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One of my personal hang-ups about investing is the fact that I do not like to invest in declining industries. I do not care how cheap a newspaper or video retailer is, I am simply not interested in acquiring that kind of asset because the margin of safety in the stock price is not enough to compensate for the long-term deterioration of the sector's profit potential (and, on a personal level, I'd rather get in the habit of dealing with companies like Exxon (XOM) that are generating so much profits that the greatest analyst concern is that the excess earnings cannot be deployed in an effective manner).

But the domestic tobacco industry remains an exception that has historically shielded shareholders from the headwinds of increased taxation and regulation across the industry. I know discussions of tobacco investing can often become emotionally tinged, but here is my stab at taking an objective view of the sector:

On one hand, you have the fact that the American tobacco industry is in decline as measured by the fact that volume shipments have been declining by 3% annually since 1980. Over just about every five year rolling period in America since then, there have been fewer and fewer locations in which smoking is allowed, and raising tobacco taxes is the go to salve for legislatures across the country when it comes to bridging budget shortfalls.

On the other hand, none of these headwinds have caused the earnings or dividends from these firms to decline. Lorillard (LO) has grown earnings by 7.5% over the past five years, Reynolds (RAI) has grown earnings by 5% over the past five years, and Altria (MO) has grown core earnings by 6.5% over that time frame, when you adjust for the spinoffs of Philip Morris International (PM), Kraft (KRFT), and Mondelez (MDLZ). This is what makes tobacco investing intriguing to some people: the earnings and dividends keep piling up, even as the volumes continue to decline.

For some investors looking to get exposure to the tobacco industry while simultaneously desiring to limit the long-term risk as much as possible, I would suggest the following: treat each dividend as a partial refund of your total investment, and redeploy the tobacco dividends into safer blue-chip stocks when the time arrives every day. Because the tobacco companies have relatively high starting yields (and grant investors relatively high annual dividend increases), it is possible to receive a substantial "partial refund" of your total tobacco investment within five years.

Let's look at how this would play out if you chose to invest $10,000 each into Altria, Reynolds, and Lorillard at today's prices.

Right now, Altria is trading at $36.35 per share, and is paying out $1.76 in annual dividends, giving investors a 4.84% starting yield. A $10,000 investment in Altria would give you 275 shares paying out a total of $484 in immediate annual dividends.

Reynolds is currently trading at $47.47 per share while paying out $2.36 in annual dividends. A $10,000 investment in Reynolds would give you 210 shares paying out $496 in annual dividends for a starting yield of 4.96%.

And in the case of Lorillard, the company is trading at $42.77 per share, and offers investors a starting yield of 5.13%. The company pays out $2.20 in annual dividends, and a $10,000 investment in Lorillard would give you 233 shares paying out $513 in annual dividends.

The five year analyst estimates for the earnings and dividend growth of the firms are as follows:

Altria is expected to grow earnings at 11.0% annually while growing dividends at 6.5% annually. The basis for these dividend expectations is driven by a share repurchase program that is taking 100 million shares off the market, a cost reduction plan that has improved operational results by 4% annually, and surprisingly resilient results from the Marlboro brand.

Reynolds is expected to grow earnings at 9.5% annually while growing dividends at 5.0% annually. The basis for these dividend expectations is driven by a share buyback program that is taking 20 million shares off the market, and cost increases in the Camel and Pall Mall brand that should reach the bottom line.

Lorillard is expected to grow earnings at 11.0% annually while growing dividends at 10.5% annually. The basis for these dividend expectations is driven by a $500 million buyback program, promotional advertising for the Newport brand, the saturation of Blue Ecigs as they roll out across 50,000 stores, and an increasing payout ratio.

If Altria's dividend grows at 6.5% for the next five years, the dividends from Altria would be as follows: $484 in the present year, $515 in the first year, $548 in the second year, $583 in the third year, $620 in the fourth year, and $660 in the fifth year. In total, our Altria investor would collect an estimated $3,410 in dividends on his initial $10,000 investment.

If the Reynolds dividend grows at 5.0% annually for the next half decade, the dividends from the company would be: $496 right now, $520 in the first year of dividend growth, $546 in the second year, $573 in the third year, $601 in the fourth year, and $631 in the fifth year. In total, our Reynolds investor would collect an estimated $3,367 on his initial $10,000 investment.

And last, but certainly not least in this case, Lorillard would be paying out $513 in initial dividends. Assuming a 10.5% dividend growth rate, our investor would see $566 in the first year of growth, $625 in the second, $690 in the third, $762 in the fourth, and $842 in the fifth. In total, our Lorillard investor would collect an estimated $3,998 on his $10,000 investment.

Rounding it all up, our investor would collect about $10,775 in total tobacco dividends on his $30,000 over the course of the next five years. That's a partial refund of 35.91% of his initial investment from the accumulated dividends. That can be a useful way to hedge your bet against the gradual decline in the industry if you think of each payment that you deploy elsewhere as a way of guaranteeing that you "have something to show for it" in the event that the tobacco industry experiences a deterioration in earnings sometime in the next 10+ years.

Over the past decade in particular, reinvested tobacco dividends have enriched shareholders, creating substantial wealth for the investors that chose to keep their dividends within the tobacco industry. So far, reinvesting into a sector that combines high initial dividends with high dividend growth rates has produced wonderful results. But with volumes continually declining, this may not always be the case. If you reinvest back into Altria, Reynolds, or Lorillard, you are escalating your commitment and increasing your wager on the long-term success of the tobacco industry. For investors that want to benefit from the high dividends of the tobacco industry while mitigating some long-term risks, I encourage you to think of each tobacco dividend as a partial refund of your initial investment to deploy elsewhere so you can have something to show for you tobacco investments in the event that the taxation, regulations, and declining volumes eventually catch up to shareholders.

Source: How To Take Some Of The Risk Out Of Tobacco Investing