We've made no secret of the fact that Philip Morris (NYSE:PM) is our favorite tobacco stock. But another tobacco stock which we narrowly missed buying in 2011 when it was trading at about $70 has now grown into a monster. Lorillard (NYSE:LO) has had a magical stock run, backed up by great earnings and increasing dividends. Here are some quick facts about Lorillard:
- LO has been trading as an independent public company since 2008.
- LO has increased its dividend by an average of 14% per year since then.
- The current payout ratio is about 75%, not a bad number for tobacco stocks.
- Lorillard is heavily dependent on menthol cigarettes. This is a clear danger sign that will send the shares crashing on any bad news about menthol.
As in the earlier exercises, let us look at the power of dividend growth for an investor who can set aside his/her money for 10 years in LO.
- Assume you purchase 100 shares at the recent price level of $132 for a total initial investment of $13,200 (just using a low number of shares than the previous examples because of LO's higher share price).
- The current yield works out to a majestic 4.7% as shown in the table below.
- Even though the average dividend increase has been about 15% so far, let us use a more conservative 10% for this calculation.
- Notice how the dividend payments and the yield on original cost almost triple in 10 years, leading to $1600 in annual dividends for 100 shares.
- Even assuming an even conservative 8%, the yield on original cost and dividends/year double in 10 years.
- We have left out the DRIP part from this piece as some investors choose to reinvest the dividends and some do not. Some DRIP during bad times to accumulate more shares and opt out of DRIP when the price per share seems to be at a fair value.
- Capital gains will almost certainly contribute to the overall returns as well, as LO is still considered to be in early growth phase. The stock has almost doubled since going public in 2008.
- However, in case the price dips, turning on the DRIP will be helpful in maximizing the returns when things turn around.
- Inflation has been ignored in this calculation as stocks are the best hedges against inflation when compared to other assets.
- One might think why not purchase a current 10% yielder instead of waiting for LO to grow into a 10% yielder in the future. Fair question. Unless a depression sets in, LO is highly unlikely to reduce its dividend. The same cannot be said for junk high yielders.
- 10 years is a reasonable time period for this exercise as the market typically moves through many cyclical highs and lows in a decade.
Conclusion: While we would still stick with PM as our sole tobacco holding, this exercise shows that Lorillard can be a great addition to a dividend growth focused portfolio. If there are no bad news about menthol cigarettes or if the company manages to diversify, odds are that LO will continue to be a great growth and dividend growth stock for investors. Also, like Altria (NYSE:MO), LO also has to counter the stringent U.S. smoking regulations.
This article does not recommend buying LO at current price level but rather intends to show the potential of even a conservative dividend growth with LO.