Tobacco Stocks Are Breaking Out

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Shares of tobacco companies started the year off mixed. Shares in two companies in particular – Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO) — have performed extremely well, with shares of both companies up nearly 7 percent year to date. Shares of Philip Morris (NYSE:PM), the world’s largest tobacco producer, and Altria Group (NYSE:MO), America’s largest tobacco producer, are down for the year. However, they are recovering and it appears as if there is some momentum in the sector. Is now the time to get involved in any of these stocks?

The tobacco industry is somewhat controversial in my mind from an investment standpoint. I don’t mean to say that tobacco use is controversial, but there are certain features that characterize these companies that make them appear to be extremely appealing investments even though there is nothing especially exciting going on in the tobacco industry.

Tobacco companies don’t grow their profits very rapidly, if at all. While tobacco use is growing in a select few parts of the world — most notably in some developing countries, where smoking is a symbol of affluence — it is declining in many parts of the world, including the United States.

With that being the case, why would anyone want to invest in a tobacco company?

The short answer is that these companies are extremely shareholder friendly. They pay large dividends of roughly 5 percent, versus the S&P 500, which doesn’t even pay 2 percent. They also buy back a lot of stock. Furthermore, they borrow a lot of money to buy back their own shares. Phillip Morris and Lorillard both have negative equity — meaning the liquidation values of their businesses are negative — because they have borrowed so much money in order to buy back stock.

Tobacco companies are in a unique position in that their businesses are extremely stable, and so they are able to borrow money inexpensively. With these stocks trading at 16 to 17 times earnings, they can justify borrowing money at 3 percent and buying back their own shares that have an earnings yield of 6 percent; in doing so, they are generating returns for their shareholders.

It follows that these companies’ earnings per share growth is manufactured through financial maneuvering.  Nevertheless, these are real profits and real returns, and investors should therefore consider owning these stocks.

But I wouldn’t simply go out and buy a basket of these. Keep in mind that tobacco use is generally declining in the United States, and so Philip Morris, which operates overseas, seems to be the best option. It is also the cheapest on a price-to-earnings basis. Philip Morris is benefitting from the growth in tobacco usage in developing economies such as Indonesia, while Altria Group, Reynolds American, and Lorillard are fighting over the shrinking American market.

Philip Morris still isn’t a high-growth company, and it is not going to make you fortunes. However, it is going to generate steady returns in the form of dividends. In this respect, it is not unlike a bond with an outsized yield, and I think it should be treated as such. That means that I wouldn’t purchase Philip Morris shares in order to hold them forever. Rather, I would carefully track the company’s dividend yield, and if it falls too low due to a rising share price, I would sell.

Philip Morris shares have been the weakest of the group this year, having fallen 6 percent. At one point the stock was down double digits, which is a big swing for a company as stable as this one. Nevertheless, the stock has recovered, and it appears to have attracted interest at around $80 per share. Keep in mind that this could end up being a pretty stable floor for the shares considering that the company itself will be in the market on a daily basis purchasing its own shares.

For this reason, I think that we can see the rally in Philip Morris shares continue, and the stock is a compelling investment in the near term. As for the long term, I don’t think that we are going to see any surges in tobacco usage, and it is more likely that we will see stagnation, or perhaps even a decline in global tobacco use. Therefore, I don’t like Philip Morris or its peers for the long term, and I would only take a long position as a trade.

Disclosure: Ben Kramer-Miller has no positions in the stocks mentioned in this article.