Tobacco Stocks Are Smoking


By Sam Stovall To find an industry to feature in this week's column, I screened on both high relative price performance and S&P STARS rankings. What did I come up with? The S&P Tobacco subindustry index.

Besides being a high dividend paying, defensive group, tobacco stocks have been in the news recently over ongoing litigation. The momentum on this industry is high -- it's in the top 30% of all industries. Year to date through Apr. 22, the S&P Tobacco Index advanced 5.7%, vs. a 4.9% decline in the S&P 1500. And the group's weighted-average STARS ranking of 3.9 (out of 5) is above the 3.7 weighted average for the S&P 1500 Composite Index.

Let's take a look at the momentum part in the chart below. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with how the S&P 1500 fared over 52 weeks. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindustry index's 14-year mean relative strength.

EASING DOWNWARD PRESSURE. Yes, the industry's STARS score is above average. But rather than take that at face value, I decided to check with Anishka Clarke, S&P's tobacco analyst, to get her fundamental opinion on stocks in the group. Her outlook for the tobacco industry is neutral, mainly reflecting stock-market pressures she foresees over the next four to six months due to ongoing legal trials and reviews. S&P's longer-term outlook for the tobacco group is positive, according to Clarke. She sees competitive pressures in the U.S. cigarette market easing and the litigation environment improving.

On the litigation front, the industry recently won an appeal which led to the dismissal of the $280 billion disgorgement claim in the ongoing Justice Dept. case against the industry. With Justice now seeking review of the appeal, S&P still contends that it will be challenged to prove that the industry has defrauded the public about the hazards of smoking over the specified time frame. In other cases, outcomes to the review of the $145 billion Engle verdict and the appeal of the Price/"lights" class-action case are expected in the first half of 2005.

Downward pressure on valuation measures for tobacco stocks has begun to ease, in Clarke's view, due to improving litigation expectations and waning deep-discount competition. Since late 1998, when the major tobacco outfits pushed through significant price increases as a result of the Master Settlement Agreement, deep-discount cigarette producers have seen their market share rise from about 2% in 1998 to over 13% in 2003, on an approximate 45% retail-price discount to premium brands. In S&P's view, market-share growth for deep-discount brands leveled off in 2004 due to narrowing price gaps (as increased regulation and litigation drive up costs, prices for low-end products have risen) and more aggressive marketing by the majors.

MODEST RISE. Also, state excise taxes have increased at a slower pace in recent years. With many states facing budget deficits, tobacco is likely to be a continued target for additional excise levies. Despite substantial increases in recent years, the number of states passing excise-tax increases fell to nine in 2004, from 14 in 2003. Clarke sees a pickup in this number in 2005.

Despite an expected 2% to 3% decline in consumption in 2005, Clarke figures industry operating profits will rise modestly, as cost-savings efforts and merger synergies offset larger investment in focus brands. Longer term, S&P sees domestic cigarette consumption falling 1% to 2% a year.

So there you have it. While the group's momentum looks attractive, in S&P's opinion, the companies in this industry still face a lot of legal hurdles -- and their share prices could be subject to courtroom setbacks.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), and their proxies (the highest STARS-ranked companies in the sub-industry index -- tie goes to the largest market value) as of April 22, 2005.

Industry

Company

Ticker

S&P STARS Rank

Recent Price

Commodity Chemicals

Lyondell Chemical

LYO

3

$25

Distillers & Vintners

Brown-Forman

BF.B

5

$54

Diversified Metals & Mining

Phelps Dodge

PD

4

$91

Drug Retail

CVS

CVS

5

$51

Fertilizers & Agr. Chem.

Scotts Co.

SMG

4

$67

Homebuilding

Lennar

LEN

5

$53

Integrated Oil & Gas

Exxon Mobil

XOM

5

$59

Managed Health Care

PacifiCare

PHS

5

$54

Oil & Gas Drilling

Nabors Industries

NBR

5

$59

Oil & Gas E&P

Devon Energy

DVN

5

$46

Oil & Gas Refg., Mktg. & Trans.

Valero Energy

VLO

5

$75

Steel

Carpenter Technology

CRS

4

$60

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of March 31, 2005, SPIAS and their U.S. research analysts have recommended 30.9% of issuers with buy recommendations, 56.6% with hold recommendations and 12.5% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's


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