Episode #375: Jonathan Fell, Ash Park Capital, “People Always Overestimate The Extent To Which Tobacco Is A Dying Business”

Episode #375: Jonathan Fell, Ash Park Capital, “People Always Overestimate The Extent To Which Tobacco Is A Dying Business”


Guest: Jonathan Fell is a founder of Ash Park, managing the Ash Park Global Consumer Franchise funds, focused on long-term, high-quality investments in the fast-moving consumer goods industry. Prior to 2013, he was team head of the consumer equity research group at Deutsche Bank in London where he covered the tobacco and beverages sectors, following earlier spells at Morgan Stanley and Merrill Lynch.

Date Recorded: 11/11/2021     |     Run-Time: 1:02:58

Summary: In today’s episode, we’re talking all things consumer staples and tobacco stocks. Jonathan has covered the space for over 30 years and shares the drivers behind successful consumer staples. Then we walk through the evolution of the tobacco industry and why he likes the setup for tobacco stocks today. We touch on the company’s current valuations, factor profile, return drivers, and the impact of ESG.

As we wind down, Jonathan shares the impact of direct-to-consumer companies on large incumbents.

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Interested in sponsoring an episode? Email Justin at jb@cambriainvestments.com

Links from the Episode:

  • 0:40 – Sponsor: Masterworks
  • 1:36 – Intro
  • 2:21 – Welcome to our guest, Jonathan Fell
  • 3:29 – Quarterly letters; Jonathan’s path to covering tobacco stocks
  • 7:20 – Ash Park’s investment philosophy
  • 9:09 – Covering high quality consumer franchises
  • 12:40 – The state of the tobacco industry today
  • 14:54 – Five big global companies across the globe that dominate the tobacco space
  • 16:26 – Is tobacco still a growing industry or are its days numbered as alternatives emerge?
  • 20:17 – The bear case for big tobacco companies
  • 24:46 – ESG and its potential impact on the tobacco sector
  • 32:07 – The potential impact of cannabis
  • 33:47 – Value in the Asian beauty space
  • 37:37 – How at risk are large incumbents from direct to consumer brands
  • 51:05 – What Jonathan’s thinking about as he looks out to the future
  • 54:47 – Is there a scenario where flows reverse and a chance for multiple expansion with tobacco stocks?
  • 56:55 – Jonathan’s most memorable investment
  • 59:13 – Learn more about Jason; ashparkcapital.com; Twitter @jonfell73


Transcript of Episode 375:

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Meb: What’s up everybody, another great show today. Our guest is the founder of Ash Park capital, where he manages the global consumer franchise funds. In today’s show, we’re talking all things consumer staples and the best-performing stock market industry in history, tobacco stocks. Our guest has covered the space for over 30 years and shares the drivers behind successful consumer staple companies. Then we walk through the evolution of the tobacco industry and why he likes to set up for tobacco stocks today. We touch on the company’s current valuations, factor profiles, return drivers and the impact of ESG. As we wind down, our guest shares his thoughts on the impact of direct consumer companies on the large incumbents. Please enjoy this episode with Ash Park Capital’s, Jonathan Fell. Jon, welcome to the show.

Jonathan: Thank you, Meb. Very nice to be on it. Thanks for having me.

Meb: I’m here in LA it’s morning time. Where do we find you?

Jonathan: I’m in London. It’s about 4:00. And at this time it’s starting to get dark already, which is a little bit miserable.

Meb: Well, it would be a perfect pairing, you with a pint, me with a coffee. I’m actually drinking tea because I’ve already had my coffee. One of my favorite things you guys do is on your website, all the partners list their favorite portfolio company product. Your coworker, Jamie, his favorite was Campari, which I’ve really never had in the first 40 years of my life until the pandemic hit. And that was kind of my pandemic cocktail was a Campari and soda, which I know is like drinking water in Europe. Like, everyone drinks that but for me, it was relatively new. And it elicits a pretty big reaction. People love it or hate it.

Jonathan: Rather weird taste, Campari, isn’t it when you first try it, but it grows on you. I’m pretty much the same. It took me probably almost 40 years to have my first one but it’s a major part of my drinking repertoire as we say now.

Meb: We’re going to get into all sorts of stuff today. I think I originally came across you… You guys write some really wonderful letters. We’ll post some links on the show notes, listeners. Some quarterly letters, I was reading one this morning. But you have a background that started in the ’90s, starting to cover tobacco stocks. And I’ll tell you a funny side, listeners know this, but I grew up partially in North Carolina, Vacca Road. My grandfather worked at R.J. Reynolds. I went to R.J. Reynolds High School, literally named after… I don’t know if you even knew that, that’s a good stat for you, in Winston Salem, North Carolina, also in the ’90s. So got to experience a lot of the tobacco story firsthand. I want to hear all about Ash Park. Why don’t you give us a little timeline origin story for Jon in the career with Merrill Morgan, Stanley, Deutsche Bank leading up to where we are today.

Jonathan: Actually, my first job was for a little English stockbroker called Smith New Court. And about six months after I joined, they got bought by the mighty Merrill Lynch. It was one of the earlier banks buying a UK broker, which was very exciting, and they really built up that equity business to become the largest in Europe at the time. So, that was a really great seat to be starting a career from a very exciting time. And my first sector that I was given to do really was tobacco on my own. That was a weird place to start.

Meb: Were they just like looking around the room and they were like, “All right, you got tech, you got energy,” and there’s like the young kid in the back, they’re like, “All right, you’re tobacco.”

