Value Line is regarded as the best independent research available. More than just recommendations, Value Line provides the rationale behind its picks for greater understanding.
- Don D., California
The Guilty Pleasures of Vice Stocks: Tobacco
Many people attempt to limit their vices. After all, vice is defined by Merriam Webster’s Collegiate Dictionary as “moral depravity or corruption.” Giving up one’s guilty pleasures, however, is not always that easy. And some investors couldn’t be happier.
Vice stocks consist of those within sectors such as alcohol, tobacco, and gaming. The draw to this kind of investment is largely the idea that people will continue to feed their vices despite the economic climate. Some will always want that cold beer, while others can’t stop craving the after-dinner cigarette. Actually, for some of these products, a recessionary environment can even heighten demand.
Moreover, many of these companies operate in industries with challenging barriers to entry, which results in most holding decent levels of pricing power. In addition, this makes it difficult for new, smaller enterprises to chip away at market share.
In reality, vice stocks aren’t necessarily recession proof, and each industry does face its own set of unique obstacles. Still, appealing investment opportunities can be found in vice stocks during an economic downturn, as well as a recovery. And those interested have multiple options when it comes a vice investment.
Tobacco has been one of the steadier vice segments of late. Indeed, investors who have already taken to the Tobacco Industry’s offerings have likely reaped some rewards in 2010. The six companies covered in the Value Line universe recorded an average price appreciation of 4.5% through July, led by a double-digit showing from industry giant Altria Group (MO). The group’s overall momentum has persisted through the early part of August, as well.
Given the current uncertain economic climate, the group continues to benefit from its appeal as somewhat of a defensive play. Indeed, the betas of these stocks are generally below the market averages, while most offer impressive Price Stability ratings, including top scores from British American Tobacco (BTI) and Reynolds America (RAI). Furthermore, half of the Tobacco issues hold Above Average Safety ranks (2), with the remainder ranked 3 (Average).
There are certainly operational challenges that must be taken into account. Health concerns are highly publicized and widespread, which has weighed on demand in the developed nations. This has also led to tighter restrictions on advertising, as well as customer usage (i.e., public smoking bans). The Food and Drug Administration’s ongoing review of menthol cigarettes may also take a toll, especially on Lorillard (LO). The tobacco company claims menthol cigarettes are no more harmful than the regular variety. However, a negative FDA finding would weigh heavily on Lorillard, given that it generates 90% of its revenues from menthol cigarettes behind its flagship Newport label.
Investors have already started showing their concerns, as this stock has been the industry laggard through the first seven months of the year. An all out menthol ban seems unlikely, though heightened regulations will have an impact. In turn, LO shares carry some extra risk compared with their Tobacco brethren.
Litigation is also a prevalent theme. But investors should not be too surprised on the legal front, given the high-profile courtroom history of these companies. In fact, there has been some positive news, of late. The recent RICO (racketeer influences and corrupt organization) ruling that Tobacco companies are not liable for future violations should prove to be a big win for the group, ending one of the larger lawsuits facing the Industry.
The key to growth here is expansion, both geographically and through an improved product mix. With demand in developed countries still stagnant, the emerging markets continue to take center stage. Companies like Philip Morris International (PM) remain focused on building their presence in these regions through tack-on acquisitions. British American, meanwhile, stands to benefit significantly, given that it has the largest emerging-market exposure of the Tobacco bunch.
New products are also vital, especially as smokers look to kick the habit. As a result, the companies are adding an array of smokeless tobacco options to their lineups. At the same time, the group is trying to regain some pricing power through selective increases.
In all, the Tobacco Industry has proven to be a sound defensive play during the latest economic malaise. Despite worries of declining demand (especially considering the highly taxed nature of these products), all but one of these companies remain on track to register top- and bottom-line gains in 2010. Altria has been the strongest performer so far in 2010. That said, its long-term appreciation potential is limited following the recent run up in price.
Instead, those looking for a 3- to 5-year option with an appealing risk/reward profile may want to consider British American shares. On the strength of its sizable emerging-markets presence, the company appears on track to register annual sales and earnings advances of 4%-8% over the long haul.
Finally, for those considering a vice investment, yet are unsure whether Tobacco is the way to go, the group’s income appeal may be the deciding factor. All of the stocks here offer healthy dividend yields, with the average topping 5%. This is well above the Value Line mean and far superior to the other vice industries, as a whole. The latest increase came from Lorillard, which raised its quarterly payout by 12.5%, to $1.125 a share. Over the long haul, all of these shares should continue to offer above-average distributions, with Reynolds American and Altria likely boasting the highest yields.
All things considered, vice investors may like the Tobacco Industry for its long-term growth and income appeal. Others may favor it because they know so many just can’t give up this guilty pleasure.
For some, a tasty alcoholic beverage might be more of a lure. Next time, we will take a look at the Beverage Industry, as it houses a number of different investment plays on the world’s adult thirsts.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.