Tobacco Going Up in Smoke

 | Sep 24, 2013 | 1:00 PM EDT
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Socially conscious investing was a minor investment fad in the last decade. We saw it both at the institutional level, with some of the biggest state pension funds, and at the retail level, as well. As an ETF trader, I clearly remember iShares launching their own socially responsible ETF, iShares MSCI USA ESG Select ETF (KLD) several years ago. While socially conscious investing has always had laudable goals, I have always found it difficult to reconcile those goals with another goal that is also kind of important: making money.

I did some research on the historical performance of socially conscious funds as an asset class, and the results aren't exactly clear. These funds have outperformed or underperformed depending on what time horizon you've picked -- but I think it's fair to say that, as an asset class, they've been competitive with the broad market.

In any case, though, socially conscious investing is based in the belief that companies that don't engage in anti-societal behavior (however you define it) will be rewarded by customers and investors in the long run. That may or may not be true. But what is true is that the socially conscious universe completely failed to capture the massive outperformance of tobacco stocks in the last decade.

Tobacco shares marched higher, year after year, with massive dividend growth. In fact, the low in the sector was marked almost to the day by the Engle case, and the huge amount of regulation that followed actually strengthened the industry, protecting profits and creating huge barriers to entry. There are a lot of different ways to slice "socially conscious," but suffice it to say that it's unlikely any of those funds hold tobacco stocks.

In 1999, you wouldn't go near a tobacco stock without a shotgun and a flashlight, but people sure have warmed up to them since then. Everyone, retirees especially, just love the dividends, and the price action has been bulletproof. Through war, depression and giant hurricanes, people have got to smoke.

That might be changing, actually. It's not new news, but the tobacco companies are taking pretty big corporate finance risks, loading up on debt to buy back stock and increase dividends, right at the point when they are facing a grave existential threat: electronic cigarettes. I've done a lot of research on e-cigarettes, and I'm convinced that, in 10 or 15 years, you won't see people smoking combustible cigarettes. It will all be e-cigs. Here's why.

E-cigarettes contain a liquid that's heated with a coil and is turned into vapor. The vapor, when inhaled, gives the user a dose of nicotine -- without all the carcinogens that are found in regular cigarettes. The Food and Drug Administration hasn't issued any statements on e-cigarettes, and it hasn't evaluated the safety of these products. But, based on the existing literature, they appear safe, and to the extent that they impart any harmful chemicals, this seems to be in microscopic quantities.

The tobacco industry has responded by rolling up some of the smaller e-cigarette makers -- which are nearly all closely held companies -- to provide their own offerings. But, in general, they've been too busy paying dividends and bribing shareholders to pay much attention to the competitive threat. Living in South Carolina, I can tell you that "vape" stores are opening everywhere, and e-cigarettes are helping lots of people to quit actual smoking. ("Vape" refers to inhaling vapor.) Smoking kills more than 400,000 people per year in the U.S., so the potential reduction in harm from e-cigarettes is just staggering.

It's hard work being short tobacco stocks, with those massive dividends and buybacks, but the hard trade is usually the right trade -- and I myself am short Phillip Morris (PM). At a minimum, I believe that tobacco's long string of outperformance is going to come to an end. I'm one of the most politically incorrect investors ever, and I have never had any qualms about rooting for Big Tobacco, but I think we are witnessing an industry that is entering secular decline. Tobacco companies are buggy-whip companies. I don't like being long buggy-whip companies, not even for the dividends.

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