Tobacco Stocks Are Still Addictive

By Aaron Levitt | February 07, 2012 AAA

While their products may be controversial, sinful stocks have been some of the best wealth generators of all time. After all, people tend to continue to continue with their vices no matter what the economy is doing. Funds like the Market Vectors Gaming ETF (ARCA:BJK) have allowed investors to tap into the industries steady cash flows and 'addictive' nature. However, to find the best performing sub-sector investor need only to light a match. (For related reading, see Sinful Investing: Is It For You?)

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Cigarettes Are Safe for Portfolios
If you can get over the fact the products could actually kill somebody, tobacco firms have been one heck of a place to put your money over the last few years. A new report by analyst at Bank of New York Mellon (NYSE:BK) shows that tobacco companies handed investors the best returns over the last decade when adjusted for volatility. The group, which includes firms such as Altria (NYSE:MO), gained more than 13% after taking into account price swings or about five times the increase of the MSCI World Index. The risk-adjusted return is calculated by dividing total return by volatility. While the Internet Retail sector outperformed tobacco stocks on total return measure, they did so with more than 50% volatility.

The reason for this outperformance: stable cash flows and big dividends. The average yield for global tobacco firms with a market cap of at least $1 billion is a hefty 5.1%. This compares to the meager 1.5% for non-cigarette firms. In addition, tobacco firm's gross margins are significantly higher and cash flows from operations have grown at more stable paces than at other companies.

The real gains for investors lie in the future. While there are some threats such as more regulation and a pending ban on menthol, global tobacco use is rising. Approximately four out of every five smokers can be found in the emerging world and the pace at which new emerging market citizens start smoking has been quite rapid. Pending declines in the developed world should be overshadowed by gains in the emerging. Smoking still has many of the perceived "cool" qualities in these markets and rising middle class incomes should help to support tobacco firm's cash flows. (For additional reading, see Socially Responsible Investing Vs. Sin Stocks.)

Smoke 'Em if Ya Got 'Em
Combining high dividends, a recession resistant product and a value stock stint due to the perceived risks associated with their product, tobacco stocks maybe exactly what investor's need. While there isn't a tobacco/cigarette focused ETF yet, there are plenty of ways investors can add the firms to a portfolio.

For those investors looking for a truly global play, British American Tobacco (NYSE:BTI) could be a great bet. The firm has the largest emerging market exposure, receiving 60% it's of earnings and 72% of sales volume from developing economies. Shares of the firm sport around a 2.5% yield. In addition, fellow U.K. firm Imperial Tobacco Group (OTCBB:ITYBY) receives around 61% of its sales from developing markets. Both could make a great buy to play the global growth in tobacco use.

Industry giant Philip Morris (NYSE:PM) isn't just resting on its cigarette laurels. With the constant threat of legislation, the company has added tobacco projects outside the realm of smoking/chewing. The company has purchased a 40% stake in Canadian biotech company Medicago (TSE:C.MDG), which is developing influenza vaccines using tobacco leaves. While it'll interesting to see if the deal produces anything worthwhile, in the meantime, Philip Morris's bread-n-butter businesses produce ample cash flows to support the companies approximate 4% dividend.

Finally for those looking for shear yield, discount cigarette producer Vector Group (NYSE:VGR) provides investors with about a 9.1 dividend yield. That may seem high when compared to other firms like Reynolds American (NYSE:RAI), the landmark 1998 litigation settlements require only the three largest cigarette makers to pay the fees. This leaves Vector plenty of extra cash to return to shareholders.

The Bottom Line
The tobacco industry has been one of the top performing sectors over the last decade, proving there's a "win in sin." For investors, the group's stable cash flows, high dividends and growing emerging market demand will surely see more of the same in the future. The previous firms, along with Lorillard (NYSE:LO) make ideal plays. (For additional reading, see The Evolution Of Sinful Investing.)

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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