Necessity is the mother of all invention, and declining industries force companies to think about new ways to generate profits.

It’s generally a bad idea to invest in companies that operated in declining industries. When demand is shrinking, you have to work harder every year just to maintain your current position. But sometimes, the competitive advantages and high market share of a particular company can override the challenges of a declining industry—and give it time to branch out in new directions.

For instance, the tobacco market has been a declining industry since the 1960s. However, a number of years ago I stuck with one of my long-time recommendations, Imasco Corp. The company was Canada’s biggest cigarette maker, and supplied over half of the domestic market.

Imasco’s extraordinary customer service and public relations effort contributed to its success.

I was an Imasco customer for a few years, prior to quitting smoking in 1976. I once wrote to the company to complain that I bought a pack of its Sweet Caporals and the filter wasn’t attached properly to the rest of the cigarette. I soon got a letter of apology from the company, signed by someone with the title of “vice president.” The next day, I found a carton of Sweet Caporals on my desk. The receptionist told me that a middle-aged man, dressed in an expensive-looking suit, had dropped it off. He wanted to come in and offer a personal apology on behalf of the company, but I was out of the office.

Imasco recognized that tobacco was a declining industry. For years, it had been taking steps to diversify away from the business. Its non-tobacco holdings included Canada Trust (Canada’s largest trust company), and Shoppers Drug Mart (Canada’s largest drug store chain). These two companies did extraordinarily well for Imasco in the next few decades. I always felt that Imasco’s customer service and public relations skills had rubbed off on them and contributed to their success.

Over its 100 plus years, Imasco had not only learned to developed quality tobacco products, it learned how to build a successful brand and repeated this with Shoppers Drug Mart.

BAT (British American Tobacco), which was then the second-largest tobacco company in the world, owned 41.5% of Imasco. It bought the remaining shares in 2000 with a generous cash offer. An investment in Imasco worked out well for investors, despite tobacco’s long-term decline. Of course, the addictiveness of the product helped to keep the company prosperous, long after the health risks of smoking became clear.

The anti-tobacco movement was in fact a good thing. It helped many people avoid lung cancer, COPD and other health scourges. But investors were wrong to accept the widespread prediction that cigarette stocks were bound to be terrible investments. In fact, the reverse turned out to be true. Despite the anti-tobacco campaign, cigarette stocks turned out to huge winners.

A number of tobacco companies have generated steady capital gains and rising dividends over the past five to 10 years. We happily follow the instructions of portfolio management clients who insist that we refrain from investing their funds in tobacco stocks. We share their distaste with smoking. I haven’t recommended a tobacco stock in decades. However, I wouldn’t support, for instance, government bans on tobacco. That would simply create a new type of black market for criminals to exploit, just as they now exploit demand for illegal drugs.

Can you predict declining industries?

Stock market predictions are terrible at determining what effect changes will have on declining industries. It’s even harder to predict how long those changes will take to appear. Of course, adverse changes are hardest on companies with bad financing, poor products, weak management or other drawbacks. Meanwhile, successful companies figure out ways to adapt and even profit from change.

Not all companies are able to thrive in declining industries. But overall, we feel that blue chip companies are best suited to navigate to safer waters. If you’ve been investing for a long time, you may have some blue chips that operate in declining industries. Before you sell your shares, take a long look at the business and see what other revenue streams it may have. They may surprise you.

We feel most investors should hold a substantial portion of their investment portfolios in securities from blue chip companies—although of course with a very low proportion in declining industries. These blue chip companies should offer good “value”—that is, they should trade at reasonable multiples of earnings, cash flow, book value and so on. Ideally, they should also have above-average growth prospects, compared to alternative investments

Have you invested in one of these companies that operate in declining industries but through subsidiaries and spin-offs thrive and prosper in today’s world? Share your experiences with us in the comment section.