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Hedge Funds Getting Addicted To Altria Despite Bears’ Warnings

Inan Dogan, PhD

After experiencing a tough 2018, Altria bought a 35% stake in Juul at a $38 billion valuation at the end of 2018. At the time it seemed like e-cigarettes’ explosive growth will continue uninterrupted and around 10% of the young adults said in surveys that they “regularly or occasionally” vape. These young adults were using vaping sites such as vaporsolo.com instead of traditional stores to shop. Juul’s deal with Altria was designed to put Juul’s products next to Marlboro cigarettes and give it top shelf space in more than 200K retail locations.

Unfortunately Altria Group Inc. (MO) shares delivered a negative total return since its Juul investment despite its hefty dividend yield which currently stands at 7.3%. Dividend stocks are trading at historical levels these days. Investors pay a price-earnings ratio of 25.8% for Vanguard Dividend Appreciation Index Fund ETF Shares (NYSE:VIG), yet Altria Group is trading at a forward PE ratio of 10. CFRA has a sell rating on the stock, saying the following:

"Our Sell opinion reflects a view that MO will struggle to grow sales and earnings, and may have to resort to more draconian cost cuts in order to support the bottom line following recent federal legislation raising the minimum purchase age to 21 for tobacco products. Although domestic cigarette sales volume will likely contract over the long term, we see cigarette companies still having the ability to raise prices. MO has pricing power as the largest U.S. tobacco manufacturer and given the addictive nature of nicotine products. Demand for higher-margin smokeless tobacco isn't expected to decline as much as cigarette demand.

...Our 12-month target price of $42 is based on a 2021 P/E multiple of 9.1x, a discount to its 10-year mean of 16.0x. While MO boasts an attractive dividend yield, weak sales trends, and recent legislation which raised the U.S. minimum tobacco product purchase age to 21 should weigh on performance."

Hedge funds seem to take a contrarian view regarding Altria Group (MO) though. We will publish the latest hedge fund sentiment figures in a few days, but at the end of September the number of hedge funds with bullish MO positions were at a recent high. Today we published Tyro Capital's 2019 investor letter. This is a small hedge fund that hasn't started filing 13Fs yet, so our sentiment stats don't capture its bullish sentiment towards MO. Here is what they said about MO in their annual letter:

" MO, a position we initiated in Q3, is an example of being able to take advantage of dislocations resulting from market overreaction to flawed narratives. The stock had been plagued by alarmist headlines about the safety of JUUL, in which MO had taken a significant stake, and, with some accelerant from the ESG push, dumped the stock to levels that priced the business such that JUUL, Chronos, the minority stake in AB Inbev were all valued at zero and the core business was valued at an impaired level. To us, this was a clear overreaction, and the market offered us the chance to take a position in one of the highest quality sources of yield in the equity market in a market starved for yield.

We continue to hold our position in MO (via stock and options), as disclosed in our previous quarterly letter. The stock was a substantial contributor to our Q4 and we remain bullish. The stock is still cheap by any metric: a forward dividend yield north of 7%, a forward FCF yield near 9%, and a P/E of 10x. We do not need any upside from MO’s stakes in Chronos, JUUL, or AB InBev for this to be a successful investment. The cigarette business will continue to decline at a relatively predictable rate for years to come, with volume declines offset by price increases, and the company will throw off mountains of cash to be returned via dividends and buybacks. Given our strong dividend yield on cost, we are inclined to hold the position for the long-term, absent the market offering us a premium price at which to sell."

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I am going to share my personal opinion regarding Altria Group Inc. (NYSE:MO) in the next issue of our monthly newsletter. One thing is certain though. We won't recommend a long position in Vanguard Dividend Appreciation Index Fund ETF Shares (NYSE:VIG).

Disclosure: None.