Bull Market Health Check. Plus, Philip Morris CEO Jacek Olczak

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

When you look out 3, 5+ years, 10 years, I think that the S&P 500 is going to offer attractive returns? Are they going to be, you know, 20-plus percent that we've, we've seen in, you know, '23, '24? We'll see what happens in '25. Probably not. They're going to be lower than that, but I think they're still going to be attractive.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Scott Wrenn. He's the Senior Global Market Strategist for Wells Fargo Investment Institute, and he's talking to us today about this AI-driven bull market for stocks. Is it a bubble or is the getting still good? We'll also hear from the CEO of Philip Morris about profits after tobacco. I mean, not really after tobacco, after the growth for the business of setting tobacco on fire and inhaling the smoke. There's still heated tobacco that doesn't produce smoke and there's nicotine products that don't have tobacco at all. You know what, we'll get into the details later. Listening in is our audio producer Alexis Moore. Hi Alexis. Hey Jack. I was just reading about the Deepseek sell-off in January of this year and I couldn't remember what it was. I mean, deep, it sounds familiar, but was it a, was this a submersible? Are we talking under the ocean? What's going on? Remember China had launched this cheap AI model. And the thought was that China had jumped ahead of the US and everyone else in AI, and this was gonna spell trouble for our companies trying to make money off this stuff. And Nvidia fell how much? What was the decline? It was January 27th, and it looks like 17%. Nvidia, the biggest stock in the S&P 500, and this wonderful performer collapses by 17% in a day. And you think, all right, that's it, kablooey, that's it for people's index funds.

Jack, I have to warn you, you have a kablooie coming up in the conversation.

In the recorded conversation, I use kablooie. You do. And now I'm, I'm one kablooie deep and that makes two. So I'm two kablooies in, not counting these ones that were— okay, I'm on early kablooie watch. I understand. Okay, so Nvidia down that much, you might've thought it was whammo for your S&P 500 fund, but in fact, your fund would've been down about 1.5% on that same day. So how's that possible? Well, Barclays points out that 70% of S&P 500 constituents were actually up that day. Investors sold out of semiconductor stocks, but they went into value stocks and quality stocks and safe havens. And so the downside wasn't quite that bad. Why are we talking about Deepseek now? It's because America is all in on AI, the stock market at least. As we've mentioned before, AI stocks now make up more than 40% of the S&P 500 index. They account for basically all of the returns since the launch of ChatGPT in late 2022 and most of the earnings growth. So if the AI narrative, companies spending all this money to build out data centers, if that AI narrative falls apart, the stock market could be in trouble. And analysts are contemplating what that might look like. Barclays does not think we're there, but it points out that they call this an illustrative analysis. They say that a 20% step down in data center CapEx would result in a 10 to 13% de-rating for the S&P 500. De-rating meaning the price-to-earnings ratio comes down by that much. That actually doesn't sound that bad for a totally theoretical downside. This, I think, is one of the biggest questions investors face now. Their U.S. index fund has performed wonderfully well, but it looks a little pricey, somewhere around 23, 24 times earnings for the S&P 500. Their overseas stock index funds have done even better, but how long can that continue? Is there anything different investors should be doing now to hedge? Is there anything they should be overweighting to offset their exposure to AI companies? For answers to these questions and some others, I reached out recently to Scott Wren. He's the senior global market strategist for Wells Fargo Investment Institute. Scott is broadly bullish. I think it's fair to say. We talked about how the market now compares with the dot-com bubble of the late 1990s and what investors should not be doing now to hedge their S&P 500 exposure. Let's hear part of that conversation now. So Scott, I would like for you to talk me out of panicking about the US stock market. It makes me nervous when things go so well for so long. I feel like something's gotta go kablooey soon. What should I make of this market?

Well, Jack, you're not the only one. I think, you know, we cater to retail investors and we have people that are certainly in the market, but they have quite a bit of cash in their account and they're just hesitant to really to get in. The money that's in their account, generally they want to get into the stock market, But, you know, between tariffs and fears of a growth slowdown and inflation and things like that, you know, it's been tough. So I think a lot of retail investors have been sitting here watching the S&P 500 just continue to set record highs.