Jonathan: Essentially. Actually, the way it worked was I started off on the insurance team. And you might think insurance and tobacco is like a really bizarre combo or a weird transition. But at the time, there was only one big listed European tobacco company. And that was British American Tobacco. Probably more than half of its market value at the time was in some insurance businesses, which it had bought, including, you might be familiar with the Farmers Insurance Exchanges. And so BAT tended to be done as an adjunct of the insurance team. And the senior insurance analyst at Merrill looked at me one day and thought, “This tobacco stuff. I don’t understand it’s too complicated. Do you want to do that?” And so, that fell into my lap. And although it was totally by chance, it turned out to be actually a real stroke of luck because the sector became very interesting. And a whole bunch of other companies were IPOs or demerged in Europe. And so, I ended up having a proper sector of my own, and the responsibility for that much earlier than I might have done if I’d stayed part of a bigger team. And that was at the time when U.S. lawsuits were being filed almost every other day and tobacco was front pages, a lot of the time. It was a really exciting job, full of interest. It was almost like a special situation.

I did that almost exclusively focusing on tobacco for the first five, six years of my career. But the tobacco companies started to push back some of those lawsuit threats and the stocks rerated a bit. Rather than just being litigation commentators, we had to write about the fundamentals of the business. And, of course, then you’re into something which is much more akin to a normal company, normal consumer company dynamics. And it became sensible to be thinking about these in the same breath as you thought about drinks companies or food companies or the household personal care businesses. So, tobacco kind of normalized and I got sucked into having to deal with the rest of the consumer universe in 2013 with Deutsche Bank with a colleague, Jamie. We set up Ash Park, and a couple of years later, two of our other colleagues from Deutsche Bank joined us, which we’d always hoped they would. And that’s how Ash Park started.

Meb: Love it. Tell us a little bit about y’alls philosophy. What are you doing over there? Is it a singular focus? I see in the most recent letter, you have some news on a new strategy going live too, which I love the name. But tell me about the general firm investment philosophy from day one, which…is that what almost a decade ago, man?

Jonathan: Not far off now. Time flies. So we thought that we had a really interesting strategy for people just by investing in high-quality consumer staples companies. Our strategy, we like to think of it the starting one was a global consumer franchise strategy. The one you’ve referred to that we’ve just launched is what we call the Monsters of Tomorrow strategy, which is like a subset of that global franchise one. We thought that there was room for a quality franchise focused strategy that just focused on consumer companies. There are lots of great businesses in other sectors, but we believe you don’t need to look outside that to create a really interesting investment product. So, day one, when we launched, we had about 20 stocks, ranging from big multinational type things, your Nestle, Unilever, Diageo type companies, to some of the smaller, more focused consumer names, maybe operating in just one or two categories or one or two countries. So, that global consumer franchise was our initial product. And just a couple of months ago, we launched what we call Monsters of Tomorrow because we had demands for clients for a product which didn’t involve tobacco, which focused more on some of the smaller and mid-cap names, some of those more focused consumer opportunities that I mentioned. We’ve got two strategies but the philosophy of both is very much the same in the way we approach looking at companies, looking at quality angle is the same.

Meb: The focus on what you guys call high-quality consumer franchises. What are sort of, like, the main buckets of that? Is it mainly tobacco and beverages or personal care staple items? Like, what are the main whatever you’d call it, industries, within that umbrella?

Jonathan: So, we within our strategies, look at all of the main consumer staples, sub-segments, with the exception that as I have said, Monsters of Tomorrow will not own combustible tobacco. But we find there are great businesses across each of food, beverage, tobacco, and household personal care. One of the questions we often use to get actually when we met new sell-side people in our old job was, what’s the best industry? What’s the best category to be exposed to? You’d get people doing lengthy analyses of Euro-monitored data or Nielsen data, trying to work out which category grew best. We thought that was the wrong way to look at stuff. What normally grows best is the categories to which the best companies are exposed to, and the best managements because the companies that have the best cultures and managements, find a way to make their categories grow.

Taking a step back, most of the staples categories should be pretty mature because there are limits to how much more you can eat or drink or wash yourself or make yourself beautiful. But it’s about finding things in the products you’re selling, in the categories you operate in that get consumers excited and create just a bit more opportunity to spend more or to go and buy more product each week or each month. It’s the companies where the management says, “Look, we’ve got this category, it’s not growing very fast. We don’t want to be exposed to that. We’ll sell it and we’ll go and buy whatever’s growing today.” Sometimes or quite often, those businesses end up chasing their tail. The reason that categories they sell have not been growing, it’s not something intrinsic in that category. It’s just because they haven’t found the right way to invest in it and innovate and market it to people. So it’s a rather long answer to your question. But we end up being pretty category-sector agnostic when we’re looking at what we’re potentially putting money. And what’s much more important to us is that culture, and that marketing, and that innovation side.

Meb: Of your portfolio today, maybe you just tell me about the construction, how many names y’all got? Is it long-only? And then what are kind of the main categories?

Jonathan: We have about 20 stocks in the largest strategy, a bit over half of that in the Monsters of Tomorrow. In the larger funds, the larger strategy rather, tobacco is about a quarter. We’ve got another quite big segment, which is focused on beauty, especially beauty in Asia. Those are sort of two large lumps. And then the rest is fairly broadly spread across some other household personal care businesses and some interesting beverage stocks as well. Lastly, a couple of the larger multinational things in there, like Unilever and Nestle.

Meb: I was laughing and this is not intentional, I promise. Listeners, if you’re watching this on YouTube, and Jon, this is just my day-to-day. As you were talking about the portfolio companies, I do startup investing, and oddly, listeners will have seen this a thousand times, but my go-to water, these are both private companies, so sorry. But maybe one day if they get big enough Ugly Water, which is actually a British founder, and then a smoothie company, Kencko, which you can’t really see. Here’s the bottle. But this is a I think French company. Both crossed the pond. Anyway, put them on your radar. Let’s start with tobacco because I think that’s probably how you and I originally crossed paths. You got suggested to us many times over. So, you got to look at this guy. He knows what he’s talking about. We were tweeting, I think at one point over the years about the best-performing industries in history going back, you can even take it back, I think to the 1930s, the French farmer data. And I think the two biggest in order out of all the industries, one is tobacco, and two is beer, which is their category, which I’m not sure if they tease out between beer and alcohol or if it’s literally just beer. Anyway, I’ll look later. But I feel like tobacco is a pretty broadly misunderstood industry. So, why don’t you talk to us a little bit about, from someone who’s been there for a couple of decades now, what’s the state of the industry today? Why is it an attractive investment? And then we’ll dig into all sorts of things.

