Will Tobacco Stock Gains Go Up In Smoke?

by: Justin Kuepper

It shouldn't be very surprising that the tobacco industry is doing well these days. Nicotine is a psychoactive drug that has been shown to make stress less severe, while high unemployment and economic turmoil have made life a lot more stressful. Of course, the mood altering effects of nicotine are merely an illusion (the body suffers precisely the opposite fate), which keeps a steady supply of these people in line to buy products to help them quit.

According to Tickerspy, the tobacco sector is trading up 20.6% this month and 74.4% since the beginning of 2008. A quick glance at the S&P 500 (or probably your own portfolio) gives you an idea of the magnitude of that outperformance. But despite the move higher, the sector trades with an average P/E ratio of just 16.1x and offers an average of a 3.3% dividend yield. So, will these stocks go up in smoke or are they headed still higher?

Companies included in this index are:

  1. Alliance One International Inc. (NYSE:AOI)
  2. British American Tobacco plc (NYSEMKT:BTI)
  3. Star Scientific Inc. (CIGX)
  4. Lorillard Inc. (NYSE:LO)
  5. Altria Group Inc. (NYSE:MO)
  6. Phillip Morris International Inc. (NYSE:PM)
  7. Reynolds American Inc. (NYSE:RAI)
  8. Schweitzer-Mauduit International Inc. (NYSE:SWM)
  9. Universal Corp (NYSE:UVV)
  10. Vector Group Ltd. (NYSE:VGR)

What's Really Driving the Growth?

Stock prices can really appreciate in two ways - earnings growth or multiple expansion. Earnings growth increases a company's earnings per share, which mandates that the share price increase, unless the multiple declines. In contrast, multiple expansion often occurs when a company and/or its industry is viewed in a more favorable light that demands higher valuations.

So, what's driving the tobacco industry? The answer: Both. Industry bellwethers, like Philip Morris International Inc., have reported higher bottom line results. While the industry saw overall declines of about 3.5% during the fourth quarter, favorable pricing and other factors helped drive higher bottom line results.

Multiples for many publicly traded tobacco companies have also been on the rise for two reasons. First, tobacco is a defensive industry that's widely viewed as being recession-resistant, making it a must-own for investors during a downturn. Second, the high dividend yields on many of these companies have made them attractive in today's low rate environment.

Will these Trends Continue?

While tobacco companies have moved higher in the past, the big question for investors is of course whether or not these trends will continue.

So far, the outlook appears promising. Companies like Philip Morris International Inc. reported record volume growth in 2011, while being one of the few industries able to implement price hikes during a recession. Meanwhile, the firm sees growth in 2012 continuing, as governments also become "more reasonable" about cigarette taxes.

And while some companies reported lower volume, such as Reynolds American Inc., analysts view the recent weakness in their stock as a buying opportunity (JP Morgan recommended RAI on February 8th in a note). This bullishness was echoed by other analysts, like Argus and Stifel Nicolaus, which raised their price targets on companies like Philip Morris International Inc.

Where are the Opportunities?

Investors should continue to build in exposure to larger industry players that are paying high dividends. These stocks offer the combination of earnings growth, stability and the potential for multiple expansion from the extended low rate environment. But of course, these should be built into a diverse portfolio, given the ever-present risk of government regulations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.