Now, I know I don't look a day over 25, but believe it or not, I was alive and working during the dot-com crash back in 2000. And so, What about people who compare now with then? There, there are some similarities, right? We've got a lot of, um, a lot of tech concentration, a lot of the same stocks running up. What do you make of that comparison between now and then?

You know, we get that question. We've been getting it quite a bit. And I think when I look back on what was going on then, you had the similarities, small number of stocks that were really driving the S&P 500 higher. I think a big part of the differences is just the quality of companies. And what I mean by that is back in, let's say when the market hit the high in March of 2000, those were companies that were built on future expectations. They were priced for what is probably going to happen down the road, products they were going to develop, services that were going to be in demand. You know, their revenues really weren't that great. They didn't have a lot of cash flow. You know, look forward to now where these handful of companies, or maybe a little bit more, that have really been carrying the S&P 500 higher, they're real companies. They have real revenues, real products, real cash flows. And so I, I think the quality of the companies are a lot better today. And really, if you look back over just, you know, the first quarter earnings season, second quarter earnings season overall, earnings for the S&P 500, they were double in each quarter what the consensus was expecting. And of course, a lot of this growth was concentrated in these large mega-cap tech companies. And really, I look at this market as hinged to a big extent on AI CapEx spending. You know, over the last 9 months or so, there's been a lot of concerns over is this going to pan out? And really during the first quarter earnings season, second quarter earnings season, all these big companies, they either said, yes, we're holding our CapEx related to artificial intelligence, we're holding it steady, or in a lot of cases we're boosting it higher. So I think there's a lot of differences today relative to March 2000. And Jack, you'll appreciate this. My number in March of 2000, earnings number for the S&P 500, the market was trading at 32 times the number that we had out there for 2000. So, you know, valuations, I mean, they're about 25 times right now, which is certainly not cheap. But, you know, high valuations can go even higher.

Describe for me the trajectory of earnings from here, not just the growth percentage, but who does it extend to? Who benefits? My concern is that right now there's this massive sum being spent to build out data centers. And I read every day about new kinds of companies that are involved, uh, there that are seeing unprecedented demand to the point where maybe they have a 6-month or a 1-year backlog of business and they're struggling to give customers as much as they want. And so the fear in the, in the back of my mind is maybe the customers out there start double and triple ordering and there's this big spending frenzy, but at some point it just kind of slows, or folks say let's take a pause on the spending and wait till we see some of the benefits coming out, and then you see you know, maybe it slips into reverse because maybe you have inventory issues. I know I'm getting ahead of myself here, but that's my concern. And it makes me wonder, are these riches going to broaden out to more and different kinds of companies going forward?

Well, you know, we certainly thought we would see some low double-digit growth in data centers as we look out really through the end of this decade. And I think, you know, coming into the year, you heard a couple of hiccups on AI spend as if, you know, it was going to slow down. Maybe we aren't going to do as much. And that was part of what turned the market down. And, you know, we had a good buying opportunity in late March and early April because of that. But I think that if you look at tech companies or the small number, a couple of companies that really are in communication services that are really helping push the market higher, you know, those CapEx numbers have continued to come through. But certainly if you get any whiff of AI CapEx spend going down or not quite panning out, and it wouldn't probably have to be much of an adjustment, you know, the S&P 500's going to go down on that. But I think that when we look at other sectors besides tech and communication services, I mean, let's face it, there's really not that many companies that are actually making money off AI right now. There's a handful of companies and maybe a few more that are, but other companies, it's more or less an expense right now, you know, one angle we've been trying to take on it is we know this data center build is going to be pretty big. It's pretty big right now. What other sectors can benefit from that? Who's going to build the data centers? Who's going to help expand or upgrade the utility grid? Who's going to make money off the surge in electricity demand that we're going to see? So industrials is a sector that we've liked because, you know, somebody's got to build the stuff, somebody's got to supply the components and do the actual building. And then of course the utility sector, they're going to see big-time demand increases, which they're already seeing increases, and they're going to benefit from this upgrade to the utility grid. So I think for us, these small handful of companies, they're pricey. We don't want to chase them. But there's some other opportunities in these other sectors that play into AI, play into that growth. And I think as we look, you know, at least through the end of next year, it's going to be growth tied to AI. That's where most of the CapEx is going. You know, you look at other segments of CapEx within the S&P 500, it's pretty flat. But AI is just going up. So I think for the time being, the growth looks pretty reliable. And I think when we look at our target for year and next year for the S&P 500, which is 7,500, I mean, the way we're going to get there are these big growth companies continuing to, you know, to knock the COVID off the ball.

