Editor's note: Porter was worried...
It was February 2014, and he had noted how "frothy" the market was looking. He thought the market was due for a big correction. So he and his research team set out looking for a crisis-proof investment.
The trade they found worked out perfectly... and his Stansberry Alpha subscribers booked huge gains.
In today's Masters Series essay – adapted from the February 2014 issue of Stansberry Alpha – Porter and his team explain how they discovered the perfect candidate for an Alpha trade...
This Is the Last Thing People Give Up in a Crisis
Since the beginning of the 21st century, the stock market has been a story of bubbles and bursts...
Bubbles inflate, then they pop. The focus of the manias changes, but the wipeouts come regardless. You can see the story in the following chart of the SPDR S&P 500 Fund (SPY)...
From early 2000 to mid-2002, the S&P 500 Index lost nearly 50% of its value, wiping out investors who had plowed cash into the Internet-fueled equity markets. From late 2007 to early 2009, the S&P 500 Index suffered another 50% drop... this time destroying investors who were lured in by the credit-boom buying frenzy.
We started worrying in June 2013 that the market was showing signs of a top... that the latest bubble might be nearing the breaking point.
The big turn downward hadn't come by February 2014... but the signs were still troubling. For example, the number of large stocks trading at unsustainable valuations had swelled to a point we hadn't seen in five years.
We scoured the market to find companies that offered maximum resistance to falls. We analyzed more than 1,600 stocks across 39 sectors to identify what types of companies held up best in periods of "tapering." It surprised us to find tobacco near the top of our "resiliency" rankings.
All of the tobacco companies sported impressive numbers. And each company had its own unique selling points for investors. But we liked Lorillard best of all.
Lorillard was the "900-pound gorilla" in the menthol-cigarette market. Menthol is a mint-flavored additive that appeals to some smokers. In total, Lorillard owned 40% of the menthol market, 17% of the premium-cigarette market, and 15% of the total market. Newport, Lorillard's flagship brand, accounted for more than 80% of the company's revenues.
With a market cap of $17 billion, Lorillard wasn't the biggest player in tobacco. But it was by far the most capital-efficient. "Capital efficiency" is one of our favorite traits in long-term investments. Capital-efficient companies generate large amounts of cash without requiring a lot of capital to grow and maintain their operations. The best companies use these excess profits to reward shareholders through dividends and share buybacks.
Lorillard was a well-run company with a history of rewarding shareholders, competing in an industry that holds up well in tough economic times. But we believed there was a real sales-growth story here... Lorillard was also the world's top player in an industry that was new at the time and had nothing to do with tobacco: electronic cigarettes.
At the time, the technology had been around for about 10 years, but usage really took off in the 18 months or so before our issue.
To its credit, Lorillard management saw this trend coming and purchased an e-cigarette company called Blu for $135 million in April 2012. Within 20 months, Blu was already available in nearly 136,000 stores and produced $230 million in 2013 revenues. These numbers were hard to believe. E-cigarettes accounted for around 5% of Lorillard's business at that point... from a standing start less than two years before then.
Lorillard had consistently generated $1.1 billion in annual cash flows over the previous five years. Analysts predicted e-cigarettes could add another $150 million per year over the next couple of years. This cash would have comfortably covered the company's $800 million-$900 million in committed dividend payments. We believed Lorillard would remain one of the most capital-efficient companies around in terms of cash profits returned to shareholders.
We found an incredible trade that at its worst would let us purchase already-cheap Lorillard shares at a 13% discount... and at its best had triple-digit upside based on our still-conservative valuations. We'll share all of the details in tomorrow's essay.
Regards,
The Stansberry Alpha team
Editor's note: At the time, you could have simply purchased Lorillard shares. But Porter's Alpha strategy would have allowed you to capture almost all of the upside... using someone else's capital... without putting up any of your money upfront. It's no wonder Porter says this is one of his favorite ways to invest. That's why he recently put together a brand-new presentation in which he shares the details behind this strategy. View that presentation by clicking here.