Smoke ‘em If You Got ‘em

Uncategorized Comments Off

In this blockbuster of an edition:

  • Feature: Smoke ‘em if you got ‘em
  • Trading note: Dundee, Acclaim Energy Trust, Manitoba Telecom
  • A heartwarming story about Market Gal and a garbage bin

Feature
Well, another earnings season has come and gone. The results were surprisingly good, which was essential given the increasingly bloated nature of the stock markets. But among the releases by Cisco, Nortel, and the big banks was a report that probably flew under your radar. And I’m guessing that if it had appeared on your radar, it would have been promptly shot down.

I’m talking about a company that just accomplished the following:

  • increased its annual dividend by 16%
  • has increased its regular dividend by 75% since 2000
  • pays the highest dividend on the TSX, currently pegged at over 6%
  • has far more cash than it knows what to do with
  • increased quarterly EBITDA margins from 42% to 48%
  • declared quarterly earnings up 22% year over year
  • has been increasing its market share in a tough environment

So what are we talking about here? Let me give you a clue: It’s a company that produces a legal product that many find extremely offensive. Get it yet? It’s Canadian tobacco company, Rothmans (ROC on the TSX). They make cigarettes such as Rothmans King Size, Craven A, Benson and Hedges, Number 7, and a host of others. I can feel you cringing right now. Some of you want to reach through the Internet and slap me. I feel like Kathy Lee Gifford after the sweatshop allegations came out. Am I now to be labeled,Market Guy: Pariah?

The ethics of performance
The final arbiter of any investing decision is performance. On that score, I’m quite satisfied. I purchased the stock about 2.5 years ago at just over $24. In 2002, the company supplemented its regular dividend with a special payout of $5 a share (holy crap). Based on my purchase price and including the special dividend, my average annual dividend yield stands at 14%. The stock has been choppy in the last year or so, but is currently trading near $28. I’ll take it.

However, many argue that performance is irrelevant when we’re talking about investing in tobacco. I should mention right of the bat that I’m a non-smoker. The city of Ottawa recently enacted a by-law that prohibits smoking in indoor public places. From my perspective, the results have been fantastic. Eating at a restaurant has never been more enjoyable. We no longer come home smelling like the combination of a chemical spill, garbage dump, and Madonna’s underwear. 

Whenever I mention my investment in tobacco, most people assert that it’s unethical to be profiting on a product that causes physical and emotional misery. I came across an anagram site the other day and someone had rearranged “A pocket of Rothmans cigarettes” into “Smoke it, fate, throat cancer, gasp.” True, tobacco smoking causes tremendous harm not only to users but to those around them. The costs to the health care system are surely staggering and the economy has been deprived of many individuals who could have made a meaningful contribution.

All true. But investing in a tobacco company is not akin to cheerleading for the product. Here’s how I see it: With every dividend payment, I’m being compensated for all the money that I’ve paid in taxes to treat smoking-related illnesses. My mother-in-law is a smoker, so with every dividend payment I’m being compensated for all the times we had to sit on her stinky couch and breathe in those noxious fumes. I’m sure that couch has cancer by now. With every dividend payment I’m being compensated for the expenses that I’ll have to incur when she becomes ill. Market Gal recalls with horror sitting with her mother and chain-smoking aunts on a 36-hour drive to Florida and being prohibited from opening the windows. Her lungs might have well been serving as the filter for a bingo hall or Vegas casino. All those years of second-hand smoke.

Still, tobacco companies are clearly established within the category of sin stocks, the poster children for unethical investing. However, the idea of using morality as a guiding investing principle doesn’t hold much currency with me. Occasionally I’ll watch Market Call on ROB-TV and be amazed when a caller asks the money manager about a tobacco or gambling company. Several managers will utter something like, “we don’t invest in companies that participate in that line of business” or some equivalent. Funny how they never seem to have reservations about alcohol or defence stocks. Anyway, unless I’m investing in a so-called ethical fund (isn’t that an oxymoron? Am I being cynical here?), I don’t pay the manager to make morality decisions on my behalf. I pay them to make me money. In fact, if you could invest in the Seven Deadly Sins, I’d be a buyer. Let’s review the sickening seven:

  • Pride: The sin from which all other sins arise. The index fund of sin.
  • Envy: Was especially popular during the 1999-2000 Nasdaq race.
  • Gluttony: Have you been to an American beach lately?
  • Lust: You know it, you love it, you can’t live without it.
  • Anger: I prefer its alternate title: Wrath. Never bet against wrath.
  • Greed: The reason we’re all here, isn’t it?
  • Sloth: Good old sloth. Getting it done in an understated way.