So industrials and utilities, any other industries you think are well positioned now? How do you feel about financials?

Well, we do like financials. You know, I, you know, I, I don't know how much of an AI play that is. I mean, using AI that may, you know, get them some more customers. But from just a financial standpoint, you know, the yield curve is steepening. That's always good. They pay us, you know, X amount for deposits and then lend it out at a higher rate. So the steeper curve helps. Lots of deregulation coming the financial sector's way. There's going to be more merger and acquisition activity, better economy, so more demand for loans and things like that. So really, if we look at the sectors we're overweight, we're overweight technology. We're overweight industrials, we're overweight utilities, and we're overweight financials. Those are the sectors that we really like and that we think have a good potential to continue to or to outperform between now and the end of 2026.

If I make the statement, well, the S&P looks expensive, therefore you should hedge by buying some blank. Now I'll fill in the blank and you tell me whether it's a good idea or a bad idea right now. You should hedge by buying a value index. Good idea or bad idea?

I think value right now is not going to get you outperformance. If the S&P turns lower, that, that'll probably really help you out. But I think right now, 10% correction, that's a buying opportunity. We'd love to see it. I think it's gonna be growth for the foreseeable future, at least through the end of next year.

You should hedge by buying small caps. Good idea or bad idea?

We think owning or even equal weighting the Russell 2000 or small-cap index is a bad idea right now. I think you need more of an earnings contraction, which we certainly have not seen a contraction and we don't expect a contraction, or a recession, which, you know, we're looking at 2% GDP this year, almost 2.5% next year. So I think small caps and high yield typically early in a cycle coming out of a recession, coming out of an earnings contraction, they do well for the first few years, but neither of those things are going to happen. And I think that quality, cash flow, balance sheets, lots of products, that's what's going to continue to drive things. So we are underweight US small caps.

One more of these. Someone who says you should shift more money to overseas markets versus the US. Is that a good idea or a bad idea right now?

You know, we've seen some good performance out of the emerging markets indices. We've seen out of the EFA index, I don't think the fundamentals support that. I think in Europe, as far as the developed world, there was a lot of enthusiasm over increased military spend from NATO. That's going to pan out, but over a 10-year period. And I think the emerging markets, even though there's some stimulus there coming from China, it hasn't been enough. And I think what's going to happen is those are export regions, whether it's the emerging markets, whether it's the Eurozone or the EU. And, you know, they're reliant on other countries buying their stuff. And so I think while you're in this modest growth here in the US, you know, the demand just isn't going to be there. And I think, you know, the US will kind of lead the world into this slowdown. And then next year you're probably going to see a little bit of a pickup in the pace. And I think the US will be the leader. So we're neutral on developed, we're underweight emerging. So we like the US over international.

The starting point for stocks, they look expensive here. We don't know what's going to happen over the next year, but therefore over the next 10 years, it's reasonable to assume that returns for investors are going to be lower than folks are used to, maybe below average. Do you subscribe to that view?

