The Nicotine Basket
“Most racetrack bettors spend far more time thinking about who will win a race than on how to bet a race.” - Steven Crist
Tobacco leaf used to be taken to and exchanged at massive auction houses. The leaves were stacked, with hundreds of pounds carried on woven tobacco baskets. Astutely trained bidders had to have a keen eye. If they acted too hastily, they could overpay, causing quality and profitability issues for their respective employers—the tobacco majors. But when things lined up right, a single bidder could essentially produce millions in profit in a single session. Each season could be make-or-break for the farmers, depending on what they yielded and the prices fetched. For some, a year would be the difference between being able to put food on the table or closing down and selling the farm.
Those days are long gone. For several reasons, which are complex enough that they deserve their own article of focus (and shall receive one in the future), small farmers have primarily disappeared from partaking in the cultivation and sale of tobacco in the United States in a material way. In the last few decades, the number of farms in the country growing tobacco has declined by more than 95%. Only a few auctions remain. Contracts directly negotiated between large-scale, industrialized producers and a small number of massive companies now make up the majority of dealings. The tobacco baskets are no longer used. They are only remnants. Memories.
The tobacco industry continues to change in many ways. In fact, the term “tobacco industry” is a misnomer. With the advent and rise of next-generation products, we are talking about the “nicotine industry.” The implications, which I routinely discuss, can be boiled down to:
Globally, cigarette volumes will decline but not collapse, primarily offset by pricing. Other legacy products will face varying but similar dynamics.
Existing and new users will shift toward next-gen nicotine products. Contingent on regulatory policies and scale, these products can have equally good or even better margins than legacy products.
Over the last three-quarters of a century, the majority of regulations designed to curb tobacco use have been based on tobacco products’ risk profiles. Next-generation products’ substantially lower risk profiles incentivize lawmakers to adopt Tobacco Harm Reduction policies rather than prohibitionist approaches.
NGPs lead to better health outcomes, a distinct benefit for consumers and governing bodies. It will also be a boon for major manufacturers as the total number of adult nicotine users and associated profit pools continue to increase.
Structural pessimism and the rise of other influences, such as ESG-driven mandates, have restricted interest and capital, creating varying discounts for nicotine equities relative to their robust cash flows.
I hold a mix of publicly traded equities to express these views. This is not a ‘tobacco basket.’ It is a ‘nicotine basket.’ I have not disclosed how I weigh the basket’s constituents other than that it is not an equal-weighting system. I routinely receive questions about why I hold the basket rather than the one or two most obvious leaders. After all, doesn’t a basket guarantee a reduction in the maximum possible return?
Let’s explore some thoughts behind this.
The idea of ‘the one or two most obvious leaders’ must be addressed. What seems ‘obvious’ rarely ever is. This is especially true when considering multi-decade periods. It is even more critical when evaluating an industry facing considerable changes, many of which will continue to be driven by uncertain future regulations.
The exact probability for any particular leader is never precisely known. But more importantly, a ‘leader’ in probability is not necessarily a ‘leader’ in value. Although no name in the nicotine basket is priced far above the broad market at an enterprise level, a relatively wide range of multiples is presented. Many forms of conventional thought argue paying up for ‘quality,’ but price is an inextricable value driver that can not be ignored.
When thinking ten, twenty, or thirty years out, some straightforward questions answer how any particular name may lead or fall behind.
Philip Morris International leads in many regards. It is the most massive and has an impressive global footprint. Marlboro is an exceptional brand. IQOS is unmatched in the heated space. The acquisition of Swedish Match catapulted its presence in the modern oral space and provided a break into the highly profitable United States market. Can competition innovate fiercely on a technological level to go against IQOS? That gap is largely insulated by protections for its intellectual property, which do not have endless durations. ZYN is a good product, but it has lost ground in its home market of Sweden, and competition continues to grow elsewhere. The company has gained USD-derived sales, but currency headwinds have been a persistent thorn. Even with efforts to curb these effects, the most straightforward way forward real returns become depressed would be a heavy strengthening of the U.S. dollar.
What happens if the U.S. dollar strengthens substantially and continually? Then, relatively, the sole company in the basket that derives all of its sales in USD, Altria, is positioned far better. This is also the company that stands to benefit most if the United States market is less responsive to the IQOS rollout. The company is also best insulated against numerous potential geopolitical events.