Jonathan: I mean, you’re right, I’ve watched tobacco for, it’s getting on for 30 years now and it’s been through some enormous swings in sentiment. I’m really excited about tobacco now as an investment opportunity because the sentiment and the way people are looking at these stocks very much reminds me of a time right at the start of 2000s, where people just didn’t want to know. It was too complicated and there were lots of other exciting things going on elsewhere in the stock market, which meant people just dumped these stocks in a fairly unthinking way. And I think the same thing has happened again. And the complications are slightly different. So, back then it was litigation. These days, a bit more focused on regulation, but also the rise of these new nicotine products, so-called reduced harm products, which have made competitive dynamics a little bit more complicated. But I also think those have the potential to create a really interesting future for the industry, which people didn’t believe it even had 10 years ago. So, for those people who are prepared to do the work and are prepared to live with some controversy and some volatility, and I know this sector and these stocks aren’t for everyone, and that’s fair enough. I think the returns that could be available for this group of companies over the next 10 years or so is really, really interesting.

Meb: The setup from a quant like me looks pretty attractive. These stocks, as you mentioned, it’s definitely got a late ’90s, early 2005, in that, the valuations are pretty low. They’re big cash-flowing businesses. So they’ve got pretty high dividends, a lot of them. What’s the universe look like? Is it dominated by the three or four big daddies or is there like 50 names that you think are investable and interesting cross-industry or is it you got to be super-picky and pick and choose?

Jonathan: There are five big tobacco companies globally, five or six, I should say. You’ve got Philip Morris International and Altria, which are listed in the U.S. You’ve got British American Tobacco, Imperial Brands and Swedish Match, which are listed in Europe, and then you’ve got Japan Tobacco, Japanese. They’re all more or less international players. Below that, there’s a bunch of really quite a lot smaller things, a couple of U.S. stocks Vector and Turning Point. And then in the end, you’ve got things, which are typically subsidiaries listed subsidiaries of BAT. You got a couple of stocks, which are not tobacco but are nicotine industry players, Smoore and RELX, both of which are Chinese or connected with China in a strong way. It’s a pretty concentrated universe and it’s a market where the largest companies already have a pretty concentrated share.

Meb: As you think about investing in these, is this still a growing business industry? Is it a situation that, hey, look, the traditional business is declining or is it I don’t even know, and it’s being replaced with other, nicotine, vaping, who knows, cannabis, whatever else may be under the umbrella? Is it a cash flow story? What is the thesis for these companies today? Are they cheap relative to history? Were they kind of always cheap?

Jonathan: It’s the cash flow story that’s really interesting. I mean, we often tell people that the way a staple strategy works, in general, okay, is that people underestimate the longevity of brands and the longevity of franchises that high-quality companies have. If you think about a lot of other businesses, other companies which are quoted on the stock market, at any one point in time, early in their life, they had a competitive advantage, which people expect over 10, 15, 20 years, whatever will be competed away, and returns fade back down to the cost of capital. You don’t make supernormal profits forever. But a well-handled staples business because it’s quite simple and it’s based on branding actually can carry on making supernormal returns for a very, very long time. And so, we sometimes describe our strategy, the important leg of it is a patience arbitrage, owning these things, 10, 15 years’ time. They’re priced as though their competitive advantage will start to fade and we believe it won’t, it’ll be as strong, maybe stronger than ever. Tobacco really works like a magnified version of that. People always overestimate the extent to which tobacco is a dying business. These things are always priced like they might not be around in 10, 15 years’ time. And that elastic stretches over time. So, sometimes they’re priced as though they might be around 15, 20 years, sometimes they’re priced as though they’ve only got 5 or 10 years left. And right now, valuations are at the bottom end of where that elastic shifts, being priced really as though they haven’t got long left. We did some work not that long ago, calculating that some of the big U.S. European stocks could take themselves private in eight or nine years if they diverted all of their cash flows to just buy the equity back. Actually, when you look at consumption patterns for tobacco products, they tend to be much more resilient than people think. Some demographic issues there as well. A lot of the people who manage money in London or New York or the West Coast, wherever are not really a big part of the core tobacco-using demographic.

So, it’s often regarded as being something that, “People don’t do that anymore. Nobody does it. So, surely that investment must be unsound.” But actually, there’s a hardcore of consumers who are using nicotine and tobacco and are likely to continue doing so for much longer than some of the worst-case estimates. And when you add into that, the newer products which are coming along, which carry very, very much lower risk than combustible cigarettes and those range from nicotine pouches that are taking off really quite rapidly in the U.S. or Philip Morris’s tobacco heating IQOS device or vaping, those have also the potential to replace combustible cigarettes as a source of people’s nicotine and do very much less damage to public health as well. And that’s something which, when the dust settles, all the regulatory battles and some of the sort of media campaigns, which are misinformed out there about the alleged risks of these things. When the dust settles, that’s got the potential to prolong the cash flows and profit growth of these businesses again for much longer than people are currently discounting.

Meb: I feel like most of the concerns seem to be well-established, like, as you think of a possible bear case, is there anything like as a good analyst always…portfolio manager thinks about what are the possible risks, or bear? Like, if you had to foresee, like, is there anything that people aren’t talking about or an actual risk that you say, “Okay, well, maybe if X, Y, Z happened, this would impact this world, this industry negatively, and make it a more challenging investment? Is there anything that comes to mind?

