Why Tobacco Bonds Are Likely To Outperform Tobacco Stocks Significantly Over The Next Decade

 |  Includes: LO, MO, PM, RAI
by: The Independent Investor

Dividend investing has never been more popular. Below is a chart showing the performance of the S&P 500 SPDR ETF (NYSEARCA:SPY) vs. iShares Dow Jones select Dividend ETF (NYSEARCA:DVY).


Some of the most popular dividend stocks have traditionally been in the tobacco sector. Specifically, leading tobacco stocks such as Altria (MO), Reynolds (RAI), Lorillard (LO), and Phillip Morris International (PM), have been some of the strongest performing dividend stocks for nearly three years.

Still, while U.S. and international tobacco stocks have consistently outperformed most of the broader indexes by a wide margin over the last several years, today many of these stocks are trading at historically high valuations. Altria, probably the most popular dividend stocks in the market today, trades today at over 15x forward earnings despite the companies net income having consistently fallen when including litigation settlements. Reynolds is trading at around 14x forward earnings estimates despite having recently cut 10% of its work force in the last ten years because of falling revenues. Reynolds payout ratio is also over 90% today.

Indeed, while many tobacco stocks have had huge runs over the last several years, these stocks are trading at historically high valuations at time when congress is beginning to increasingly talk about raising taxes on capital gains and dividends. Well the recent democratic Senate plan would only raise the dividend tax 5%, even a 5% raise in these taxes could be significant given the current valuation of many tobacco and dividend stocks.

This is exactly why I question whether tobacco stocks are the best investment for individuals whose primary goals are income and safe returns. Today there are over $100 billion in state and municipal tobacco bonds outstanding. While, obviously, bonds usually offer limited total returns, many tobacco bonds have rallied over 15% this year, and bonds issued by state governments and municipalities often offer tax free yields. A Ohio municipal tobacco bond maturing in 2042 can be bought today with a tax free yield of nearly 6%. Well tobacco bonds are generally unsecured, these bonds simply roll over if the income is insufficient to cover the interest payments, and the investor can continue to collect income until the interest payments are paid off in the future.

If an investor is getting a 6% tax free return, the annual return over a would offer a return of approximately 180% over 10 years. If an investor were to purchase shares of the largest U.S. tobacco company, Altria, and reinvest the 4.6% annual dividend, taxed at 15%, over ten years, an investors total return would be 147%. While obviously Altria and other leading tobacco stocks are likely to continue to raise dividend payouts over the next ten years, Reynolds and Altria are already paying out over 90% of net income., and dividend taxes are likely to rise at least modestly in the coming years. These companies also still face some regulatory and legal risks, and these companies stocks are trading at or near fifty-two week highs.

To conclude, while investing in companies consistently raising dividend payouts is always appealing, it is likely that many leading tobacco and dividend stocks are pricing in multiple dividend raises today. With taxes likely to rise and tobacco companies trading at historically high valuations despite these companies having extremely high payout ratios, the fixed income market may offer stronger and safer returns for long-term investors focused on dividend and income.

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