Tobacco Can Mean Big Returns, But Wait for a Better Entry

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The tobacco companies have always been excellent dividend payers, but after a rapid gain like the one just experienced in the market, it becomes more important to figure out whether or not your favorite dividend stocks are worth getting into. My “big three” of tobacco stocks, Altria Group (NYSE: MO), Lorillard (NYSE: LO), and Reynolds American (NYSE: RAI), for instance, have popped by around 8% in the past month alone. All pay very comparable yields and trade at similar valuations, so the one you pick is more a matter of personal preference than anything else. Let’s take a quick look at these companies, and more importantly, how your entry point affects the end result of your investment.

Altria Group 3-month chart:

**Author’s note: before I go any further, I know there are some who find it unethical or irresponsible to invest in or promote the cigarette companies as an investment. As a former smoker, I completely understand, and I’ll further address my ethical stance on this issue later on in the article.

The “big three”

For the purposes of this article and the advice it gives, I’m going to focus on the companies listed in the introduction, which happen to be the three largest U.S. tobacco companies. Just a quick intro so you can connect the products with the names…

First, Altria Group, which is better known by its former name, Phillip Morris, produces some of the most popular tobacco brands such as Marlboro, Virginia Slims, and Parliament. The company accounts for roughly half of all U.S. cigarette sales, and has a market cap of $74 billion (Note: the stock that trades as Phillip Morris International (NYSE: PM) represents the international tobacco business that was spun off in 2008). 

Lorillard is the smallest of the three at $17.6 billion in market cap and sells cigarettes under the Newport, Maverick, and Kent brands. Right in the middle is Reynolds American, which produces Camel, Pall Mall, Kool, Winston, Salem, and others. 

A quick note about the tobacco industry

While it is true that the percentage of smokers in America is decreasing, the actual number of smokers is not necessarily declining as much as you would think. As an example (not the real numbers), let’s say that in 1950 there were 120 million Americans, 50% of whom smoked, for a total of 60 million smokers. Let’s also say that today there are 350 million Americans, 20% of whom smoke, for a total of 70 million smokers. So, the point is that the growing U.S. population is helping to offset the decline in smokers. 

Numbers

All three of these companies look so similar on paper (other than their size) that it would be silly to list each company’s numbers separately. All three have a P/E of between 15.1 and 15.8 times 2013’s expected earnings, and all three pay a dividend yield of between 4.73% and 4.77%. Additionally, their charts seem to move very similarly to one another, which is why there is only one chart shown above.

Why a little more yield makes a big difference

It seems that these stocks generally yield 5%, or close to it. Generally, when the yield drops much below that, the share price winds up pulling back or a dividend increase by the company boosts the yield. So, why am I making a big deal about a small difference in yield?

Based on the above chart of Altria’s share price, about a month ago shares were yielding about 5.1%. While this is just a small difference numerically from the current yield, it can have huge implications over the long run. For the sake of illustrating this point, let’s say that you were to make two $10,000 investments in the tobacco companies, one with an average yield of 4.75% and one with a yield of 5.1%. Let’s also assume that you reinvest all dividends, the share price itself rises by an average of 6% per year (reasonable), and that you are 30 years away from retiring.

After 30 years have passed, the 4.75% yielder would be worth a total of $213,950. Not bad, right? Over the same time period, the 5.1% investment would have climbed all the way to $235,192. This is $21,242 more or 10% extra return over a 30-year period, just from an extra 0.35% of yield. 

Final thoughts

My central point in this article is to get you thinking more about your specific entry points into your favorite dividend stocks. The tobacco companies are some of my favorite dividend stocks due to their high, consistent, and predictable yields. While it is impossible to time your entry points perfectly, the consistent-yielding nature of these companies make it easier than most. 

All three of these companies report their earnings this week. Altria Group reports on Tuesday, Reynolds American on Wednesday, and Lorillard issues its quarterly report on Thursday. Pay attention to any reactions by these stocks to their reports, as any small earnings miss could trigger an excellent entry point in these companies.

Finally, here is a note for those who have an ethical issue with investing in tobacco companies. As a former smoker myself (I smoked Marlboro Lights from the time I started college until I was 29), I completely understand the position. I simply choose to look at an investment in Altria (the maker of my particular brand) as a nice refund on the thousands of dollars the company made off of me over the years. I highly encourage my readers who smoke to take the money you spend on cigarettes and invest it in one of these companies instead. Not only will you live longer, but you’ll have some money to spend in your old age as well!

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. 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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