Jonathan: I mean, what you got to bear in mind is that the industry has been regulated on an ever-tightening basis for 40 years now, longer in Europe with health warnings, advertising bans, in lots of places, rules about the tar and nicotine that can be delivered from cigarettes. We’ve got plain packaging now in large parts of the world, big ugly graphic health warnings. This has always been there. And in a funny way, it’s one of the things that makes the industry more resilient because it’s not as though these issues are new. They’ve always faced them. Of course, what governments and regulators do first is the stuff they think will make the biggest difference. So, as you go through time, the sort of incremental moves that public health can make to really squeeze down smoking further, they do become fewer and fewer. You’re left with not many levers, you can pull. And some of those levers break if you pull them too hard. So, tax, for instance, any market in the world, you can name will already have tax as a massive, massive portion of the retail price. These things cost at retail, much more than they ever cost anyone to produce. So, if you push the tax lever too hard, then people end up just buying their cigarettes from somewhere else. It doesn’t have the impact on consumption that you would hope. When you ask, what are the threats out there, the bear cases that people aren’t thinking about, there aren’t many. And essentially, it comes down to various forms of outright ban of tobacco use.

Meb: Yeah, that was like the only thing I could think of my head is, like, all of a sudden, China’s like is, “You know what…?” As arguably like the greatest tobacco consumer, they’re just like, “No, you can’t.” Why would that ever happen? Everyone in China seems to love tobacco.

Jonathan: China is a really interesting thing. And I don’t know whether you know, but essentially 100% of the Chinese tobacco industry is a domestic tobacco in monopoly. It’s all state-run state-controlled. And for a long time, while I was doing this job, the idea that China might liberalize one day and allow people in was a major bull case. It’s never happened. It never will. But a weird one because China just kind of sits there, doing its own thing when it comes to tobacco, doesn’t have a lot of influence on what the rest of the world does. But you have got things like, I mean, the U.S. People in U.S. public health have been, there’s a faction of them that have been convinced for 25, 30 years that a really good thing to do would be to try to make combustible cigarettes non-addictive. So to mandate manufacturers to remove essentially all of the nicotine from those products. I mean, that is something that the FDA and Scott Gottlieb when he was FDA commissioner revived as a policy in 2017. And that really scared people. When you look at a chart of tobacco stocks at the time, they really fell out of bed. Since then, that has gone under the radar a bit again. I think the FDA has looked at it. It’s come off the formal regulatory agenda because I think they realized how problematic that would actually be to implement. And it might actually be illegal. I mean, when the FDA got authority to regulate cigarettes, to regulate tobacco products, it was specifically forbidden by Congress. It was forbidden from banning cigarettes and forbidden from reducing nicotine levels to zero. So, if they ever wanted to move ahead with that policy, there would be major legal battles. But arguably as well, you can’t really do that unless you’re giving people who are addicted to nicotine an alternative product they can use that’s properly regulated and widely available. And that’s why all this stuff that’s been going on with vaping and the product authorization requests that manufacturers have had to put in recently, and which the FDA is now reacting to, that’s why this issue is so crucial or one of the reasons why it’s so crucial and one of the reasons why the FDA’s approach to it is creating so many problems.

Meb: What’s the impact…? You can talk to us a little about it. I’m sure it, like, comes up in every single conversation almost you have with investors or media about general ESG. How do you think about that as an impact, as a filter, vice clauses of funds and investors, excluding, avoiding these stocks? What does that mean to you? Is that a topic? How do you think about and address that sort of whole world that seems to be increasing in noise and attention over the past 5, 10 years?

Jonathan: I think there’s absolutely no doubt that it has had an impact on share prices and the tobacco sectors valuation. And in Europe, we’ve had a new bunch of regulations related to fund marketing this year, which has forced fund managers, big fund managers to make decisions about whether their funds are marketed as ESG funds or whether they’re not. And that has kind of automatically pushed more people to divest, I think. I don’t think that trend’s going away. What I do think is that the discussion about the right way to behave, the right ways to approach ESG investing has gone a long way to develop and arguably mature. I mean, I think the way a lot of big fund houses do it at the moment, it’s by template. It’s not particularly thoughtful and it’s not particularly helping solve any problematic situations in the world. And I think that’s also true when it comes to tobacco. These companies don’t need to raise money. They generate so much cash internally, that whatever projects they want to finance, they’ll always be able to do that internally, I think, very, largely.

If you don’t invest in tobacco companies, it’s not that you’re putting them out of business. You’re just making their share price lower, you know, what does that do for people who are prepared to own the stocks? It actually pushes up returns. You’re getting a higher dividend yield with no other implications for the future of the business. So, it’s the point that Cliff Asness has made really well, I think. This is supposed to be how ESG works to some extent. If you divest from stuff, you push up the cost of capital, you push up the rewards from people who will invest in those things. The more important thing, though, when it comes to divestment of tobacco companies is, who do you want owning these things? Let’s assume that there’s a bunch of people out there who want to use nicotine, they’re going to get it in some form or other, pretty much whatever you do. And if they can’t buy in the shops, they’ll buy it in their own garden, grow it in their garden, or buy it on the street corner or wherever.

I think society is much better off if those companies that are selling those products are public and accountable. If you take them private, then you actually lose a lot of the levers of influence over them that you might otherwise have. And what you actually want them to be owned by is engaged, responsible shareholders who encourage them and push them to do the right thing. Ten years ago, before we had this suite of potential reduced risk nicotine and tobacco products available, that was a sort of academic debate. The products that might have been able to make a difference to consumers into global public health just didn’t exist. But now they do. And you want to encourage companies to invest and innovate and work very hard to transition their business away from combustible to nicotine pouches or heating, or vaping, or whatever. Without that leverage from public shareholders, say, all the big tobacco companies got taken private next month and owned by some bunch of secretive billionaires, they might just take the decision to milk the business for cash and maximize short-term profits. And that’s not a desirable outcome. So I think there’s a range of styles of ESG investing, where we come out very firmly as wanting to do the engagement stuff. Blanket divestment to us, you know, might make people feel better but it doesn’t achieve much. We’d much rather be responsible and engaged and trying to move businesses in the right direction.

