Can a business survive by poisoning its customers? Assuming that it can, might it be a good investment?
This is the issue confronting the tobacco company investor. An amazing number of intelligent people treat tobacco stocks as ordinary investment vehicles, to be traded based on the usual criteria of earnings, dividends, market prospects, etc. I believe our grandchildren will regard this approach the way we view 1920s investors who took stock tips from shoe-shine boys: As the amusing but foolish behavior of people who let their money get in the way of their good sense.
Tobacco companies are in a class by themselves. The normal, ordinary use of their product causes serious physical harm to the customer and widespread economic damage to the customer’s family, employer and government. As a result, the tobacco business has more in common with a Ponzi scheme or a game of musical chairs than with a normal investment. Eventually, but at an unpredictable time, courts or legislators will reallocate the burdens of tobacco to those who presently reap the benefits. Whoever happens to own the business at that point, loses.
Or, as Philip Morris said last year in a footnote to its financial statements, “Management believes that the ultimate outcome of all pending litigation matters should not have a material adverse effect on the Company’s financial position. However, management is unable to make a meaningful estimate of the amount or range of loss that could result from an unfavorable outcome of all pending litigation.” In other words, we think we can put off the day of reckoning indefinitely, but there is no telling what will happen if we can’t.
Leaving aside any discussion of ethics or “social investing,” there is no reason for an investor to believe that tobacco companies can forever avoid accountability for the enormous costs their product imposes. The U.S. nuclear power industry is all but extinct as a result of safety and regulatory burdens imposed after the Three Mile Island accident in 1979. If we can kill off nuclear power with nary a second thought, who will cry if the tobacco companies go broke? Only the people who make their living in the industry.
Conflict of Interest
Which brings up the second reason investors should be wary of tobacco stocks. There is an unusually severe conflict of interest between management and shareholders.
Suppose you decide to gamble on a tobacco stock, figuring that the tremendous cash flow (even in the declining U.S. market, not to mention overseas venues where smoking is still growing) will probably put you way ahead before the party ends. You would want the tobacco company to pay fat dividends, so you can invest the profits in businesses that are not exposed to tobacco’s potential liabilities.
Now suppose you are a tobacco company executive watching all that cash roll in. Do you mail the check to the investor? No, because you want to have a growing business to manage, not to mention a source of income if the worst should happen to tobacco. Instead, you tell the shareholder, “This is your lucky day! I have just taken your money and invested it on your behalf in the [pick one: food/insurance/real estate/hotel/jewelry/defense/oil/
broadcasting/computer/baseball card] business. Our baby is a conglomerate! Have a cigar!”
|Company Name||Philip Morris||RJR Nabisco||B.A.T. Industries||Loews Corporation||Brooke Group Ltd.|
|Tobacco Subsidiary||Philip Morris||R.J. Reynolds|
Brown & Williamson American Tobacco Co.
Benson & Hedges 100's
L & M
Oil and Gas Drilling
Maxwell House Coffee
Oscar Meyer Hot Dogs
PMCC Financial Services
Mission Viejo Real Estate
LifeSavers Roll Candy
Ortega Mexican Foods
Eagle Star Ins. (UK)
Allied Dunbar Ins. (UK)
Bulova Defense Products
Diamond Offshore Drilling
CBS, Inc. (20%)
New Valley Corp. (formerly Western Union)
MAI Systems Inc.
Sky Box International, Inc.
|Non-Tobacco Revenue (% Total)||57%||47%||n/a||86%||30%|
The problem for the investor is that just as we cannot tell when tobacco’s bills will come due or how large they will be, we cannot predict exactly how the courts and legislators will dispose of all these assets that were acquired with tobacco money. For a precedent, recall that the Manville Corporation’s asbestos liability was settled via a fund generated through non-asbestos lines of business.
Of course, the tobacco companies hire smart lawyers and MBAs and they know all this. Unfortunately, tobacco executives seem to be big impulse shoppers. The table above provides a peek at what they have picked up near the checkout counter.
The tobacco companies have tried to create legal structures that will insulate their non-tobacco businesses. Will those structures work? Investors probably will not find out until it is too late to do anything about it. From the investor standpoint, a spin-off of the non-tobacco businesses seems to make much more sense, yet most of the companies are resisting.
American Brands Divestiture
Note, however, that American Brands sold its U.S. tobacco business last year to B.A.T. Industries, allowing Am Brands to focus on other lines of business (Franklin life insurance, Masterlock hardware, Jim Beam whiskey and Titleist golf balls, to name a few). Am Brands continues to have a significant tobacco business overseas, unfortunately, so its shareholders still may not be off the nicotine hook.
How did the market react when American Brands sold the tobacco business for a relatively low $1 billion? By boosting the shares around 10%. This indicates that, though the market is charging a risk penalty for tobacco exposure, so far the penalty is rather modest compared to the potential loss.
Any investment represents a balancing of risks and benefits. In the case of tobacco the normal risks of the business are dwarfed by the peculiar hazards of the product, to the point that the companies themselves do not know what the risks really are. Beware, investor: Someone will eventually be left holding the bag.