kali9/E+ via Getty Images
kali9/E+ via Getty Images
Howard Marks is one of the greatest investors in history, delivering 19% annualized total returns since 1995.
Rule number one: most things will prove to be cyclical.
Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”
That is backed up by historical research which finds that 80% of blue-chip returns are explained by valuation mean reversion.
In recent months few companies exemplify the power of deep value blue-chip investing better than British American Tobacco (NYSE:BTI ).
While the market has been wobbling and tech has been falling, BTI has been on fire soaring 41% since December 1st.
Today I wanted to share with you four reasons why BTI's epic rally might be set to continue. Not just in 2022, but for many years to come.
In fact, this Ultra SWAN global aristocrat could be one of the best high-yield blue-chips you can buy this year and could help you retire in safety and splendor.
How on earth can a stock be up 41% when the rest of the market is falling and tech is crashing?
The answer is threefold and begins with what the Fed is doing.
Historically when interest rates are rising value outperforms growth. Why?
Because most of the cash flow generated by growth stocks is in the future.
And so the discounted value of that cash flow goes down when interest rates go up.
In contrast, value stocks like BTI, generate far more of their cash flow in the present, and so are less affected by rising rates.
But rising rates are just one reason BTI is soaring this year.
Quality value tends to outperform the most and BTI is an Ultra SWAN quality deep value global aristocrat.
And finally, we come to the most obvious reason that BTI is a coiled spring that's finally popping hard and fast.
BTI 2000 Through 2010 (Lost Decade For S&P)
The last time BTI was this undervalued the market was in a tech bubble and went on to deliver zero returns for the next decade.
BTI delivered 13X returns over that time.
Adjusting for inflation S&P delivered -20% total returns over 10 years, while BTI delivered over 900%.
During the tech crash, BTI was delivering steady and impressive positive returns.
The same valuations it was in on December 1st when it began its 41% (and counting) rally.
BTI has delivered exceptional returns not just since 2000 but since 1986.
Since 1986 BTI has tripled the market's inflation-adjusted returns.
And from its lowest valuations in decades (were in December) as much as 30X returns over 17 years, and 25% annual returns over 15 years.
Basically, BTI's 41% 10-week rally is justified by three things.
While I don't make short-term predictions about stock prices, there is one more reason to be optimistic about BTI's prospects for repeating 2000's incredible 68% rally.
Momentum ETFs and funds rebalance into the hottest stocks every three to six months.
This means that if the value rotation continues for a few more months, momentum funds will start selling tech and buying value.
The hotter the value stock has been the more they'll buy, and there are few blue-chips with more positive momentum than BTI right now.
I have zero interest in recommending or buying value traps, cigar butt companies with weak fundamentals (such as Viacom right now).
The reason I've been recommending and buying BTI so aggressively for years is that its severe bear market was 100% the result of starting valuations, not fundamentals.
Just like no one said that "stocks no longer work for the long-term" because of a 50% crash from 2000 through 2002, the same was true of BTI during its four-year bear market.
The Dividend King's overall quality scores are based on a 237 point model that includes:
credit default swap medium-term bankruptcy risk data
short and long-term bankruptcy risk
accounting and corporate fraud risk
historical cash flow growth rates
long-term risk-management scores from MSCI, Morningstar, FactSet, S&P, Reuters'/Refinitiv and Just Capital
dividend friendly corporate culture/income dependability
long-term total returns (a Ben Graham sign of quality)
analyst consensus long-term return potential
It actually includes over 1,000 metrics if you count everything factored in by 12 rating agencies we use to assess fundamental risk.
credit and risk management ratings make up 41% of the DK safety and quality model
dividend/balance sheet/risk ratings make up 82% of the DK safety and quality model
How do we know that our safety and quality model works well?
During the two worst recessions in 75 years, our safety model predicted 87% of blue-chip dividend cuts during the ultimate baptism by fire for any dividend safety model.
How does BTI score on one of the world's most comprehensive and accurate safety and quality models?
Approximate Dividend Cut Risk In Pandemic Level Recession
20% OR LESS Max Risk Cap Recommendation (Each)
5% Margin of Safety For A Potentially Good Buy
BTI: The 86th Highest Quality Master List Company (Out of 509) = 83rd Percentile
The DK 500 Master List includes the world's highest quality companies including:
All global aristocrats (such as BTI, ENB, and NVS)
All 13/13 Ultra Swans (as close to perfect quality as exists on Wall Street)
BTI's 87% quality score means its similar in quality to such blue-chips as
Even among the highest quality companies on earth, BTI is of higher quality than 83% of them.
BTI was founded in 1902 in London and is neck and neck with PM for the title of the world's biggest tobacco company. This is a blue-chip that's built to last and a proven source of safe and growing income.
BTI's future is in smoke-free reduced-risk products. And just take a look at how well BTI's execution on those smoke-free future plans went in 2021.
With leverage within our target range and expectations for c.£40bn of free cash flow before dividends over the next five years, we will continue to invest in a faster transformation and deliver strong returns to shareholders. In addition to maintaining a growing dividend, the Board has approved a £2bn share repurchase program for 2022." - CEO earnings announcement
And what about 2022's guidance?
