Why You Should Invest in Tobacco & Marijuana

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

Investing in tobacco companies is like flipping a coin. On one side, you have high regulations, taxes, and a poor PR image. On the other side, you have predictable growth and generous capital allocation policies. At any given time, the market will react largely to just one side. Do you flip? In this article, I explain my thoughts on two top tobacco producers and explain why medical marijuana will help slant the odds of the coin toss in your favor.

What Others Are Saying About Altria (NYSE: MO)

Altria is the leading cigarette company and owner of the famous Marlboro brand. In fact, Marlboro is the most popular cigarette brand in the world with a market share rank of either 1 or 2 in the regions it is operating in. On top of that, the producer has executed time and time again. In the fourth quarter, revenue came out to $6.24 billion and was ~45% better than expected. 

Perhaps the biggest downside comes from regulatory scrutiny. There has been increasing pressure on cigarette products due to associated health effects. Cigarette companies have been threatened with regulations for more conspicuous warning labels on cigarette packets, taxes, anti-tobacco advertising, you name it. The European Union, through its Health Commission, is also implementing similar regulations. Due to government efforts to discourage the use of tobacco products, cigarette consumption has fallen in several countries. However, large companies such as Altria continue to generate good levels of cash flow. This resilience is being attributed to the diversification of its products.

Should Altria Market a Marijuana Brand? Yes!

At the same time that regulatory pressure is rising on tobacco, it is declining on marijuana. This market has already garnered significant interest at the Motley Fool and other popular investment sites. Several analysts have already covered Cannabis Science and Medical Marijuana, so I want to briefly highlight what tobacco producers can learn from a new entrant in the "Green Rush," called "Nuvilex." This is important in showing how Altria can very easily get upside to outweigh downside by just doing the same and simply entering the market.

Nuvilex is ultimately a biotech company. In a Phase II trial, its pancreatic cancer treatment did three big things: (1) it doubled the median survival time compared to the standard treatment; (2) it doubled the number of survivors past one year; and (3) it had no adverse immunological events. This is important, because one of the main headwinds medical marijuana stocks face is that investors see them as purveyors of pseudo-science.

However, with successful experience in biotechnology, Nuvilex removes this kind of thinking. Its recent decision to enter the marijuana industry by developing a cannabinoid that treats glioblastoma multiforme was more or less instantly greeted with double-digit returns. By virtue of its size and execution, Altria can also enter the marijuana industry and thereby similarly expand upside while maintaining a stable core business. In my view, few would look askance at diversification that takes the eyes off higher excise taxes, blunter product labeling, and countless lawsuits.

Already, Altria has shown the power of its brands; it should be noted that the company has been able to increase prices without scaring away customers. In the third quarter of 2012, the company had a 3.2% increase in earnings. Technical analysis has attributed much of this growth to higher prices on cigarettes. Imagine what the company could do if it were to launch a new marijuana brand? It would create a very strong first-mover advantage in a high-growth industry at no risk to its traditional income streams. Plus, according to an AskMen article and other peer-reviewed scientific literature, THC within marijuana has shown several health benefits and poses less risk to smokers than tobacco. Again, this is the kind of PR fix that Altria--long a target for higher excise taxes--needs to re-catalyze growth.

In regard to the current fundamentals, Altria trades at a respective 16.8x and 13.5x past and forward earnings. This, in my view, appears reasonable in light of the 20x industry average. If just the discount to peer multiples were closed, the stock would soar 15% on top of an already stellar 5.1% dividend yield. 7.3% annual EPS growth is expected over the next five years--relatively predictable in light of the simplistic business model (ie. it's not terribly difficult to forecast penetration rates, prices, and usage trends with past data). Think about this: If the company just does what it is expected to, it will provide annual returns of 12.6%--not bad for a company with less than half the volatility of the broader market. If it adds on a new high-growth marijuana subsidiary, it could, however, increase the market's expected growth rate and thereby justify a higher valuation.

Reynolds American (NYSE: RAI) Product Strategy

Reynolds America is also a leading tobacco company. In a recent study, it was evident that graphics warnings on cigarette packets may be instrumental in helping people quit smoking. This comes as a relief to public health advocates eager to get the surgeon general's approval. With such findings, is it still wise to invest in tobacco companies like Reynolds American?

Companies have definitely taken note, and they are working hard towards fighting back. A major strategy that has been put to use is product diversification and price hiking. Reynolds has entered the e-cigarette and smokeless tobacco categories. It has also tried to thin down cigars to make them look more like cigarettes…but of course without the regulations. However, with companies like Altria selling superior brands such as Marlboro, it becomes difficult for smaller ones like Reynolds to have a significant impact on the market. 

Reynolds is being rated as a "hold" by most analysts. According to FINVIZ.com, the consensus rating is a 2.9 out of 5 where "5" is a "sell." However, TheStreet rates it as a "buy" due to the company’s growth per share and its good return on equity. The company's positive outlook should also keep investors glued on the upside.

Conclusion: Should You Invest in Reynolds, Altria, or Neither?

With Reynolds, you get a company that is relatively cheaper at 13.1x forward earnings with slightly lower (and less predictable) growth prospects than Altria. Reynolds is forecast around a 50 bps lower growth rate over the next five years. Altria has a 23.7% return on invested capital--roughly double Reynolds's. So, all things considered, I strongly recommend an investment in Altria over Reynolds.

However, with that said, I find that there are stronger tobacco companies than Altria out there. Lorillard (NYSE: LO) is incredibly cheap at 14.5x past earnings and a 5.2% dividend yield. What is particularly impressive is that it trades at such a discount to its peers despite having a much stronger growth rate for the years ahead. It has grown by a rate of 11% over the past five years, and I have little doubt it will be able to replicate this success in the years ahead. It therefore makes sense to balance an investment in an established company like Altria with a company coming off of a sharp growth curve. Furthermore, if any of these large-cap firms were to explore the marijuana industry, it would ignite investor interest in the upside just like other small-cap stocks already have.

TakeoverAnalyst 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 hereResearch covered in this article is for readers, subscribers, and prospective research clients, repeat or new, who may now or in the future have a position in the company. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

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