The ongoing bull market is almost 10 years old and hence it has become the longest in history. It is thus natural that many investors are afraid of an imminent bear market, particularly given the high volatility in recent weeks. The last bear market caused devastating losses to numerous investors and hence these investors want to avoid having this traumatic experience ever again. However, it is impossible to time bear markets. It is also a shame to miss the great long-term returns of the stock market waiting on the sidelines. Therefore, in this article, we will analyze why Altria (MO) is a great holding, even in the event of a bear market.

Low-Beta Stocks

Investors who are afraid of bear markets should prefer low-beta stocks in principle. These stocks are characterized by low price volatility and hence they usually outperform the S&P during bear markets. Low-beta stocks usually have robust business models, with reliable and resilient earnings even under adverse economic conditions. Altria is a quintessential example of a low-beta stock with these virtues.

Business Overview

Altria is the market leader in American cigarette sales. In 2015, its flagship product Marlboro had a higher market share than the next 10 competitor products combined. The company’s operations are broken down as follows:

• Smokeable products (86% of revenue)
• Smokeless products (13% of revenue)
• Wine (1% of revenue)

Altria has always faced a negative secular trend, namely the continuous decline of the percent of the U.S. population that smokes. The percent of the U.S. smoking adult population has steadily decreased, from approximately 42% in 1965 to 18.8% lately.

Despite this persistent headwind, Altria has taken advantage of the inelastic demand for its products and has thus exhibited an exceptional growth record. It has grown its earnings per share in 9 out of the last 10 years and has achieved a 9.2% average annual growth rate of earnings per share over the last decade. In addition, it has raised its dividend 52 times in the last 49 years. This impressive performance is a testament to the strength of the business model of Altria and the resilience of its earnings even under the worst economic conditions.

The company has always pursued to raise its prices at a much faster rate than the decline rate of smoking people. As a result, it has easily offset the above headwind. In addition, as its production volumes have decreased, the company has enjoyed lower production costs. Consequently, it has steadily enhanced its operating margin, from 25.7% in 2010 to 37.8% this year. Overall, the tobacco stalwart has consistently grown its earnings thanks to price hikes and margin expansion.

The Headwinds

Altria has pronouncedly underperformed the market in the last two years. During this period, the stock has lost 19% whereas the S&P has advanced 17%. There are various reasons behind this remarkable underperformance.

As most of the shareholders of Altria are holding the stock for its generous dividend, Altria has been adversely affected by the environment of rising interest rates. As interest rates rise, they enable investors to find decent yields elsewhere and hence they exert downward pressure on the valuation of Altria.

Moreover, the FDA has announced that it intends to reduce the nicotine levels in cigarettes in order to make them less addictive. This has raised concerns over the potential impact of such a measure on the tobacco stock. However, we believe that this process will take many years of negotiations and the effect of a negative outcome on Altria can hardly be quantified. Furthermore, Altria is in negotiations with regulatory authorities to earn a “reduced-risk” label for its IQOS. The high uncertainty over the outcome of these negotiations has weighed on the stock price of Altria.

Valuation – Expected Returns

Due to its underperformance, Altria is currently trading at a price-to-earnings ratio of 13.5, which is much lower than its 10-year average of 16.2. As we expect the stock to revert to its average valuation level over the next five years, the stock will enjoy a 3.7% annualized boost thanks to the expansion of its price-to-earnings ratio over this period.

Moreover, thanks to the inelastic demand for its products, Altria is likely to continue to grow its earnings via price hikes and margin expansion. While the company has grown its earnings per share at a 9.2% average annual rate over the last decade, we prefer to be somewhat conservative and assume 7% annual growth going forward.

Furthermore, the stock is now offering a 5.9% dividend yield, which is a 5-year high yield. Given the 80% payout ratio, which is in line with the target of management, its healthy balance sheet and its growth prospects, Altria is likely to continue to raise its dividend at a meaningful pace for the foreseeable future. Overall, the stock is likely to offer an approximate 16.6% average annual return over the next five years thanks to 7% annual earnings-per-share growth, its 5.9% dividend and a 3.7% annualized gain from the expansion of its valuation level.

Competitive Advantage - Resilience To Recessions

The main competitive advantage of Altria is the strength of its brands and the inelastic demand for its products. In addition, the company needs to spend minimal amounts every year to maintain its market share. In each of the last nine years, the company’s capital expenses have been less than 5% of its operating cash flows. As a result, almost all its earnings are available for shareholder distributions.

Moreover, thanks to the strength of its business model, Altria is markedly resilient to recessions. In the Great Recession, when most companies saw their earnings collapse, Altria continued to grow its earnings and its dividend. This is a major strength of the stock, particularly for the investors who are afraid of an imminent bear market.

Final Thoughts

Altria has remarkably underperformed the market in the last two years due to the environment of rising interest rates and uncertainty over the pending issues with regulatory authorities. However, the company is likely to continue to grow its earnings per share at a meaningful pace thanks to the robust demand for its products. Given also its 5-year high dividend yield and its suppressed valuation, the tobacco stalwart is likely to offer double-digit returns over the next five years, even if a bear market shows up during this period.