The only bad thing about 2021's strong results is that RRPs are still losing money, and thus strong growth there reduced operating margins.
(Sources: S&P, Fitch, Moody's)
U.K.-Based British American Tobacco PLC Outlook Revised To Negative On Share Buyback Announcement; Ratings Affirmed
The announced share buyback was not in our previous assumptions, and it will slow down the company's leverage reduction.
We revised our outlook on BAT to negative from stable and affirmed our 'BBB+/A-2' long- and short-term issuer credit ratings on the company.
We would consider lowering the rating if the company does not continue its leverage reduction trend, with adjusted debt to EBITDA remaining close to or slightly below 3.5x during 2022-2023.
We could revise the outlook to stable if BAT's adjusted debt to EBITDA approaches 3.0x over the next 18-24 months. This could derive from stronger performance in new product categories, a robust pricing environment in combustible business, and a prudent approach in terms of discretionary spending." - S&P
S&P says there is a 33% chance of a downgrade to BBB. And a 66% chance BTI retains its BBB+ rating. Why?
Even with aggressive buybacks, BTI's leverage is expected to continue trending in the right direction as is its interest coverage.
Bond investors are the "smart money" on Wall Street, and anyone who thinks BTI is a dying business should ask why bond investors are willing to lend BTI millions for the next 34 years at modest interest rates.
Credit default swaps are insurance policies bond investors take out against potential default.
BTI's profitability is historically in the top 20% of peers.
Pandemic costs and supply chain disruptions resulted in a temporary decrease in profitability over the last year.
In the last year, BTI's profitability was in the top 41% of peers.
BTI's profitability has been steady or improving for over three decades, including FCF margins that have risen to 35%.
Analysts expect steadily rising margins at BTI, and returns on capital to rise modestly to 221% by 2025.
Return on capital is annual pre-tax profit/operating capital (the money it takes to run the business).
BTI's ROC is expected to be over 3X the industry norm and 15X more than the average S&P 500 company.
BTI's ROC has been doubling every 10 years since 1996, confirming a wide and stable moat.
Dying businesses don't have strong and rapidly growing ROC, another strong data point showing BTI has never been a value trap.
Rating agencies consider 85% to be a safe payout ratio for tobacco companies.
Analysts expect 64% payout ratios over the next four years allowing BTI to retain, after dividends, almost $18 billion in earnings.
Analysts actually expect BTI to repurchase nearly $10 billion in stock in the next three years, around 4% of shares at current valuations.
And with 6% annual buyback fueled growth potential, it's no surprise that analysts have become steadily more bullish on BTI's growth outlook.
BTI's long-term future is 100% focused on RRP nicotine and cannabis (13 private equity investments in that space).
And what about the medium-term?
BTi's sales are expected to grow at a modest 2% in the coming years, though cost-cutting and margin expansion is expected to drive 5% to 6% growth in cash flows and net income.
(Sources: FAST Graphs, FactSet Research Terminal)
Very steady expected growth in both the top and bottom lines, as well as dividends.
Does this look like a dying company to you? One in secular decline?
What about BTI's long-term growth outlook?
When has BTI's growth consensus been negative? Never.
And now it's been soaring faster than the stock price thanks to excellent earnings results for 2021.
Smoothing for outliers historical margins-of-error are 20% to the downside and 10% to the upside.
Over the last 20 years, BTI has grown at between 3.6% and 10.3% CAGR.
Now analysts expect 4% to 11% and management 7% to 9%.
BTI has a clear path to achieving this expected growth, including up to 6% annual buyback fueled growth.
How undervalued is BTI now that it's become a Wall Street darling once more?
For 20 years, outside of bear markets and bubbles, hundreds of millions of income investors have paid between 13.5 and 14.5X earnings for BTI growing at 3% to 10%.
Upside To Fair Value (NOT Including Dividends)
BTI is still trading at just 9.6X earnings a massive discount from its historical valuation.
And pricing in just 0.5% long-term growth according to the Graham/Dodd fair value formula.
Compared with 8.7% growth consensus and management's 7% to 9% CAGR long-term earnings growth guidance.
Can you see why I'm still excited about BTI?
And now take a look at the return potential.
For context, here's the return potential of the 18% overvalued S&P 500.
(Source: DK S&P 500 Valuation And Total Return Tool) updated weekly
Stocks have already priced in all of the 100% EPS growth from 2020 through 2024 and are trading at 19.6X forward earnings.
S&P 500 2023 Consensus Total Return Potential
Analysts expect the S&P 500 to deliver potentially -9% total returns over the next two years.
Inflation And Risk-Adjusted Expected Returns
(Source: DK S&P 500 Valuation And Total Return Tool) updated weekly
Adjusted for inflation, the risk-expected returns of the S&P 500 are about 2% for the next five years.
Theoretically Interest Rate Justified Market Decline
(Source: DK S&P 500 Valuation And Total Return Tool) updated weekly
Even adjusting for low (and rising) interest rates, stocks still require a 12% correction before they become theoretically fairly valued.