Where have all the customers gone?
The number of smokers has been declining for many years and that’s bad for business. However, there will always be a segment of the population that smokes. It’s unavoidable. The number of tobacco companies is also on the decline. Many of the smaller players have been gobbled up by larger, deep-pocketed firms. That means the cash is being divided up amongst a smaller group of players. A couple of years ago, Rothmans tried to acquire a smaller US firm, but was beaten out by US giant, RJ Reynolds. In late October, Reynolds and British American Tobacco merged their US operations. The resulting company will have 30% of the US cigarette market. In any event, my investment will persist so long as Rothmans is getting a decent share of the take.

The Market Guy wishes you wouldn’t smoke…but if you do and refuse to stop, why not go for the full, refreshing flavour of Rothmans King Size?  

Taxes and product positioning
G
overnment taxation of tobacco products continues to rise, with Manitoba, PEI and the NWT planning further increases in 2004. This helps to explain the recent popularity of so called price-based (discount brand) cigarettes. These products result in lower margins, but Rothmans has been doing a good job of growing market share in this segment of the industry. The company has also been increasing the prices of their premium brands and so far, this strategy has been quite profitable. However, with every price increase, contraband becomes more of an issue. If there are smugglers around, let’s hope the RCMP has a Canadian equivalent of Crockett and Tubbs (they’d probably be called Mackenzie and Proulx…just doesn’t sound that exciting). Thousand Islands Vice anyone?

In any event, I’m not very happy about taxation of tobacco products because all those taxes just disappear into the great, deep, dark, bottomless spending pit that is government. If there was some way of assuring me that all of the money was going to fund health care, I’d be happy. But how likely is that? Well, by investing in the company and receiving the dividends, I receive compensation directly without going through the governmental middleman. Of course the government gets their cut when I pay taxes on the dividends. The house always has an edge.

The blame game
Our perception of the legal risks is tainted by what’s been going on south of the border. However, even in the land where someone else is always responsible, the risks to big tobacco appear to be waning. The states have been getting their pound of flesh and the climate appears to reflect the reality that a bankrupt tobacco industry is detrimental to the state coffers. Plus, the Canadian legal environment appears to be far less litigious than in the US. Perhaps there is also a growing emphasis on personal responsibility? Just maybe? Probably not. However, my eyes are wide open here and nothing would come as a surprise. For now, I’m a holder and regard Rothmans as a source of dividend income.

Trading note
I recently initiated the following positions:

  • Dundee Realty (D.UN) at $22. This long-standing real estate concern recently converted to the income trust structure and has holdings in the office, commercial, and industrial sectors. The company has 1300 tenants, with no single tenant accounting for more than 2.5% of the total space. The federal government is the single largest tenant (hey, maybe this is another way to get a few bucks back from them). The units are currently trading at a discount relative to many of the other REITs and I believe the spread will narrow. Even if that doesn’t happen, I’m quite content with the approximately 10% yield. 

  • Acclaim Energy Trust (AE.UN) at $11. The company just completed an issue of units via a bought deal and I decided to participate. For info purposes, a bought deal involves the underwriters buying all of the issued stock and then trying to sell it to other investors. I like the very conservative payout ratio (around 75%), high-quality reserve life of almost 10 years, balanced production profile (55% gas, 45% oil), and the fact that distributions are expected to be almost entirely tax-deferred through 2004. I hadn’t anticipated adding any energy holdings to the portfolio (beyond ARC Energy), but this deal came at what I consider to be a good price. 

  • Manitoba Telecom (MBT) at prices under $40. This one could go absolutely nowhere, but there are some interesting possibilities. I’ll get to this in another column.

A heartwarming story about Market Gal and a garbage bin
The other day, Market Gal’s supervisor at work was calling around to various companies looking for a new outdoor garbage receptacle. When she heard about it, Market Gal burst into the office yelling, “BFI! You have to call BFI!” Her supervisor was confused, wondering why an employee would have such a clearly-defined preference on the matter. “Because my husband owns some BFI shares,” she said. Well, her supervisor ended up getting a BFI bin (BFC.UN on the TSX), and I couldn’t be happier with the missus. Thank you BFI…and Market Gal!

What has your better-half done for you lately?  


The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. On Halloween he became nauseous at the sight of Christmas trees making their first appearance in the malls. Send a lump of coal to mail@marketguy.ca