I think you could make a rational argument that we've pulled forward a lot of performance over the course of the last 3 years. But I think when you look out 3, 5+ years, 10 years, I think that the S&P 500 is going to offer attractive returns. Are they going to be, you know, 20+% that we've, we've seen in, you know, '23, '24? We'll see what happens in '25. Probably not. They're going to be lower than that. But I think they're still going to be attractive. And I think that most of our clients, they have some exposure and as I mentioned, they have some cash. And I think what we've been talking to them about is Pullbacks happen. We're trying to be patient. We try to be patient coming into this year. 10% pullbacks over the history of the S&P 500 happen about every 10.5 months. So they occur. And what you need to do is you need to have a plan. And then when the pullback occurs, you got to do what's going to really make you nervous, which is, you know, stick a toe in and get some exposure to stocks. I mean, if you've got to write a big check for your daughter's wedding in 3 months, well, you know, you might want to hold on to that cash. But if you've got a longer-term view, if you're not dollar-cost averaging, you certainly want to put some money in the market when it's down and you're nervous, your friends are nervous, the financial media's nervous. That's the best time to buy stocks.

Last question. I'm, I'm feeling better, by the way. You've lifted my spirits here. I, I want to know about either something that I've neglected to ask you about that you think is important for investors to know right now or to think about, or about a mistake that you see a lot of investors making right now.

Well, you know, you mentioned the mistake, and that's investors that have time on their side and are sitting on a lot of cash. And then when you get opportunities like we did in late March and early April, they don't do anything. They sit on their hands. You know, they may even tell themselves, you know, we're waiting for a pullback. Their friends are saying, you know, we're waiting for a pullback. Financial media is saying we're waiting for a pullback. And then the pullback happens and they don't do anything.

And then they say, so this is only the beginning. It's going to get so much worse.

That's right. That's right. And so I think that's just human nature. And, you know, the way to enhance your returns and build wealth over time is you got to be in it to win it. But also when you get the pullback, you need to step it up. If you're a dollar-cost averager, well, when the market pulls back 10-plus percent, you want to put more money in than what you normally do. And that's tough to do. But I think that's, you know, that's a mistake that a lot of investors make.

Thank you, Scott. Let's take a quick break. I'm going to consult ChatGPT for words other than kablooey to use on the second part of this episode. When we come back, we're going to speak with the CEO of Philip Morris International. Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks. Welcome back. It was November of last year when I mentioned a company called AppLovin on this podcast. AppLovin with no G on the end. And I had a question then, which was something like, how in the heck is this company worth $100 billion? Not that there's anything wrong with the company, just that its rise had been so fast. And I now have a follow-up question. How in the heck is this company worth over $200 billion? Because the stock has gone nuts since we spoke about it. Now, this is not me saying, hey, look at me, I brought you this stock and the stock went up like crazy since we talked about it. This was not a stock pick. I don't pick stocks in this podcast. We were just talking about what had happened to it back then and what the company does. And now it is apparently doing a lot more of that. Here's a recent note from Wedbush. It says AppLovin has repeatedly proven that its phenomenal growth will continue for the foreseeable future and at a staggering profit margin. That sounds bullish. The company does marketing and user acquisition for mobile gaming, and it's expanding beyond that into some other areas like e-commerce. And I don't really have much more to say about it right now. This is one we should revisit soon. And on the subject of what stocks have done since we last checked in with them, I wrote a column for Barron's Magazine back in the middle of March this year on Philip Morris. You're supposed to say Philip Morris International. I know Alexis is nodding her head. That makes her happy. That stock is doing fine since I wrote about it. It's up, uh, 8%. It's got a good dividend, so it's about a 10% return. But the S&P 500 has done much better since then. If you look year to date, however, Philip Morris stock has returned more than twice as much as the S&P 500. Does everyone, or I guess I should say, does anyone remember a movie from around 20 years ago based on a book from closer to 30 years ago called Thank You for Smoking? The tobacco industry, I'm going to guess, was not a big fan, but I think this is useful for summing up public perception about tobacco companies. I don't remember every last detail of the plot, but I remember that there were spokespeople for the tobacco and alcohol and firearm industries and that they would meet every so often for a lunch and they called it a little club. They called themselves the Merchants of Death and they would talk very cynically about their industries and about their job defending their industries to the public. And I just remember the scene where the tobacco spokesperson shows up for one of those talks that you give about what you do to a classroom of little kids. And it was maybe a little awkward. My mommy says cigarettes kill.

Now, is your mommy a doctor?

No.

