Saturday, July 5, 2014

An Element of Sin: Investing in Tobacco Stocks 101

While some people don't like to invest in so called "sin stocks," owning shares of tobacco companies could potentially fill an important gap in your investment portfolio. Tobacco stocks are characterized by low P/E ratios and high dividend yields. As a result, many investors seeking a steady stream of income find them to be attractive, especially when interest rates are low. Investing in tobacco stocks is inherently risky, because the companies are exposed to near constant litigation from former smokers seeking damages.

While tobacco companies have generally been successful at fighting this litigation, it is a constant source of hesitation for the industry. Additionally, there is uncertainty associated with the future of tobacco companies now that they are regulated by the FDA. At this point, it is unclear if tobacco companies will be forced to further curtail their marketing practices, change ingredients, or drop brand segments all together.

The domestic tobacco industry is mature, and cigarette volumes are declining in the United States and Western Europe. Draconian taxes and smoking bans have made cigarettes less accessible. Marketing restrictions imposed in the 1990's have severely restricted the ability of tobacco companies to reach new customers. Additionally, the public's perception of smoking is more negative than at any time in the past. However, cigarettes are very addictive, and smoking is an extremely difficult habit to quit. Add the fact that smokers tend to be extremely brand loyal, and it becomes clear why this slowly declining industry is still very profitable. Internationally, cigarette volumes are increasing.

Most developing nations lack strict smoking bans like those seen in much of the United States and Western Europe. Smoking in bars, restaurants, and the workplace is still legal in many parts of the world. Combine this with low taxation and it's easy to see why smoking cigarettes is still extremely popular in many countries around the globe. Smoking is also perceived differently in many developing nations than it is in the United States. In America, a smoking habit is often seen as a sign of weakness, while smoking a Marlboro or Camel in a developing nation is frequently considered a status symbol or an affordable luxury.

The long term future for both domestic and international tobacco companies is inherently negative. Increasingly, governments are gaining the political will to pass strict laws taxing and regulating tobacco products. However, as we have seen in the United States and Western Europe, the industry is much more resilient than anyone could have previously thought. Although cigarette volumes are slowly declining by a few percentage points each year in developed markets, the business is still extremely profitable. While tobacco companies know that manufacturing cigarettes may not always be a viable business, the day of reckoning will not come for a very long while.

In the meantime, tobacco companies are increasingly diversifying by developing new tobacco products seen as less harmful than cigarettes. These products, mainly variations of smokeless tobacco, can be used discreetly in places where smoking cigarettes is forbidden. Smokeless products provide the user with a nicotine fix while not upsetting bystanders or impacting the health of others. Analysts estimate that the smokeless tobacco segment will grow by 5% in 2010.

All of the large tobacco companies are publicly traded, meaning that anyone can easily buy their stock through a stockbroker. Domestic companies include Altria Group (MO) Reynolds American (RAI) Lorillard (LO) and Vector Group (VGR). Tobacco companies with international exposure include British American Tobacco ADR (BTI) Imperial Tobacco Group ADR (ITYBY) and Philip Morris International (PM).

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