Why This Stock Will Smoke the Competition

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

What does it take to separate yourself in the tobacco industry? All the companies are inherently tied to tobacco consumption, tobacco taxes and tobacco regulation. The U.S. is dominated by three manufacturers, including Altria (NYSE: MO), which sells roughly half of the nearly 500 billion cigarettes sold in the U.S., Reynolds American (NYSE: RAI) and the Loews subsidiary Lorillard Tobacco (NYSE: LO).

All three major U.S. tobacco companies are now paying a dividend yield in excess of 5%, which, in this low-rate environment, is very enticing. All three of the tobacco companies have also made the foray into the electronic cigarette market. So how does an investor choose the best stock?

I believe that Lorillard presents investors with the best opportunity in the tobacco industry. According to Imperial Tobacco, Altria owns 50% of the U.S. tobacco market share, while Lorillard is in third with 10% of the U.S. market share, leaving tons of room for growth.

Getting to know Big Tobacco

Reynolds operates R.J. Reynolds Tobacco Company and the smokeless tobacco company American Snuff Company. The American Snuff brand offers its flagship Grizzly brand. Worth noting is that Reynolds does offer investors a super high-end cigarette, Natural American Spirit, which is also the only USDA certified organic cigarette on the market.

Reynolds has plans to eliminate various surplus labor over the next few years in order to save $70 million annually by 2015. As for the hot topic e-cigarette category, Reynolds has developed its own patented vapor technology and is testing a new product called Vuse.

Altria is at the top when it comes to tobacco sales, but only recently decided to make the entry into the e-cigarette market. However, the company does have a presence in the wine market and its Black & Mild brand is the leader in the "other smoke-ables" category.

Altria's popular tobacco brands include Marlboro, Virginia Slims, Copenhagen and Skoal. Marlboro is the leading cigarette brand in the U.S. and some of Altria's key plans include the expansion of its distribution of Marlboro Southern Cut and Marlboro NXT into 27 states this year.

Lorillard offers the leading menthol brand, Newport. Lorillard made the first entry by large tobacco companies in the electronic cigarette market with its early 2012 purchase of Blu Ecigs for $135 million. Lorillard is also looking to grow beyond its staple Newport brand by launching new products, which include Newport Smooth Select Menthol cigarettes -- these have a flavor of menthol and are made for smokers who prefer a less robust taste unlike Newport. Now let's get down to what makes Lorillard the top investment in the tobacco industry.

Valuation & volatility

From a valuation standpoint, Lorillard is by far the cheapest, trading at 14 times earnings and 2.62 times sales, versus Altria at 16.1 times earnings and 3.2 times sales. Reynolds is the most expensive at 17.9 times earnings and 3.5 times sales. With a 0.38 beta, which is a common measure of stock price volatility, Lorillard also has the least volatility. Altria has a beta of 0.46 and Reynolds 0.63.

Dividend

While all three tobacco companies are paying dividend yields of 5%, Lorillard has been one of the top companies at returning capital to shareholders. This includes having upped its dividend payment by almost 80% over the past five years.

Meanwhile, Lorillard has also led the industry when it comes to buying back shares, having reduced its shares outstanding by over 25% over the past five years.

Lorillard also has the lowest dividend payout ratio as a percent of earnings at 70%, compared to Altria's 80% and Reynolds' 90%.

Hedges agree

Going into the second quarter, a total of 30 hedge funds were long Altria, a 3% decrease from the previous quarter. The top hedge fund was Gardner Russo & Gardner with a $250 million position that made up 3% of its 13F portfolio (check out Gardner's top picks).

Meanwhile, Lorillard had 24 hedge funds long the stock. Despite being below Altria's hedge fund interest, this was 4% increase from the previous quarter compared to Altria's 3% decrease. Jean-Marie Eveillard's First Eagle Investment Management had the most valuable position, worth $450 million (check out First Eagle's high yielding stocks).

Reynolds had 15 hedge funds long the stock, which was a 17% decrease from the first quarter. David Winters' Wintergreen Advisers had the largest position that made up 10% of his fund's 13F portfolio (see Wintergreen's top stocks).

Bottom line

All-in-all, Lorillard pays an impressive 5% dividend yield and is the cheapest stock among major U.S. tobacco companies. What's more is that the company has also managed to reduce shares outstanding and increase its dividend at much greater paces than its peers, making it a top pick in the tobacco industry.

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Marshall Hargrave 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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