Tobacco companies, from a return on investment capital and market share perspective, are some of the world's greatest businesses. In fact, one of the world's greatest investors, Warren Buffett, loves the product economics of Altria Group (NYSE:MO) and Philip Morris International (NYSE:PM)for just these reasons. In the late 1980s, the legendary investor gushed over cigarettes' profit potential:
It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty.
"Barbarians at the Gate," page 218
Despite loving the economics, Buffett refuses to own either company. Before diving into why Buffett will not buy them, let's look at why he loves them.
Altria and Philip Morris International are textbook Buffett businesses
In his 1996 letter to shareholders, Buffett defined a breed of companies that he calls "The Inevitables."
Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." ... [N]o sensible observer, not even these companies' most vigorous competitors, assuming they are assessing the matter honestly -- questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime.
Altria and Philip Morris International are "Inevitables." The tobacco industry -- no matter what the regulatory environment -- will still be dominated by these two companies in 30 years. Advertising restrictions prohibit smaller competitors from gaining market share; the only way to gain significant share in the cigarette market is through acquisitions.
Both companies produce and distribute the world's leading cigarette brand -- Marlboro. Altria distributes Marlboro within the U.S and commands a 50% share of the U.S. cigarette market. Philip Morris International distributes Marlboro outside the United States and has a 29% share of the worldwide cigarette market outside of the U.S. and China. As regulations grow tougher, smaller tobacco companies will find it even more difficult to compete against these "Inevitables."
In addition to protected market share, Altria and Philip Morris International enjoy significant pricing power. Just as Coke drinkers will not give up their favorite soft drink for a Pepsi, Marlboro smokers refuse to abandon their favorite cigarette for a different brand. Altria and Philip Morris International can raise prices without losing many customers, so they earn high margins; Altria's smokeables segment, which includes cigars, turns close to 30% of revenue into operating profit, while Philip Morris International's overall operating margin comes in at more than 18%. By comparison, Coca-Cola -- one of Buffett's favorite companies -- generates a 20%-25% operating margin. Clearly, these companies have wonderful product economics.
Why Buffett won't buy
Buffett's reservations about tobacco companies have less to do with investment risk than reputational risk. When Salomon Brothers -- owned by Buffett at the time -- made a bid for RJR Nabisco in the late 1980s, CEO John Gutfreund asked Buffett to participate in the deal. But Buffett demurred, saying:
I'm wealthy enough where I don't need to own a tobacco company and deal with the consequences of public ownership.
"Barbarians at the Gate," page 218
Buffett gave Gutfreund his blessing so that Salomon Brothers could participate in the leveraged buyout, but Berkshire Hathaway would participate only indirectly through its minority stake in Salomon. Buffett believed that owning a tobacco company would give him a black mark that was far worse than whatever money he could make on the deal, so he decided not to pursue direct involvement.
Many investors, especially individual investors, share Buffett's moral hangups when it comes to owning tobacco companies. Philip Morris shareholders (now Altria and Philip Morris International) have raked in enormous gains over the last two decades -- a $10,000 investment in Philip Morris on Jan. 7, 1994 would be worth $238,500 today -- but tobacco use killed tens of millions of people in the same period. Cigarette smoking is linked to one-in-five deaths and is the leading preventable cause of death. These facts alone are enough for many investors to toss tobacco stocks from consideration.
However, there may be more than moral reasons to avoid tobacco companies. Fewer Americans smoke cigarettes today than did 10 years ago, and those who do smoke do it less often. The decline is the result of greater awareness of the risks of smoking, higher excise taxes which push up cigarette prices, and improving cessation therapies. Long-term negative demand trends are never good for a company -- no matter how dominant its industry position.
Warren Buffett knows that Altria and Philip Morris International will still dominate the tobacco industry in 30 years. However, actions by governments and individuals make it difficult to know how large the tobacco industry will be even in 15 years. Uncertainty about tobacco's future, combined with the reputational risk of owning such controversial companies, prevents Buffett from buying either company.
Ted Cooper has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.