What happens if, even if it goes against practical expectations, regulators around the world significantly tighten their grip on next-gen products? A company that has been far more conservative in its NGP investments, such as Imperial Brands, will be relatively better off. Should legacy volumes decline at a less severe rate, all majors stand to benefit, but Imperial and Altria would shine a bit brighter.
Even though it is off the table for now, who faced the most significant impact of a menthol ban in the United States? British American Tobacco. What about other markets, currencies, and product categories? BAT, which owns a significant stake in ITC, could produce staggering returns contingent on the Indian market. What about changes to Europe’s Tobacco Products Directive? Most majors are poised to be affected differently, but Altria will not be directly affected.
What happens if handmade cigar users do not transition to NGPs at a rate similar to other legacy product categories? Scandinavian Tobacco Group stands to benefit, even though it has recently made multiple bets in the modern oral space. Handmade cigars experience their own cycles, and STG is practically the sole name affected. Likewise, what would happen if the United States embargo against Cuba were eventually dropped? STG would be disproportionally affected, while no major would likely bat an eye.
What happens if modern oral continues to grow at a rapid pace? Many of the majors stand to benefit. But what happens if competition continues to expand as it has, and manufacturers can not establish brand equity as well as hoped? Even more of an outlier than STG is Haypp Group. The company stands to benefit disproportionally. Conversely, the company could feel great pain if specific markets eliminate pouches or the online sales channel, or enact other deeply restrictive policies.
The list of questions goes on and on. Drill down, and there is endless nuance. Category mixes, brand portfolios, geographies, currencies, margins, leverage, multiples, growth rates, strategy, communication, management, and culture come into play. One of the greatest threats to the industry is capital allocation—stemming from the immense profitability of the core business. Even while distributing a good deal to shareholders, there has been no shortage of instances in which cash piles up and management teams have taken large sums and malinvested—sometimes tacking on extra debt simultaneously. All it takes for any one name to become the laggard is to dream up a giant, half-baked idea and charge headfirst. Likewise, many of these companies hold strategic assets that can produce windfalls or be squandered.
I’ve previously cited Chapter 3: Crist on Value from the 2001 book Bet With the Best: Strategies from America’s Leading Handicappers. The chapter has been cited and written on by many others as well. Most of the time, discussions focus on two points summarized in the chapter:
Probability and Odds - “Recognize the difference between picking horses and making wagers in which you have an edge. The only path to consistent profit is to exploit the discrepancy between the true likelihood of an outcome and the odds being offered.”
The Competition - “You are playing against only the other bettors at the track, not against the game or the house. Although they do a pretty good job on the whole, your opponents make more than enough mistakes for you to win.”
The chapter has a third part that is discussed less frequently:
Using Multiple Bets to Improve Your Prices - “Multiple bets can make apparently valueless races highly playable, and can multiply the existing value in a race because of the opportunity to capitalize on more than one discrepancy on the board.”
As the book focuses on horse betting, some of the maths, especially concerning the third point, do not translate fully into equity markets. However, I highly recommend reading the chapter in its entirety. You will still be able to draw helpful parallels.
Regarding the nicotine basket, there is no defined distance to race. It could be one day, one year, ten years, or thirty—take your pick. You can also change your mentality, ending or extending your duration. There aren’t set payouts—so make your own maths. There isn’t an exorbitant takeout, so crafting what appears to be an exacta, trifecta, superfecta, daily double, or otherwise may seem to provide no distinct benefit. However, although some parts appear less favorable, perhaps so unfavorable that it would feel outlandish to take them on alone, each leg provides positive counters to potential negative events for others. With a favorable industry structure, low multiples, high cash returns, and the unique qualities of each, I view using a multiple-bet approach as an advantaged form of insurance. While this reduces the theoretical maximum return, this does not mean it is inadequate, and the utility provides greater odds of being able to circle the track many more times.
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Ownership Disclaimer
I own positions in tobacco companies such as Altria, Philip Morris International, British American Tobacco, Scandinavian Tobacco Group, and Imperial Brands. I also own positions in Haypp Group, a major online retailer of reduced-risk nicotine products.
Disclaimer
This publication’s content is for entertainment and educational purposes only. I am not a licensed investment professional. Nothing produced under the Invariant brand should be thought of as investment advice. Do your own research. All content is subject to interpretation.
Great piece. I apply this same approach to other industries as well. If industry economics are strong, sometimes it’s not worth the effort to try to pick winners.
I own all 4 majors with a bias towards the UK listed ones simply because there is no dividend withholding tax. Ironically it was zirp that pushed me into tobacco :)