You Might Want to Avoid This “Can’t Miss Industry”

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There’s a theory among certain investors, that a handful of industries offer “can’t miss” opportunities regardless of the economy. For many years, this theory has held true, and the tobacco industry has led the pack – but new trends suggest otherwise.

The Perfect Secular Investment

There is no industry in the world that has dealt with more controversy than the tobacco industry. The industry itself has been the subject of intense political pressure, commercials, laws that restrict smoking in public places, and increased taxes on tobacco.

Let’s just pretend that a report comes out tomorrow that proves the iPhone causes brain cancer. As a result, laws are created against its use in public places, taxes increase drastically on purchases, and information arises that Apple knew of this condition and intentionally aimed the product at children. Theoretically, if this were true, do you think Apple would survive? My answer is of course not!

Yet, the tobacco industry has dealt with these problems, plus more, for the last 10 years and has taken all criticism in stride. The stocks in this space have greatly outperformed the S&P 500 over the last five years, and have pretty much traded higher on a continuous basis for the last 20 years. To explain, take a look at just how good these stocks have been over the last five years.

<table> <thead> <tr><th> <p><strong>Company</strong></p> </th><th> <p><strong>Ticker</strong></p> </th><th> <p><strong>5 Year Stock Return</strong></p> </th><th> <p><strong>Yield</strong></p> </th><th> <p><strong>5-yr Dividend Increase</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p><strong>Altria Group</strong></p> </td> <td> <p><span class="ticker" data-id="204556">(NYSE: <a href="">MO</a>)</span></p> </td> <td> <p>73%</p> </td> <td> <p>4.87%</p> </td> <td> <p>38%</p> </td> </tr> <tr> <td> <p><strong>Lorillard</strong></p> </td> <td> <p><span class="ticker" data-id="210627">(NYSE: <a href="">LO</a>)</span></p> </td> <td> <p>85%</p> </td> <td> <p>4.90%</p> </td> <td> <p>78%</p> </td> </tr> <tr> <td> <p><strong>Reynolds America</strong></p> </td> <td> <p><span class="ticker" data-id="205182">(NYSE: <a href="">RAI</a>)</span></p> </td> <td> <p>88%</p> </td> <td> <p>5.11%</p> </td> <td> <p>46%</p> </td> </tr> <tr> <td> <p><strong>British American Tobacco </strong></p> </td> <td> <p><span class="ticker" data-id="203008">(NYSEMKT: <a href="">BTI</a>)</span></p> </td> <td> <p>50%</p> </td> <td> <p>3.88%</p> </td> <td> <p>73%</p> </td> </tr> </tbody> </table>

Why wouldn’t you invest in tobacco? It has been a gold mine! These companies have not only outperformed the S&P 500 four-fold (average), but also pay market-leading yields and continue to give back to shareholders in dividend increases (and also buybacks). In a very volatile market, these stocks have been a safe-haven of sorts, as they have little volatility, high and consistent ownership, and operate in an industry that has endured everything imaginable. 

This “Can’t Miss” Rally Might Be Over

While investors have bought tobacco stocks by default as the perfect secular investments – after all, people are going to smoke regardless of the economy – there is one more chart that I find telling. This particular chart is why I am saying that the tobacco run may be over.

<table> <thead> <tr><th> <p><strong>Year</strong></p> </th><th> <p><strong>% Of U.S. Adults Who Are Smokers</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>2009</p> </td> <td> <p>21%</p> </td> </tr> <tr> <td> <p>2010</p> </td> <td> <p>21%</p> </td> </tr> <tr> <td> <p>2011</p> </td> <td> <p>20%</p> </td> </tr> <tr> <td> <p>2012</p> </td> <td> <p>18%</p> </td> </tr> </tbody> </table>

According to the U.S. Centers for Disease Control and Prevention, the percentage of American smokers is declining rather rapidly. This in part is due to anti-smoking drugs such as Chantix and nicotine replacement remedies such as Nicorette gum.

After seven years of 20%-21%, the rate of smokers is finally beginning to decline. So what is it that’s creating this decline? Over the years the tobacco industry has endured every possible roadblock and has always done just fine. But apparently, electronic cigarettes are attracting its smokers, and not all of the large tobacco companies were prepared. Already, we are seeing revenue declining year-over-year. While this has occurred in the past, we are yet to see sharp industry declines to correlate with fewer smokers among the general population.

Sooner or later, as with any business, a decline in revenue will signal a declining stock. Of course, there will be some tobacco companies that will thrive and continue to grow, although the industry as a whole does appear to be heading down a dull stretch. To conclude, let's take a look at a few areas that are weighing against each of the noted stocks above.

  • Altria is a holding company with brands that include Philip Morris, which commands 50.3% of the U.S. cigarette market with Marlboro. Despite this share, the company does not have an e-cigarette brand (although it will in the future). The company has zero revenue growth and trades at 16.2 times earnings. While this is only slightly higher than the S&P 500, it is far above the company's historic ratio at 11.7. With zero growth, I think this premium is too expensive.
  • Lorillard, and its brand Newport, are less than 10% of the U.S. market. However, with menthol being one of the only bright spots within the industry, Lorillard is producing modest growth of 4-5%. The problem is that Lorillard controls 40% of e-cig market, and with its larger competitors coming to the market it could lose significant share, thus leading the company to miss expectations. 
  • Reynolds is the second largest tobacco company, with 27% of the total market. Much like Altria, the stock's P/E ratio of 17.7 is far above its historic level (12.11). Moreover, the company has a dividend payout ratio of 89, and since companies can't successfully manage a ratio above 90, it leaves very little dividend upside due to zero growth.
  • British American Tobacco is a global company producing every type of tobacco product. The company is known for its cigars, roll-your-own cigarettes, and pipe tobacco, which are all dying forms of tobacco. The company's revenue has been flat for the last two years and is not expected to grow. Therefore, at 17.5 times earnings, the stock is very expensive, much like all others in the space. 

Final Thoughts

There’s no doubt tobacco companies have been great investments for many years, and they continue to pay out great dividends. Therefore, you might want to maintain your holdings. However, we are now seeing an industry shift. We are seeing fewer people smoke and more people switch to e-cigarettes. Much like other multi-year uptrends, all rallies eventually end. The tobacco space has seen a multi-decade rally, and rightfully so, but with a lot of questions surrounding its future it might finally be time to take gains and invest elsewhere. 

Altria has been the best-performing stock of the past 50 years, but as the number of smokers in the U.S. continues to steadily decline, is Altria still a buy today? To find out whether everyone’s love-to-hate dividend stock is a savvy investment choice or a hazard to your portfolio, simply click here now for access to The Motley Fool's premium research report on the company.

Brian Nichols has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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