The daily swings of the stock market might make it difficult for investors to determine what a stock’s future returns will be. Stocks can be volatile from day to day, and it is impossible to know for sure whether a stock will rise or fall after buying it. This might discourage investors from buying stocks at all. But those investors who practice discipline, and understand the drivers of a stock’s future expected returns, can put themselves in a better position to succeed in the market.
The expected total returns of a stock are derived from three sources—a company’s earnings growth, its dividends paid, and any upward or downward changes to its valuation multiple. Picking undervalued stocks with positive growth potential and attractive dividends, can result in superior returns over time.
Altria Group (MO) offers a combination of all three qualities that result in high expected returns. The stock is undervalued, the company has positive earnings growth potential, and investors receive a hefty dividend. As a result, investors can expect 10% annual returns from Altria stock over the next five years.
What is Expected Return?
The expected return of a stock is the rate of return investors anticipate over a given period of time. Total returns are comprised of all capital gains (or losses) from changes in the stock price, and any dividends paid throughout the holding period. Share prices rise or fall based in large part on whether a company’s earnings are increasing or decreasing, and also changes in the valuation multiple (typically measured as price-to-earnings ratio).
A declining share price results in unrealized losses for shareholders. While investors never want to be in the red, the upside of a falling share price is that the stock becomes cheaper, assuming earnings remain flat or increase. This could actually make its future returns even better, as the stock could be undervalued. In addition, a falling share price causes a stock’s dividend yield to increase, since prices and yields move in opposite directions.
It is important to remember that stock prices can fall in the short-term simply out of investor irrationality. Many factors can drive a stock price lower over a matter of days or weeks, some that are completely outside the company’s control, such as geopolitical events or changes in interest rates. Falling share prices can be due to eroding investor sentiment. But just as sentiment can become more negative, it can also improve if the company continues to perform well.
In Altria’s case, the stock has declined 14% since the beginning of 2018. It has deeply underperformed the broader market index, as measured by the S&P 500, which has gained 9% year-to-date. And yet, there is no clear justification for Altria’s stock decline, other than the possibility that the stock was overvalued heading into 2018. This is why investors should consider the valuation of the stock they are considering before making an investment.
Market sentiment has become more negative toward Altria than it was at the beginning of the year, presumably due to fears of declining smoking in the United States. This is a real concern, but the company has taken significant steps to invest in new product development. As a result, Altria’s long-term prospects are still sound.
From the perspective of fundamentals, Altria is still a well-run business. The company continues to grow earnings-per-share, and maintains a positive growth outlook for the future. In addition, it is a very shareholder-friendly company, with a management team that is committed to paying a high dividend rate. And, thanks to the declining share price over the course of 2018, Altria shares now look undervalued. The combination of all these factors is what leads to high expected returns over time.
Fundamental Strength Intact
Altria is a consumer staples giant. It sells the Marlboro cigarette brand in the U.S., which remains the “flagship of the fleet.” However, in recent years Altria has diversified its portfolio. It has a number of non-smokeable brands, including Skoal and Copenhagen chewing tobacco, and Ste. Michelle wines. Altria also has a 10% ownership stake in global beer juggernaut Anheuser Busch Inbev, the maker of Budweiser and about 200 beer brands.
Altria’s second-quarter earnings report stoked investor fears of the declining smoking rate. Altria’s cigarette shipment volume declined by 5% for the second quarter, which was even worse than the industry-wide decline of 3.5%. As a result, Altria’s revenue net of excise taxes declined by 5%, and failed to meet analyst expectations.
But despite the revenue decline, Altria has a unique ability to continue growing profits due to its tremendous business model. Adjusted earnings-per-share increased by 19% from the same quarter a year ago. and beat expectations by $0.01 per share. Earnings growth came from cost reductions, share repurchases, and a lower tax rate thanks to U.S. corporate tax reform.
Altria generates a great deal of cash flow. This should not come as a surprise, as the tobacco industry offers fantastic economics. First, it is a highly regulated industry, which means for the most part Altria does not have to worry about competition. The tobacco industry’s high regulatory hurdles result in steep barriers to entry, which insulates Altria from competition. For example, tobacco companies are banned from advertising on television in the U.S., which saves Altria a lot of money.
In addition, cigarettes are addictive, which provides Altria a highly recession-resistant business model. Plus, the addictiveness of cigarettes means consumers are willing to pay higher prices each year. Altria’s pricing power boosts its revenue growth. In the most recent quarter, the average pack of Marlboros cost $6.79 last quarter, up 2.3% from the same quarter last year.
New products will fuel Altria’s future growth. Altria is innovating new products, to help offset the declining smoking rate. Its non-combustible product portfolio includes e-vapor and e-cigarettes. Altria’s Nu Mark subsidiary grew shipment volume by 16% last quarter, as the MarkTen Elite e-vapor product was expanded to over 23,000 retail stores. These new product lines will help Altria navigate the decline in cigarette sales.
Altria’s Path to 10%+ Annual Returns
As previously discussed, expected returns are a combination of a company’s future earnings growth, any changes in the stock valuation, and dividends paid. First, due to Altria’s pricing power, new products, and share buybacks, the company is expected to generate 7% earnings growth each year over the next five years. Next, the stock appears to be undervalued, given its earnings growth potential.
Based on management forecasts, Altria expects to generate earnings-per-share of approximately $3.99 for 2018. As a result, the stock currently trades for a price-to-earnings ratio of 15.6. This seems too low for a company with Altria’s brand power and growth potential. A more reasonable estimate of fair value is a price-to-earnings ratio of 16-17, which is in-line with the historical average valuation of the stock in the past 10 years. An expanding price-to-earnings ratio to fair value could boost annual returns by approximately 0.8% per year.
Lastly, Altria’s dividend will be a major contributor to its total returns. Altria has a dividend yield of 5.2%, which is very attractive for income investors. Altria is also a dividend growth company. It has raised its dividend 52 times in the past 49 years, including two dividend hikes in 2018. Putting it all together, and Altria’s earnings growth, expanding price-to-earnings ratio, and dividend yield result in expected returns of 13% per year over the next five years.