A Few Tobacco Stocks to Consider Buying

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

The thought of investing in Big Tobacco may make socially responsible investors cringe, but, in my view, you don't have to sacrifice your morals to profit off of the industry. Buying stock in a secondary market does not generate capital for the company, since the equity has already been issued. If anything, your ownership of the firm entitles you to voice social concerns. If you are willing to invest in the industry, you should take a look at Altria and Reynolds American, two companies that have--PR spin or not--taken steps to address political scrutiny while driving shareholder value.

Atria Group (NYSE: MO)

What should we make of Altria in this macro climate? The company has a characteristicallyy low beta of 0.4 and a high dividend yield--traits that make it appealing to low-risk investors. However, this doesn't necessarily mean that the firm will underperform. Value can be unlocked in several ways.

First, I believe that the market spends too much time focusing on the regulatory risks. It is true that governments across the world are making regulations more stringent. However, some investors argue that the number of smokers has remained constant despite the political pressure. Even if there were a greater percentage of smokers ten years ago, and the percentage of smokers has reduced by, say, 20%, the population can still increase by even more than that 20%. Rising consumer incomes will drive up profitability in the meanwhile.

Further, as the owner of the world's most popular cigarette brand, Altria carries significant pricing power. An increase in the price of cigarettes does not necessarily result in a proportionate decrease in sales volume. Put differently, cigarette smokers do not seem to care how much a cigarette costs once they run out of cigarettes. Of course, there is a limit to this aforementioned statement; but, for the most part, it has held true.

Further, the company could unlock value through restructuring, which is expected to increase efficiency and consequently increase margins. Although this company’s shares are not the cheapest compared to others in the industry, it has demonstrated an assuring level of stability.

Reynolds American (NYSE: RAI)

As a major competitor to Altria that is diversified more in the smokeless category, Reynolds is also a worthy peer investment. Reynolds’ has an excellent dividend yield of 5.7%. Let's put that into perspective: Even if the company grows earnings by just 3%, it will deliver nearly a 9% annualized return excluding any multiple appreciation. That's an incredible return for such a riskless investment!

It is also important to note that the company is committed to being shareholder-friendly. Dividends have risen concurrently with stock appreciation. As observed, from 2008 the dividend has risen by 39% while the share price has gone up by about 35%. The company’s current payout ratio stands at 90% compared to a payout ratio of 100% in 2009 and 2010, so I am slightly concerned that it is not investing enough into marketing innovation wherever that is possible.  

Earnings per share have also been driven in part by share buybacks, another form of returning free cash flow to shareholders. The total amount of shares bought back by the company in 2012 amounted to 15 million, which were worth some $625 million. Reynolds has also been constantly expanding margins through reducing headcount. A 35% reduction in headcount has occurred since 2004. The balance sheet meanwhile remains incredibly strong. Moreover, Reynolds managed to reduce long-term debt by 44% since 2008.


I find that the tobacco industry is an ideal place to place money aside if you are weary of the macro economy and looking for predictable returns. While they can be expensive, there are strong alternatives. Lorillard (NYSE: LO), for example, trades at only a respective 14.4x and 13.2x past and forward earnings. It is forecasted for 8.6% annual EPS growth over the next fiv years. During the past five years, it achieved a premium growth rate of 11% keeping it ahead of the competition. It is therefore surprising that the stock's multiples are at such a discount to those of peers. When you factor in the fact that this stock has 60% less volatility than the broader market and an incredible 5.2% dividend yield, Lorillard comes ahead of the pack. It is, in my view, one of those rare combinations of low downside and high upside.

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