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Anti-smoking campaigners have notched up enormous successes in their battle against tobacco companies. In Malaysia the sickly pairs of lungs decorating the box is enough to put you off having a puff, while in the UK it’s increasingly difficult for minors to buy cigarettes. Yet, tobacco companies have continued to produce wonderful returns for their shareholders.
This is highlighted by RE: CM’s investment director Daniel Malan, who admits his team underestimated potential returns to be had out of this allegedly dying industry. They stocked up on pharmaceutical companies instead, which performed even better than tobacco stocks – so their clients didn’t lose out from this oversight.
The RE:CM team have cut back on drug companies this year. Says Malan: “We pared back our exposure over the past year as the discount closed quite considerably, but it remains a sizeable fund holding.” This serves as a reminder that a good investment isn’t just about investing in a good company or a growth industry; it’s about understanding the value of a company and whether this value is reflected in the share price. – JC
By Daniel Malan
When we last looked at big pharmaceutical businesses (‘Smoke ’em & Dope ’em – The Tale of the No-Growth Ruse’, REVIEW Volume 17, July 2011) we compared the industry to a very similar situation with big tobacco at the turn of the century. Fund capital allocation to tobacco – an allegedly dying industry – proved worthwhile, because the assets were priced for bankruptcy. Instead of dying, the industry responded by consolidating, cutting costs, increasing profit margins and returns on capital, and buying back shares. This generated significant shareholder returns in the decade that followed.
When this article was written midway through 2011, the market consensus appeared to be that the pharmaceutical industry was ex-growth – their product pipeline had dried up resulting in there not being enough new products to replace the ones coming off patent. While we were unexcited about the prospective returns on offer in the tobacco sector in 2011, we instituted a significant exposure to pharmaceuticals. This was in the form of basket of global pharmaceutical businesses, cumulatively representing the largest investment in the RECM Global Fund, at the time.
Our key motivation for owning a basket of these stocks was that we didn’t have the expertise to judge which individual company would be successful in delivering blockbuster new drugs from their research and development spending. But we didn’t need to. By owning a basket of the largest pharmaceutical businesses, we could capture over 75% of the world’s research and development spending pool at a low price, while being paid a handsome 4% dividend yield.
What’s happened since then
Chart 1: US Dollar Returns: August 2011 to August 2013
Source: Thomson Reuters Datastream, RECM
Both the pharmaceutical basket and the four tobacco companies featured in the original article produced strong absolute and relative returns over the two years since the first article.
More importantly, our investment thesis started playing out and remains on track. The pharmaceutical companies in our basket have slowly but surely started delivering successful new products and expanded revenues, market sentiment about their prospects has turned more favourable and their market valuations have increased.
But we didn’t get it all right. We were surprised that the tobacco companies did so well. We suspect this performance may be a function of the latest global obsession with investing in companies with ‘reliably predictable’ earnings profiles.
Our return could have been even higher if we’d hedged the currency exposure as the underlying non-US dollar currencies all weakened against the dollar over this relatively short timeframe.
And although our view that industry consolidation could occur started playing out, we didn’t benefit to the extent we might have. While many smaller pharmaceutical companies were acquired at significant premiums to their market prices during this period, we didn’t own any of these takeover targets in our basket.
Taken as a whole, the equal weighted basket of companies currently remains priced at a discount to our calculation of intrinsic value. We pared back our exposure over the past year as the discount closed quite considerably, but it remains a sizeable fund holding. Our investment thesis remains intact and we’d only consider further reducing our exposure if the basket price caught up to intrinsic value or a far cheaper high quality investment idea presented itself as an alternative.
What we learned
This investment idea re-affirmed our already strongly-held conviction that sensible idea generation and fund construction processes can include the limited use of basket groupings. Our investment process already caters for this where these are constructed in proven, clearly defined and disciplined ways. We don’t intend such baskets, taken together, to ever form a dominant component of any fund that we construct. This is because we’ll always favour investing predominantly in high quality individual assets that we understand well and can use to construct a reasonably concentrated portfolio.
Our continued study of the two baskets covered in this article further developed our understanding of the tobacco and pharmaceutical industries. It also confirmed the critical importance and value of sensible capital discipline by investee company management and the ability of companies with attractive business characteristics to overcome leadership, cyclical and structural adversity.
* This article is republished here with the kind permission of RE:CM.
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