Well, she doesn't exactly sound like a credible expert now, does she?

He really put that small, inquisitive, and well-meaning child in her place. I mention this because I think that reforming the image of a tobacco company is a long and difficult job. I talked about this a little bit with Jacek Olczyk. He's the CEO of Philip Morris International. That's the company that sells Marlboro and other cigarettes overseas, outside of the US. And increasingly, the growth in the business is coming from non-combustible products. Those include IQOS. IQOS is a device that uses these tobacco sticks. It kind of looks like a cigarette, but you don't set it on fire. There's a vapor-ish thing. I can't tell you all the science of how it works, but it's considered a reduced-risk product. In other words, if you are someone who smokes cigarettes, maybe you should consider moving to IQOS. If you're not someone who uses either, you should stay where you are and don't use either. And it's kind of the same thing with the company's nicotine pouches. Philip Morris International bought a company called Swedish Match, and they're known for these tobacco pouches that you put under their lips. But nowadays they make these ones that have nicotine, they're non-tobacco Anyhow, I think I discussed the Zyn backstory and history in a previous episode, so I won't do that again now. I think public skepticism of big tobacco runs deep, and I think if you said to the average person on the street that Philip Morris, the company known for the Marlboro brand, would rather that you switch from smoking cigarettes to using another product that's less harmful, I think they would say, yeah, right, I'm sure that's what they say. But there's great money in cigarettes. And one of the things I talked to Jacek about is I think we have reached the inflection point where you can look at this just as a financial matter and say that the non-cigarette products are becoming a better business. In other words, beyond the health risks associated with cigarettes, I think there's clear financial incentives for Philip Morris at this point to push beyond cigarettes into these non-combustible products. We'll get to that in a moment. Here's Jacek.

I have to admit it was more difficult to have these conversations 10 years ago. Today, the number is helping the whole narrative. We demonstrated that it can be a very good idea from an investor shareholder's perspective. At the end of the day, this product's actually yielding better margins than a combustible product.

Okay, so Jacek says that non-combustible products are a good idea for investors and shareholders. Let's put some numbers on that. 41% of Philip Morris's revenue now comes from smoke-free products. The key is, what's the percentage of profits? If you told me it was 20%, I'd say, okay, this is a company making the best of a bad situation. They see that there are declines in cigarettes and they're offsetting that with the growth of these less harmful products, but they're taking a hit on the margins. That's not what's happening here at all. Jacek says 42 to 43% of profits for the smoke-free products compared with 41% of revenues. If the profits are higher as a contribution than the revenue, it tells you that these products are pushing overall company profits forward. It tells you these products have reached a point where you'd rather sell them than cigarettes if you're Philip Morris, speaking just financially. That's true even if the difference is only a percentage point or two, because the difference is growing. These products are becoming more profitable. If I look at Wall Street estimates for Philip Morris, they showed double-digit earnings per share growth on average over the next few years. Jefferies, the investment bank, writes that cigarettes are in structural decline, about 1% to 2.5% per year. And they say they expect this to be fully offset by volume expansion in heated tobacco. That's IQOS. Zyn, the nicotine pouches, those are the fast grower of the product portfolio. Jefferies estimates that the overall, what they call modern oral category, will increase volumes at close to 44% this year. So when you put those together, Jefferies estimates that margin improvement is accelerating. They write, and I'll decode this as we go along, given the ongoing growth momentum for key next generation products, DIN and ICOS, we now expect 262 basis points— that's like saying 2.6 percentage points— of operating margin improvement in fiscal 2025. That's faster than last year's margin improvement. They say that's underpinned by a speedier delivery of operating leverage within the next-gen category. In other words, the company has already spent upfront a lot of money to develop these categories. Now it's ramping up the sales. Going forward, Jefferies expects continued benefits from scale and mix. Scale meaning you sell a lot more of these products without the associated development costs that you took on early on, and mix meaning that these less harmful products make up a bigger portion of your overall business. So they see continued margin gains next year and the year after, not quite as fast as this year, close to a percentage point next year, 0.9%. And let's call it around 0.7% the year after. So there's sales growth, there's margin expansion, which means there's healthy earnings growth. And I think that's what is turning investors to the stock. I don't think investors are buying this stock because they're saying, hey, Philip Morris, it's a do-good company now. I think they're buying it because they're saying, hey, that do-good stuff Philip Morris has been talking about, I think there's actual money to be made here for investors. The incentives to me look financial at this point. The harm reduction that goes along with this, that's an extra bullet point to the case for the stock. If you're someone who agrees with that, maybe you're not. I think it's a fair question to ask, if you're so into harm reduction, why are you still selling cigarettes? I think it's so fair that I did ask. What do you say to someone who says, you clearly understand the risks of smoking cigarettes, you switched yourself, and you have been out there with the message that anyone who smokes tobacco should switch to one of these products? So why do you still sell tobacco? Why not look for a way to get out of the cigarette business?

