Investing in Tobacco Stocks

Posted on April 22, 2009

Tobacco shares have historically been among the most resilient in recessionary times. But last year the sector tumbled along with the rest of the market on fears that the incoming Obama Administration would raise cigarette taxes and increase health regulations.

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The reality turned out to be less dire than anticipated, prompting some fund managers to jump at the chance to buy beaten-down tobacco shares at high yields. David Winters, manager of the Wintergreen Fund, has 17% of his fund in tobacco. Charles Norton, who runs the USA Mutuals Vice Fund, says he has more invested in tobacco than ever. And Burns McKinney, co-manager of the Allianz NFJ Dividend Value Fund, says yields of tobacco stocks as a group top those of any other industry. “It’s a pretty great combination to get the highest yields out there that are also some of the safest,” says McKinney.

For many years investors shunned the stocks because of potential liabilities, but the risk has largely abated. Some of the biggest cases have been settled, and on Mar. 25 the industry won over a jury in Florida, where thousands of similar cases are pending, in a suit brought on behalf of a smoker who died of lung cancer in 1997. “Today [the risk] is no more than any kind of industrial business might face,” says Norton. In February, Obama and Congress agreed to raise the federal excise tax to $1 per pack, from 39¢—in order to fund an expansion of children’s health-care insurance—and many states are talking about hiking taxes. But industry profits aren’t likely to take much of a hit: Companies have already pushed through price increases over the past six months that will keep revenue steady as higher taxes prompt some customers to smoke less.

Altria Group, the former Philip Morris, is a top pick of several managers. Morningstar analyst Philip Gorham cites its “fantastic collection of brands.” After adding the Skoal smokeless tobacco brand through its $10 billion acquisition of UST last year, Altria is poised to generate billions of dollars in free cash flow this year to maintain its dividend, currently yielding 7.4%. Lorillard, owner of the Newport brand, is another company analysts consider undervalued.

Shares of U.S. producer Reynolds American, meanwhile, have fallen 2.4% this year. Some investors fear the leading purveyor of smokeless tobacco products could be hurt in a price war now that Altria has acquired its main rival.

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Winters says Reynolds has little to fear from Altria. “There may be some skirmishes, but all these companies have always been able to do quite well,” he says, noting that Altria paid “a large price” for UST and wouldn’t want to drive down profit margins. Including the value of its outstanding stock and debt, Reynolds trades at less than half what it is worth, he figures.

The tobacco market outside the U.S. has a different dynamic. Consumption is rising in many countries, and low or nonexistent taxes make cigarettes more affordable. One beneficiary is Philip Morris International, the non-U.S. tobacco business that Altria spun off a year ago. Another is Japan Tobacco, the top holding in Winters’ fund. It’s the third-largest player worldwide and has been growing through acquisitions. Its purchase of Britain’s Gallaher Group in 2007 boosted sales in such fast-growing markets as Russia. The company, says Winters, “is diversified, becoming more efficient, and very undervalued”—a rare find.

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