With the S&P 500 having slumped by 7% since the turn of the year, defensive stocks have become increasingly en vogue. That's especially the case since the outlook for the stock market is highly uncertain and with tobacco sales likely to hold up in even the most severe of recessions, tobacco companies such as Philip Morris (NYSE: PM) have proved popular with investors.
In fact, Philip Morris has outperformed the S&P 500 by 8.5% since the turn of the year due mainly to its defensive appeal. Of course, it also has stunning income appeal, too. For example, Philip Morris currently yields a highly enticing 4.5% has been able to deliver a rise in dividends per share of almost two-thirds in the last five years.
While buying Philip Morris for its dividend appeal and defensive characteristics is a good idea, we think there is a lot more to the company's future than those two aspects. In fact, we think that Philip Morris' shares offer superb capital gain potential, with a key catalyst in the medium term being a lack of a sharp rise in US interest rates.
With Philip Morris operating exclusively outside of the US, interest rates matter since they have a major effect on the value of the US dollar. In recent years, Philip Morris has been hurt by an appreciating US dollar (for example in 2014 it reduced EPS by $0.80) and while the market has anticipated further pain in this area due to the Fed's interest rate rise in December and the prospect for further rises, that no longer seems to be the case.
In fact, we think that the Fed will now keep interest rates pegged back due to the high degree of uncertainty in China and the global economy. This would be likely to cause the dollar to weaken and would have a positive impact on Philip Morris' earnings, with the potential for better than expected results and the subsequent positive movement in the company's share price.
A second potentially positive catalyst on Philip Morris' future earnings growth is its move into reduced risk products (RRP). Unlike a number of its sector peers, Philip Morris has focused on heat-not-burn products in addition to e-cigarettes (e.g. through Marlboro Heatsticks and Nicocigs respectively) and we think that this strategy is extremely prudent given the potential for consumer tastes to change rapidly.
In other words, Philip Morris has not placed all of its eggs in one basket, since the tobacco industry is currently undergoing a massive transition as new products become available which offer customer satisfaction but also reduced health risk.
Clearly, this sector has huge growth potential and we think that the tobacco sector in general is highly appealing because of this, with the major tobacco companies having exposure to it either through acquisition or in-house development. However, what sets Philip Morris apart in our view (and is a key catalyst) is its diversity in this space. This should allow it to take advantage of shifts in consumer demand and provide stronger, more reliable growth in future years.
A third potential catalyst which could push Philip Morris' earnings and share price higher is a demographic tailwind. While in the US the number of smokers is likely to come under pressure in future years as people become more health conscious, world population growth of 2.4bn in the next 35 years is likely to mean that the number of smokers worldwide increases.
With Philip Morris being exposed to non-US countries only, we think this could be a major advantage for it and allow it to deliver relatively strong profit growth compared to its sector peers. This could allow it to command a premium valuation over its tobacco rivals.
On the topic of valuation, Philip Morris currently trades on a P/E ratio of 19.6, which is roughly in-line with the S&P 500's P/E ratio of 19.7. However, we think that there is scope for a higher rating than this for Philip Morris due to its potent mix of defensive and income prospects, as well as its potential to dominate reduced risk products through multiple types of offering in this space.
And with Philip Morris also having exposure to the regions of the globe where the number of smokers is set to increase and also likely to benefit from a US dollar which is not as strong as is currently being priced in, we think that Philip Morris' share price is set to beat the S&P 500 over the long run.
Disclaimer: This article is in no way a recommendation to buy or sell any stock mentioned, nor should it be considered financial advice. These are only the author's personal opinions and you should do your own research.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.