I think the fact that we're doing these transformations while still owning the classical tobacco conventional cigarettes assets allows us in the better allocation of resources, which actually lead to the accelerations of smoking transformation. So it was our decisions to invest essentially most of the commercial resources, entire R&D budgets, marketing budgets out of the support of a combustible for combustibles and for removing the behind. We didn't introduce IQOS and subsequently other products as an additional part of our portfolio. The element which differentiates and still I believe differentiates us versus the rest of the market industry participants is that we wanted deliberately to cannibalize cigarettes to accelerate that whole thing. Because I believe it is better for smokers and it's better for the public at large. And I think actually it's better for us. For the investors. You could consider, why don't you just divest the cigarette part? But if I divest cigarette part, I am no more in charge of resource allocation. So I think that's the trick into this whole thing. Needless to say also that the cigarette category has a very strong cash generation. So actually, we finance all the investment needed behind the smoke-free from cigarette cash flows.

Okay, so cigarettes are still harmful and Philip Morris still sells them, but Jacek's case is the world is better off with Philip Morris selling them than someone else, because at least it can put some of the money it makes into less harmful products. Maybe you agree with that argument, and maybe you don't. I think investors are definitely warming to the stock. Philip Morris International traded recently at 22 times this year's projected earnings. That's only a little bit below the stock market's valuation. There was a long period— not recently, in the past— a long period, and we've talked about this on prior episodes where the public perception was, wow, these tobacco companies, their investors must be in deep trouble because all we ever hear about are bad things concerning the lawsuits and the health. And then you'd look at the return for the stocks and the old Philip Morris, which was a combination of today's Philip Morris and today's Altria, which sells Marlboro here in the US, this stock had beaten the broad US stock market decade after decade. Why? Because the valuation was chronically low. Investors hated the stock so much that it sold so cheaply that if you bought it, you got a gigantic dividend yield and expectations were low. And that's a perfect setup to surprising investors on the upside. But what about today where the valuation is higher? The dividend yield isn't quite as humongous. I have it at 3.6%. This is no longer a stock that's just catering to income investors. It makes me wonder, what kind of stock is this? Who should it appeal to? Jacek says that he thinks Philip Morris today is for growth investors.

If you look at the valuation of Philip Morris today versus other companies in the industry, you see the completely different approach to our terminal value. We have a growth. I could see more and more growth-oriented, growth type of funds which are interested in a Philip Morris stock. It's completely different conversation. Okay. By definition, they recognize technology. They also see how the products which we have today opens another avenues of opportunities for growth going forward.

Thank you, Jacek. And I want to thank Scott from Wells Fargo. Do not smoke them if you got them. If you got them, get rid of them. You can try one of those less harmful products. You could do what I did. You have two kids, then you got to stop smoking because you don't want to smoke around the kids. It's kind of a labor-intensive route because then you have to raise two kids, but you know, you stop smoking. Thank you all for listening. If you have a question you'd like played and answered on the podcast, you can send it in. It could be on a future episode. Just use the voice memo app on your phone, send it to jack.hough@barons.com. Alexis Moore is our producer. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you're listening. And if you listen on Apple, you can write us a review. See you next kablooie. Snuck one more in under the wire. Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.