Meb: I was trying to chat about this on Twitter and got some pretty interesting responses. Most of the ESG crowd, in my opinion, I said, I’m a quant. Okay? So I tend to agree with Cliff. Reducing breadth on the return side to me is not a foolish choice, but just a suboptimal one. But thinking about the whole ESG category, which is very nuanced and complicated, you come up with different ESG rankings and you have some pretty shockingly different inputs and outputs, depending on your perspective, too. But this concept of I was talking about tobacco specifically, but ESG in general, I said divestment in a sector where everything is funded by cash flows. It’s not like you’re doing original equity issuance or even debt in these scenarios. These companies have so much money that they’re returning most of it to shareholders through dividends and buybacks. So you’re not really doing anything. I was like, if you really wanted to have an impact, you actually want to own the shares and vote on any control issues and future of the company but that elicited some interesting responses.

Jonathan: One further point on that as well, which is that there are already signs of this approach working to the extent that the big tobacco companies that have been successful in transitioning more of their business already to these reduced harm products… Philip Morris International and Swedish Match are the two who’ve got the biggest portion of their revenue coming from these newer products and trade on much higher valuations than those companies who are more reliant on the traditional combustibles. That should be a message that is brought cast more widely about the potential for ESG engagement and a more thoughtful approach than blanket divestment. It’s already having an impact.

Meb: I was reading some old Robeco papers about ESG, in general, and it was talking about it’s like, you know, like specifically tobacco industry, it’s outperformed. Historically it loads very heavily on two quant factors I love, one of which is essentially quality, you know, return on capital, but also the big one is total assets, meaning, said differently, we think a lot about companies that are returning cash to shareholders through dividends and net buybacks, but also avoiding the ones that are the serial issuers, which a lot of people tend to neglect the importance of that concept of massive dilution. And so, tobacco companies have historically had both of those. And on top of it now, they also have a third, which is strikingly lower valuations. So, it’s lining up as a pretty great investment theme.

Jonathan: One point, just worth adding to what you just said. I mean, because of the flow of M&A and deals that have happened in the sector, the larger companies, until quite recently have been in balance sheet repair mode. So they’ve been paying down debt. But one of the things which is also interesting for the next couple of years is that that balance sheet repair necessity will disappear. You’ve already seen Philip Morris and Altria this year resume share repurchases. And I think it’s pretty likely that BAT and Imperial will be in that position before long as well. And with valuations where they are, there’s a massive opportunity for self-help, which some of that might be offsetting ongoing dribbles of divestment but then being able to buy their shares back on PEs that are single-digit some of them, this should be very good for ongoing shareholders.

Meb: Yeah. Is cannabis even something on y’alls radar when it comes to tobacco industry or do you consider it something totally different and is that an area that’s of interest yet or is it too early?

Jonathan: We’ve been watching it for a while. And this is another interesting point, again, 10 years ago, it didn’t seem like they were really obvious places for tobacco companies to diversify into. Being through that diversification thing decades earlier in Philip Morris buying food, Reynolds buying food, in the past being as well, for Philip Morris BAT we mentioned at the start, insurance, those things never really worked. And it made sense for the tobacco assets to be separated. But I think, yeah, now with the arrival of the cannabis space and it becoming more legal in more places, that is a much more obvious potential adjacent space for tobacco companies to move into. And a lot of them have done it, albeit through toeholds at the moment, but Altria bought half of Cronos, BAT has made an investment in one of these things, so has Imperial. And cannabis, yeah, it’s an obvious thing to be looking at.

I still find cannabis as a standalone investment prospect a little bit terrifying. It’s certainly not in the quality bucket yet, not least because the U.S. Federal legalization question hasn’t been dealt with. It probably will be at some point. And then a whole lot of other regulatory pieces will fall into place, which will allow us to see what the real long-term investment opportunity is like. But for now, it doesn’t really suit our stock because you’ve basically got to make a bet on the way the regulations go. And your outcome is going to be massively different depending on what that outcome is.

Meb: I agree with you. As we hop around sort of this consumer staple franchise space, tell us about anything else in the rest of the portfolio as far as themes or names. What else is looking attractive to you guys?

Jonathan: Well, I mentioned that both of our strategies have quite big positions in beauty.

Meb: You mentioned Asia, too. What do you mean by that?

Jonathan: I mentioned at the start about us generally being category agnostic. And I stand by that. A couple of points about the beauty industry do stand out to us as being a little bit different from some other categories. One is that if you look at, for instance, the U.S. GDP data is really good for this. If you look at personal consumption expenditure on food or drink or tobacco, it slightly lags GDP over time. Not surprising because people get wealthier, but you can’t eat ever more food or drink ever more drink. And it doesn’t by the way, make those sectors a bad investment because what you do tend to find is that the winners in them stay the same over decades. Whereas in some of the higher growth industries and categories, you have this disruption cycle, which means that the companies or the leaders change every 10 or 15 years.

The one staples category, which does grow in line with GDP is beauty expenditure, personal care expenditure. I guess putting it simply, while there might be a limit to how much you can stuff down your throat, you can always be spending a bit more to make yourself look nice, especially these days, if you’re a man, there’s a whole untapped market that never used to exist at all. It’s got that going for it. And then when it comes to beauty, in particular, as well, you know, China is a really interesting opportunity because you have had a culture where makeup wasn’t really allowed for quite a few decades and where there is still an enormous catch-up opportunity. We’ve been for ages looking at ways to get exposure to China. That was quite frustrating in lots of ways because a lot of the things that were there didn’t seem particularly attractive to us thinking about our categories. Tobacco was shut anyway. It’s a monopoly. Food, very local. We’ve seen some of the multinationals buy Chinese food businesses. And that typically is not gone especially well.

Meb: What’s the reasoning about why do you think it traditionally doesn’t go well?

Jonathan: There are some cultural clashes there. We’ve seen a lot of our companies in the past buy things which didn’t turn out to be the quality they hoped or where they ended up having problems with their local partners, even some famous examples where the local partner kind of opened a factory of their own and started bootlegging the product and…

Meb: It’s funny but not funny.

