Finding Value In An Overpriced Market

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

Some people now believe that after the rally at the end of last year and the beginning of this year, the market overpriced and due for a significant correction. Indeed, with earnings season upon us this prediction may come true. Many analysts are saying that companies have slashed costs all they could earlier in the year and now the true state of their earnings will start to show through revealing a further deteriorating consumer and economic environment.

If this is the case then how do you avoid the prospective upcoming doom and invest protectively?

Tobacco To The Rescue?

In my opinion the market is slightly overvalued and there are very few stocks left that are appealing at these levels. Having brought all the undervalued cyclical stocks I believe are worth buying. I am now looking for more defensive plays and one of the most defensive sectors around is tobacco.

The tobacco sector in my opinion is now undervalued. After being sold off on fiscal cliff worries, tobacco now looks cheap. Furthermore, the fiscal cliff situation is now to some extent mitigated and these big tobacco players have not yet recovered.

The Big Daddy

Philip Morris International (NYSE: PM) is the main player in the group and usually everyone’s choice pick for the sector. Philip Morris is currently trading on a forward P/E multiple of 14 - below its 5-yr average of 15. However, the selloff has also driven the yield up to 4% - a large yield for a company that is generating high-teens EPS growth.

Philip Morris International has something most US listed tobacco companies don't and that is international exposure. Unlike the rest of the tobacco companies in this article, Philip Morris has exposure to the still growing tobacco market in Asia and Africa. In addition to this growth the company has also just embarked on a $18 billion stock buyback, this equates to roughly 13% of the company’s total market capitalization and as I have discussed in another article Philip Morris has one of the best records for correctly administered share buybacks. 

The Most Punished

Moving on to the most sold off stock - Lorillard (NYSE: LO). Lorillard has been hit hard twice over fiscal cliff worries and worries over its menthol brand. Some believe that there is a possibility the FDA could place restrictions on the sale on menthol cigarettes. However, there is belief that these worries could be overdone on the stock as it is unlikely that the FDA will place any significant restrictions on the use of menthol in cigarettes. This sell off has driven the stock down to a forward earnings multiple of 12.5 - the lowest in the tobacco group. The stock now also has a 5.4% yield about the same as the rest of the sector.  Lorillard is the smallest tobacco company in this group but it is wrestling market share away from its competitors. Lorillard has grown market share in its leading cigarette brand from 7% of the total market in 2007 to roughly 14% this year. This growth is set to continue as  well as improving margins and cash flow within the company. 

The Best Yield

Reynolds American (NYSE: RAI) has been the most punished when it comes to yield as the stock now yields up to 5.7%. The group trades on a P/E of 13.5 once again below his 5-yr average however, the group is struggling growth wise as it loses market share to other brands. The company’s lack of international exposure is also hurting the sales volume. Although the group is trying to branch out and is developing it own brand of electronic cigarettes which could be highly lucrative.

Safety In Diversification

And lastly for the safest play there is Altria (NYSE: MO). Altria is one of the best performing stocks ever in the S&P 500 when dividends are included. Altria has a product portfolio of tobacco and non-tobacco products, including a holding in SABMiller a smokeless tobacco division and a finance division. The company is currently trading on a forward earnings multiple around the same as its 5-yr average and yields 5.4%. For a diversified product base with a high yield Altria could be the value play the rest of the market is not able to put forward. 

Despite falling cigarette volumes in the US Altria's high margin Marlborough brand is still managing to pull in plenty of income for the company, leaving Altria with a huge free cash flow. This free cash flow gives plenty of room for the company to increase dividend payments, buybacks or investments into other industries and diversification. 

Finally

Tobacco stocks have outperformed the S&P 500 every year for the past ten years even without dividends reinvested. With dividends reinvested they become all-stars!

Even though the tobacco industry is suffering from falling sales volumes and worldwide ‘stop smoking’ campaigns the stocks really show no sign of slowing down. Earnings and shareholder returns continue to grow and this pullback presents the perfect buying opportunity. The choice pick would have to be Altria and Philip Morris for both diversification, international growth and a strong yield.


RupertHargreav owns shares of Altria Group and Lorillard. 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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