Many of the world's governments are proposing and passing tobacco regulations. In light of this, tobacco companies are clearly not the best stocks for investors today. They fail to compensate investors for the industry-specific risk that they face.
Why are cigarette stocks and tobacco stocks considered attractive? Cigarette companies are getting dividend investors hooked on unsustainably high dividend yields. The headwinds for these stocks and their unstable dividend policies are bad omens. Alternative high dividend-paying stocks are suggested to help income investors kick the cigarette stock habit.
Tobacco Crackdown: From Russia with Love
The Russian government could pass a bill that bans smoking in public, advertisements of tobacco products, and would increase the excise taxes on tobacco by 40% between now and 2014. This legislation has been proposed in an effort to curb the rapid population decrease in Russia. Since the World Health Organization ranks Russia as the second largest market for cigarettes behind China, the passage of the bill will largely affect the sales volume of tobacco companies.
Tobacco companies such as the British American Tobacco (BTI) and Philip Morris (PM) are lobbying against this bill. Philip Morris is the largest tobacco company in the world, while British American Tobacco is the largest in Europe and Japan Tobacco has the most market share in Asia. These giants make up the majority cigarette sales in Russia: Japan Tobacco has 37% of the market, 26% is held by Philip Morris, and 21% is held by British American Tobacco.
The taxes on cigarettes were raised 8-fold, and there are plans for further increases in the future. Other regions including Europe and Asia are also joining suit in implementing tougher tobacco laws. This will probably have a big impact in the tobacco market.
Tobacco Regulations Down Under
Russia is following in the footsteps of other governments. Australia tobacco companies are now required to place images of cancer victims and gangrenous limbs on cigarette packs. To comply with new government standards, there must be images and health warnings covering seventy five percent of the front of cigarette packs. New packages will display disgusting images including tongue cancer, a skeletal man dying of lung cancer, or an infected foot. Additional warnings have to cover the sides of the packages and ninety per cent of the back.
Government officials hope that the new packaging will curtail the recruitment of young people as smokers. Australia's health minister Tanya Plibersek said:
Young people are the ones most affected by the packaging and by the advertising, and no parent wants their kid to start smoking.
Health officials are hopeful that ugly new cigarette packaging will dissuade more consumers from smoking in general. After most of the packaging is not covered in cautionary warnings, the remainder is required to be drab. According to the state law, the background of the packaging must be a specific greenish-brown color and any trademarks or product names have to be in Lucida Sans font. State officials will lookout for deviation from these regulations.
These regulations will be mimicked elsewhere. Margaret Chan, the World Health director-general said:
With so many countries lined up to ride on Australia's coattails, what we hope to see is a domino effect for the good of public health.
Countries including the United Kingdom, Turkey, New Zealand, India, and Russia expressed interest in more severe plain packaging rules.
There is no way to predict the future, but that the possibility of such hard impositions on packaging and advertising will likely manifest in many more countries. Since this risk could become reality, cigarette and tobacco stocks should be much, much cheaper than other stocks.
Consider the following cigarette and tobacco companies:
Alliance One International
British American Tobacco
None of these stocks are trading at low enough valuations, given the macro picture of stifling government regulation. Intel (INTC) has a much lower price-to-earnings ratio of roughly 9, for example. Some of these firms have negative accounting values for equity, which is worse, considering how such firms have historically underperformed firms with positive book equity.
It also appears that cigarette companies are using by unsustainably high dividend payout rates to keep investors hooked:
These dividends will not last forever, since payout ratios above 60% don't leave enough margin for error if earnings decline or if governments initiate new restrictions on your products. Only one dividend-paying tobacco company, Universal, has a sustainable payout ratio.
Tobacco and cigarette stocks are trading at high to mid-range static valuations which do not reflect the regulatory headwinds they will face. Many of these firms have dividend policies which are not sustainable. Any downward revisions to dividend policy could act as a signaling mechanism which could be interpreted by the market as a sign that management does not have confidence in firm operations. Investors should steer clear of this industry, regardless of personal conviction, based purely on investing prudence.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.