Jonathan: We wrote one of our letters about the sort of various disasters we’ve come across in China. So, it’s been a problematic area for us to get exposure to, in a way we’re comfortable with, despite it looking really interesting. And beauty is the area where we’ve happened upon, where we think are really interesting opportunities. But for some of the international players as well, where, hopefully, on some of the governance issues, you can just be a little bit more comfortable that things aren’t going to go badly wrong. I guess also, we’ve thought a lot about do we play beauty through the really well-known names like L’Oréal and Estee, which are both brilliant businesses. But we’ve come across some businesses actually listed in Asia, Japan, particularly where we would expect these companies to have businesses and brands which resonate more with consumers in the region, which are maybe a little bit more under the radar and have more growth runway ahead of them.

Meb: What is the impact? So you talk about this in your recent letter. I’ll give you the mic on this. You were talking about oatmeal, D2C brands like Harry’s and Dollar Shave Club and this disruption concept. How at risk are these bigger companies? I mean, when I say bigger, I mean, even above a billion in market cap, maybe public companies, from what’s happened over, not just the past year, so COVID, but also the past 10 years, this trend towards this direct-to-consumer world. Is that like something keeps you up at night or is it just eventually these big companies just, like, are like an amoeba and they just consume and acquire everything? Like, what’s the thought on the disruption going on in that space?

Jonathan: I wouldn’t say it’s keeping us up at night, but it’s certainly keeping us busy answering questions about it. I mean, we talk about disruption all the time and have done pretty much constantly for the last five, a bit more, years, probably. Let me just summarize it. I think disruption is much more of a threat in terms of investor attention than it is really to the underlying businesses of incumbents. Just to explain that a bit more. Large consumer businesses have always reinvented themselves. That’s why they’ve been successful. Although they’ve always been selling the same kind of products, in any country, in any category, you know, there’s always changes in trend, in fashion, change in the products that people want to buy. And unless you as a company stay on top of those, and of course, you want to be driving them and being the cause of them, unless you stay on top of them, you won’t exist.

So it’s in the nature of successful large businesses like the P&Gs, Nestles, Unilevers, whatever, to transform themselves all the time. I think people are in a little bit of danger of forgetting the degree to which that’s always been the case. They’ve always bought stuff, probably never been a forte of any really large business innovating. What gets a resource in a company, it’s the major products which make you the most money now. The guy who says I’m going to invent something that doesn’t make any money yet but might do in 10, 15 years’ time is always going to be a difficult thing in a big organization to make them a priority and give them the space to create stuff that works. You also have what I call the iceberg effect. Whenever a big company buys a small one, there’s a lot of attention on the small one, you know, what a brilliant success it was. Why couldn’t the big company have done that? But what doesn’t get talked about is the other eight or nine businesses, which got founded at the same time as the other smaller one, which never worked and just fell apart. They might have had a really good push, they might have had quite a bit of success for some time but then for whatever reason, it hasn’t worked.

Meb: Survivorship bias, right? People just see the one that worked. I was laughing as I was reading your letter, where you were talking about Aperol, Campari acquiring that back in the day, it seeing phenomenal growth. And I said, well, I could have had a Peter Lynch effect there as, like, based on my mother in law’s Aperol Spritz consumption during COVID in the past year-and-a-half. I don’t know why, like… There’s probably some psychological reason why everyone was all of a sudden attracted to Aperol Spritz in the last year. I don’t know if you have any insight into why that is. As a success, we don’t see the other 20 Aperols that didn’t make it.

Jonathan: It’s a Campari brand. It’s a portfolio company that has actually great marketing. It’s helped by also being a pretty simple drink to make, by being not too alcoholic, I think the color is really helpful too because it stands out. It’s a happy kind of color. It makes people think of the summer. And that’s been a big part of the Campari story over the last 10, 15 years, and I think it still has a lot of room to grow.

Meb: It’s a good point.

Jonathan: So coming back to that survivorship bias thing and these smaller brands, that’s a part of it. Arguably, it’s much more sensible for a Colgate or P&G or whoever, to spend most of their time looking in the market for other people’s things, which work, are proven by the market, then buy them and scale them to do everything from scratch themselves and, you know, incubate 100 brands and only have three or four of them come through as real survivors. You know, that’s one thing that I think is very worthwhile reminding people. The other is, which is more a symptom of the current market environment we’re in, is that you’ve got two different business goals. I mean, for better or worse, and we think for better because it’s the bedrock of what our strategy is, the big guys have to make money, and they’re not interested in buying stuff unless it’s making money and it’s going to make a decent amount more money in 10, 15, 30, 50 years’ time.

But there’s an alternative model, which is quite in vogue at the moment of people creating businesses which don’t make money but grow their revenues rapidly. And businesses are being valued on revenues, sold on revenues, sold on to other people based on revenues. And that, to us, is quite dangerous. At least, looking at the space we’re used to being in. Clearly, some people have made fantastic sums of money out of that approach. And there are lots of new companies, which I’m sure will be around for a long time, which will make a lot of money in the future in other categories. But it’s risky I think playing that game with staples categories because it’s not a winner takes all markets. And if something’s never made money, but has grown rapidly, and then you buy that thing on the basis that it’s going to grow a ton more and eventually make money, that’s quite a risky prospect.

And we’re much happier buying things that are already profitable and have grown at a steady rate with room for a lot more growth in the future. Things which grow rapidly can also decline very rapidly. It’s partly based around the way we think is the right way to grow brands. And we’ve spoken to people about this before in the context of the U.S. beverage market and beer, in particular. Two big players, Heineken and AB InBev. And AB InBev is great at lots of things. It hasn’t been great at innovating and growing brands, especially in the U.S., where we went through this phase of launching stuff, putting loads of money behind it year after year, and those things would grow very rapidly to start with because they have enormous distribution. It would get massive marketing dollars behind them. But then they would just fade a year or two later, they’d be gone. Because there wasn’t the patience there. There wasn’t the slow seeding of the brands. It wasn’t building it outlet by outlet, getting buy-in from advocate consumers who then spread the word to their friends, who then spread it wider and wider. It wasn’t an organic growth. It was just a machine that pushed, eventually ran out of support for whatever was being pushed.