But here's what investors buying BTI today can reasonably expect.
BTI 2024 Consensus Total Return Potential
BTI could deliver 24% annualized total returns over the next three years, literally the market returns of the last three years.
Does anyone think that in a rising rate environment the S&P is going to be able to come even close to deliver 24% annual returns?
Those are Buffett-like returns from this blue-chip bargain hiding in plain sight.
BTI 2027 Consensus Total Return Potential
If BTI grows as expected and returns to historical mid-range fair value
DK DK Automated Investment Decision Tool
DK Automated Investment Decision Tool
BTI offers 2.5X the market's risk-adjusted expected returns, and 4X the much safer yield.
It's one of the best high-yield blue-chips you can still buy today, even after a 41% rally since December.
Long-Term Inflation And Risk-Adjusted Expected Returns
BTI has historically delivered 15% long-term returns and that's what analysts and management expect in the future.
That's more than the aristocrats or the Nasdaq, and better than any major investment strategy on Wall Street.
There are no risk-free companies and no company is right for everyone. You have to be comfortable with the fundamental risk profile.
It's worth noting R.J. Reynolds, which falls under the umbrella of parent company British American Tobacco -- saw the FDA reject more of its e-cigarette products than the agency authorized. All told, 10 flavored e-cigarette products were denied authorization, aligning with the pronounced health problems linked to flavored vaping goods in 2018 and 2019. The three green-lighted products are the Vuse Solo vaporizer and two replacement cartridges for use with the device." - Motley Fool
How do we quantify, monitor, and track such a complex risk profile? By doing what big institutions do.
Here is a special report that outlines the most important aspects of understanding long-term ESG financial risks for your investments.
ESG is just normal risk by another name." Simon MacMahon, head of ESG and corporate governance research, Sustainalytics" - Morningstar
ESG factors are taken into consideration, alongside all other credit factors, when we consider they are relevant to and have or may have a material influence on creditworthiness." - S&P
ESG is a measure of risk, not of ethics, political correctness, or personal opinion.
S&P, Fitch, Moody's, DBRS (Canadian rating agency), AMBest (insurance rating agency), R&I Credit Rating (Japanese rating agency), and the Japan Credit Rating Agency have been using ESG models in their credit ratings for decades.
Dividend Aristocrats: 67th Industry Percentile On Risk Management (Above-Average, Medium Risk)
(Sources: MSCI, Morningstar, Reuters', S&P, FactSet Research)
(Source: DK Master List) - 5 non-rated companies mean BTI is in 57th place
BTI's risk-management consensus is in the top 11% of the world's highest quality companies and similar to that of such other companies as
The bottom line is that all companies have risks, but BTI is very good at managing theirs.
When the facts change, I change my mind. What do you do sir?" - John Maynard Keynes
There are no sacred cows at iREIT or Dividend Kings. Wherever the fundamentals lead we always follow. That's the essence of disciplined financial science, the math retiring rich and staying rich in retirement.
2022 has so far been VERY good to tobacco investors after a four-year bear market.
That makes sense given that BTI has spent that time executing very well on its smoke-free future plans and steadily de-leveraging.
Now that buybacks are beginning, with $10 billion worth of share repurchases expected over the coming years, BTI's growth prospects have more than doubled in recent months.
While it may be hard to believe BTI's monster 41% rally since December might be just the beginning of a multi-year rally that returns it to its historical fair value of about 14X earnings.
More importantly, BTI's strong execution and steady growth in recent years, at the peak of pessimism about this industry's growth prospects show that the legendary high-yield tobacco giants likely still have a bright future.
Not from selling cigarettes, but in cannabis, reduced risk nicotine, and even medical vaporizers.
The best-performing industry in history has made countless income investors rich and helped them retire in safety and splendor.
For three years I've been recommending BTI to anyone comfortable with this industry's risk profile because all the facts said this was not a value trap.
Finally, Wall Street agrees, and now BTI is a Wall Street darling once more.
But remember that this red hot rally could be just the beginning of a life-changing opportunity to lock in generous, very safe, and steadily growing income.
In other words, the more it fell, the more I bought, and now British American is hot, hot hot!
And that momentum could continue, not just for the rest of 2022, but for years and decades to come, helping anyone buying BTI today retire in safety and splendor.
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This article was written by
Adam Galas is a co-founder of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 5,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.
The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha).
I'm a proud Army veteran and have seven years of experience as an analyst/investment writer for Dividend Kings, iREIT, The Intelligent Dividend Investor, The Motley Fool, Simply Safe Dividends, Seeking Alpha, and the Adam Mesh Trading Group. I'm proud to be one of the founders of The Dividend Kings, joining forces with Brad Thomas, Chuck Carnevale, and other leading income writers to offer the best premium service on Seeking Alpha's Market Place.
My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives.
With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and safe and dependable income streams in all economic and market conditions.
Disclosure: I/we have a beneficial long position in the shares of BTI either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: DK owns BTI in our portfolios.