from the production standpoint. I think there's a lot of different reasons why tobacco is unique and alcohol has sort of not delivered the same returns.

I think they have been okay, but just not as great. And that's just from unique dynamics there. When you look at the other send stock industries, you know, we compare it to casinos, defense names, alcohol, and so forth. And I think we have this idea that send stocks do well simply because nobody wants to own them. There's an interesting study by Rubiko, which shows that a lot of these so-called sin industries do well because they're highly profitable. So they sell things that people need and good times and bad.

they are in a way recession resistant. They have a high degree of consistent cash flow, so they're not very cyclical at all. They tend to have clean balance sheets, so those are sort of proxies for what we call the quality and low volatility factors. And in a lot of ways, and this is especially true in tobacco, they very rarely get overvalued. And so if you compare that, for example, with Coca-Cola. and Pepsi, that's a similar industry in the terms of it being more or less a duopoly. Their products are more or less recession-resistant, highly profitable, tremendous brand, loyalty,

and so forth. But at different periods of time, they've become very expensive in the case of Coca-Cola. It's really been almost bubble-like in two instances, the late 90s and the early 70s with the nifty 50. that sort of froth has never really happened in tobacco. I think about the highest the multiples ever got was the low 20s. I think Gene can correct me on that. That's pretty high for a low growth industry,

but it's not so high to the point where it's going to impair your returns over time. And so I think maybe defense is another industry that has similar dynamics. The returns very rarely fall out of line from a historical, pattern. There doesn't seem to be a lot of incidents of excessive valuation. You have the whole sort of ESG problem there with a lot of people not willing to own

weapons manufacturers and maybe that plays a part in keeping valuations under wraps. But again, it's a very oligopolistic industry with a lot of consolidation, a few major players, very high barriers to entry.

There are not a lot of those industries around, but there are few. And I think that's kind of what I look for in the industry is saying, is this a place where it's going to be a good place to do business and look at those kind of big picture dynamics and then sort of go down from there and see what are the best opportunities for those various players in this industry that I know is going to be around for a while. Well, Gene and Lawrence, thank you so much. So I guess the lesson is, is sell addictive sin products and have an oligopoly.

Is a good, is the secret plus a lot of government regulations and other things that make it hard to compete is the secret. But now that was fantastic and really appreciate both of you coming on. Thank you for the opportunity. It's a pleasure to be with you, folks. Thanks for having me. Thank you so much. Tracy, I love talking to anyone that just like knows a specific industry that well. I mean, both of them super interesting by hearing gene, sort of like history of how the industry came to be what it is.

I loved hearing all that. Yeah, absolutely. And it's probably not surprising that selling an addictive product can be a real moneymaker over time. I think everyone knows that at this point. But just watching how the industry evolved and also seeing how government regulation that was actually supposed to clamp down on cigarettes. in many ways concentrated power in the existing tobacco companies. I thought that was really interesting. And also the dynamic between Philip Morris and RJR,

how one of them was basically very successful and the other one kind of floundered, just because, well, of different strategies. You still had an oligopoly, but vastly different outcomes. That was really interesting. Just hearing all of the different things, that sort of like set this industry on its way to being a sort of a unique asset class from an investor perspective. I also thought that was really interesting. I love Gene's analogy about like, okay, you're sitting on an oil well. You know the oil well has only so much life in it, right?

Like there is a finite amount of oil and maybe there is a finite amount of people who will ever smoke cigarettes. And so the question is, do you take that cash and try to find the next oil or the next cigarettes, or do you just, you know, keep disciplined with that cash? Don't try to find the new thing, reinvest in the business and give a lot of money back to shareholders. And the sort of the divergent paths. And in the end, sounds like the companies that just sort of stuck to their knitting and bet on tobacco as opposed to trying to find the next big thing were the ones that won out. Yeah. I mean, another one of the surprises in that conversation was that RJR was the company that diversified, which is,

what you're traditionally supposed to do when you have a product that's falling out of favor and they did a lot worse than Philip Morris. You know what I was kind of thinking during that oil analogy? Tell me. Maybe the tobacco company should set up like a sovereign wealth fund, right, with their capital. If they're just throwing off returns. Like some sort of like trust, yeah. Yeah.

They might as well, right? If they're going to give up on tobacco products eventually. I mean, I guess, you know, I don't know. It would be interesting to hear them to. get into a further conversation about the sort of master settlement agreement, because I kind of feel like there might be an analogy there between state sovereign wealth funds in oil rich countries and the funds that various, well, literal U.S. states have set up with that sort of recurring royalty stream from that settlement agreement from tobacco companies. There's probably,

there's probably actually a lot to draw there in terms of comparisons and then how that cash is used and how that cash is sort of funneled to public authorities. Yeah, I think you're right. Well, I guess we have another idea for an episode then. Yeah, one day. All right. Shall we leave it there? Let's leave it there.

All right. This has been another episode of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And follow our guests on Twitter, Lawrence Hamtel. He's at El Hamtel.

I don't think Gene is on Twitter, but you can check out his book Going Down Tobacco Road, RJ Reynolds, Tobacco Empire, the Gold Leaf, and North Carolina. And be sure to follow our producer, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca today. And check out all of our podcasts under the handle. at podcast. Thanks for listening.

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