If you grow brands in a much more patient way, which is classically the way Heineken has always built the Heineken brand when it’s gone into new markets. They go into a place, knowing it’s going to take 10, 15, 20 years to get to where they want to be. The last thing you want to do with a high-quality premium brand is just blast it out and make it national in a couple of months because you’re not creating the roots, you’re not creating the structure to support the brand for the long-term. You need to get the advocates there. You need to get the advocates in bars. You need to get influencers growing the brand at the right speed and with the right people. It’s different for every D2C brand out there, but as a general philosophical point that we’re not anti-anything new.

And we look at everything new that comes along, all these business models fascinate us. And we don’t want to ever write anything off. We also don’t want to lose sight of the fact that what we think and what we have firm conviction in makes a high-quality business in the long run, which is being able to grow volumes and market share year after year after year, and to use the operating leverage that gives you to reinvest in the brand and innovate year after year after year. Moonshot things just kind of are not working and take Dollar Shave Club, which when people first started asking us about disruption was a big driver of where those questions were coming from. You know, how can the Gillette’s of the world, the P&G’s survive if Dollar Shave Clubs and the like are able to come along and get people to buy a totally new razor blade and sells themselves for a billion dollars?

The history of Dollar Shave Club since is pretty instructive. Unilever who bought it said that it’s growing, it has grown every year since they’ve acquired Dollar Shave Club. It is not particularly profitable. It hasn’t changed the world. Procter& Gamble with Gillette after a while, it took them a while and caused them some problems, but they’re, after a bit of a strategy and pricing reset, back on form now. This is an interesting side point as well, the sort of worst disruption threats always come where the incumbent has not been doing the right thing. What was the root cause of Gillette’s issues? What created the umbrella for Dollar Shave Club? Well, it was the fact that P&G kept jacking the price up year after year, and their innovations got more and more marginal. And once you’ve got five blades on a thing, where are you going to go? You’re going to go up to 10? I mean, there was a space, an umbrella that they created for basic, simple, better value, product and Dollar Shave Club brilliantly went for it. If P&G had done a slightly better job of managing the category, that opportunity might never been there.

Meb: Yeah, one of the defining characteristics of, it seems like a lot of the portfolio companies in this space, is consistency and then in the sector as a whole too. Do you guys engage with management at all, or do you try to take a pretty passive approach? And are you ever reaching out to some of these and chatting with them? And along these same lines is, like, how do you think about sell criteria? Is it more operational traditionally, where the business is struggling or changing or is it more valuation? What’s the sell discipline on the portfolio names?

Jonathan: Absolutely. We do engage, we like to think of ourselves as the kind of investors that managements want to talk to, firstly, because we tend not to be very focused on short-term stuff. We’re never going to go in there and ask them about last month’s trading. That doesn’t interest us. Whenever we have these meetings, we’re going to be asking about strategy, longer-term stuff, having a deep dive, doing a kicking the tires kind of exercise. I think managements tend to enjoy those types of discussion more, rather than having to dead back questions they can’t really answer anyway. I also think our background as analysts, having covered the stocks for, most of us, a couple of decades at least, means that there are a lot of managements who find the conversations they have with us interesting as well. We know some bits of the industry sometimes better than them.

We’re not a specifically activist engagement fund. If we see an issue that we think needs to be tackled, then we will. And you might have seen in the tobacco letter that we wrote last year. Around this time last year, we did write to our tobacco holdings asking them to have another look at the balance sheet and use of cash flow policy because we felt there was an opportunity there for maybe shift of balance a bit more towards buybacks than we’ve been seeing up until recently. There are some situations where we will definitely make suggestions. We’re not a classical activist in terms of wanting to stir up trouble for everything we own.

Meb: And then what’s the traditional way you boot these companies out? Is it, they reach your price targets? Because I assume you mentioned they tend to be longer holds, longer-term perspective. Is operational changes rare? What tends to be the sell criteria?

Jonathan: So we don’t change very often. Our portfolio turnovers, probably running about somewhere between 10% and 15% since the launch of our fund. So we’ll be changing one or two stocks a year on average. Tends not to be valuation driven, which is not to say we would never take any decisions based on that. And quite often, we’ll make adjustments in allocation between the stocks based on where valuations have got to. Remember what I said earlier that we take the view that the market hardly ever values these stocks properly. Our whole philosophy strategy is really based around the idea that they’re worth a lot more than the market will ever pay for them. We’ll not typically set a price target at which we expect to sell a stock.

Having said that, if there’s two businesses, where we think the quality and opportunities are the same almost, but one is very, very obviously much cheaper than another, then it would make sense to reallocate money from the more expensive one. What really makes us want to sell a stock is operational stuff and not short-term things but it’s red flags, bad behaviors. I mentioned that we’ve got this very, very firm view on what makes a high-quality consumer staples business, its ability to grow volumes and market share, and reinvest organically. It’s businesses starting to take shortcuts on those fronts, which particularly worry us. Companies start suffering a bit on the sales front and trying to make up the numbers by reducing the marketing budget, that’d be an absolute classic for us in terms of being a stock that we didn’t want to own for the long run. It’s those kind of behaviors that we are on the lookout for most and which are most likely to cause us to change our minds.

Meb: As we look out to the horizon into the future, and you guys are thinking about kind of industry trends, you started off your most recent letter with Pieter de Montes, I don’t know if I pronounced his name right. I always crush it. Some of the trends going on in this world, what else are you thinking about we haven’t talked about today? Anything that’s on the brain, you’re excited, confused, worried, optimistic about, that’s occupying some brain space?

Jonathan: Our strategy boils down to something that’s really quite simple. You’re investing in companies, which everybody knows, are ready to understand, and are selling products every day, and every week that most people buy. They’ll never be the most exciting businesses in the world. They’re never going to invent completely new categories or products. We’re not talking Tesla’s type electric cars here. We’re not talking tech stuff which didn’t exist. They’re always going to be doing something you could recognize. And of course, that puts limits on how fast they can grow. What is kind of puzzling at the moment is that kind of investing style is out of fashion. For most of my career, if you presented me with a bunch of stocks, which you said, let’s say the average yield on these things are 3% or 4%, and they’ve got a record of growing 7%, 8%, 9%, and have done so incredibly consistently year after year, you don’t have to take too much risk here to get low double-digit total returns. That kind of product to me would have been extremely attractive. I think what’s happened in the stock market and in the investment world in the last 5, 10 years, has made people forget the extent to which those kind of returns are attractive. People are thinking about doubling their money over a year. People are thinking about not interested in 7%, 8%, 9%, 10%, 11%, 12%. I want 30%, 40%. That mentality is sometimes making life a little bit difficult for us as a fund manager that has this style we do. And, you know, I wonder how long that will persist because there have been times in my career where the attitude of markets to those sorts of things has been very different to what it is now.

Meb: The funny thing about that, we talk a lot about this, the sentiment surveys have been inching up and then seemingly in the past year, they seem to be going a little parabolic. I mean, there are so many examples. Schroeder’s, Natixis both had individual investors, particularly in the U.S., because U.S. has been leading this charge up north of 15%. Pretty rare, pretty lofty. But I was chuckling this morning at a poll on Twitter, where this lady, a local LA venture capitalist posed a question, so would you rather have $10 million today or $100 million in five years? Ignoring the comments, “I’d rather have $10 million today because the future is uncertain. But there was a large amount of responses that were basically, like, why would I ever take $100 million in 5 years? I can easily turn $10 million into $100 million in that time.” Like, that seems like a terrible mathematical choice, 10 into 100, it doesn’t seem like anyone’s joking. Like, it seems like this is a totally honest assessment. So, I didn’t ever think I would see another late ’90s period in my career in the U.S. You see them everywhere, right, a lot of investable countries or sectors on occasion kind of go bananas but this has a lot of feels similar to that period. So who knows?

On the macro side, is there a scenario where these companies ever rerate, these PE’s double? I see a scenario where people are just happy to collect these fat 7% dividends or something into infinity. But is there a scenario where flows reverse into these companies? Like, could that just be the really expensive stuff? I see we have the highest amount of companies in the U.S. trading at a price of sales of 10, depending on the universe, either ever or second to late ’99. What do you think? Is there a case that these companies actually, not just do well, but actually multiple expansion?

Jonathan: I think that’s definitely potentially the case. It happens. You know, after the TMT boom burst, there was a lot of big staples companies which were treated as value stocks and had ratings commensurate with that, not just tobacco, but some of the other so-called boring staples companies as well. And they were very, very strong performance for the next decade because growth was scarce and people realized that the things which could actually deliver that growth consistently and at relatively low levels of risk were more than they previously thought. So, we don’t base our pressure again, really on, A, thinking about the way macros are going to go, because we’re not experts in that and our experience is that really no one else is either, so…

Meb: But nobody is, right?

Jonathan: It’s not worth too much time worrying about it. Also, we’ll never invest in something just because we think the valuation is going to expand over the next X years. There always has to be an internally driven cash flow and growth dynamic there, which means that we can get our returns that we want without that valuation expansion happening. But that’s obviously not to say that it will never happen over the long-term. The valuation of large staples businesses, and some of the sub-sectors within that does fluctuate a lot. And it’d be pretty weird if it didn’t ever fluctuate again. Absolutely. That is one scenario that could happen. We’re not betting on it.

Meb: As you look back on this career, a lot of great stories, a lot of great market events over the past couple of decades. What’s been some of the most memorable investment? Anything on the good side, the bad side, in between, but anything burned into your brain?

Jonathan: As I said at the start, I’ve only been doing the investing side of this in the last 10 years or so. And still, a bit more than half of my career has been on the sell-side. To bring things full circle, I remember going to see a friend of mine once who was on the buy-side. It must have been about 2000s. And this was still when I was at Merrill’s. I was only covering the tobacco sector in those days. And he was starting to look at these stocks, told me afterwards a few years on, “Jon, I knew it was a good time to be getting stuck into these tobacco things because your face when you turned up to me that time was so miserable.” It was like that. Nobody wanted to know. Nobody had the slightest interest in stuff, which, yeah, but still there, it was a good business. It was making a lot of money for the people who did own it. But it just was completely off most people’s radars.

I mean, that friend actually ended up founding his own asset management business and had massive holdings in tobacco early on, and those things did a great job for him. That’s always stuck with me as a big lesson. Of course, you can’t ignore what the consensus is saying and you can’t push against market trends forever yourself. But there are occasions where the consensus is incredibly wrong and where things can turn around actually, really quite quickly. Predicting those things in advance is tough. But I think one thing my career has told me is stick to your convictions and stick to your framework. Probably the worst mistake you can make is to have your way of looking at the world and your framework blown about by whatever’s going on in the news, going on in markets, which is not to say, again, that you don’t accept some feedback and make some maybe adjustments to the framework but you’ve got to have an anchor there, which means you don’t drift too far from what you think the long-term goal is. And I’m confident that if that’s the approach you take, you’ll end up where you want to be.

Meb: Jon, this has been a wonderful romp around the world. Where do people find you? We’ll add a lot of links on the show notes. Your letters are some of my favorite in the biz. So, keep it up. Where’s the best place? People want to find out what you guys are up to, your writings, where do they go?

Jonathan: Yeah, they can go to ashparkcapital.com, and that gives lots of contact info for us. If you’re specifically influenced or interested in tobacco stuff and I don’t give investment advice on Twitter, but I will tweet about developments, especially when it comes to regulation or reduced harm. You can find me on @JonFell73, J-O-N-F-E-L-L-7-3 on Twitter.

Meb: And you can go to the website to find Jon’s favorite portfolio product as well. Jon, thanks so much for joining us today.

Jonathan: Thank you very much for having on. That was a really interesting conversation. Cheers.

Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at the mebabershow.com. We’d love to read the reviews please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening friends and good investing.

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