Why Are You Still Buying U.S. Tobacco?

This really puzzles me: Right now Altria (NYSE: MO  ) and Lorillard (NYSE: LO  ) are five-star picks on Motley Fool CAPS, our online community of investors. And Reynolds American (NYSE: RAI  ) (to which I've given a bearish CAPscall) somehow gets a respectable three stars.

Why? What is it, exactly, that draws you Fools to these stocks?

Is it their amazing track record of shareholder returns? Past performance, as the saying goes, is not indicative of future returns. 

Is it their big, fat 5% dividends?

You do realize that the dividend is -- at most -- your entire expected return here? This is because these companies are now paying out all of their free cash flow in dividends (and share buybacks, in Lorillard's case) with de minimis reinvestment.

This is to be expected, as declining businesses have little need for free cash flow. But this does mean that the dividend yield (plus buybacks for Lorillard) likely overestimates what your future annual return will be. U.S. tobacco volume continues to fall by about 4% per year, which isn't surprising considering fewer people are smoking and those who smoke are smoking less. At some point, price increases won't offset volume declines, and the dividend, which, again, is your whole expected return here, will have to be cut.

So, for taking on tons of regulatory risk, interest rate risk (they're basically perpetual bonds), and a business in decline, you're getting an expected return of less than 5%. Does that sound rational to you? Sounds like a nasty case of dividend addiction to me. 

If you really, really, insist on yield -- which is never advisable -- then go with junk bonds. They offer just as much growth opportunity (read: none) and a higher yield at 7%, with less risk than U.S. tobacco equity. The SPDR Barclays Capital High Yield Bond is an easy way to play 'em in a stock portfolio.

But really, there's no point in reaching for yield. Great and growing businesses like Coca-Cola or Budweiser offer the steady returns of U.S. tobacco without the risk. Or head overseas for the much superior Philip Morris International (NYSE: PM  ) .

At some point, U.S. tobacco could go up in smoke. Don't let your portfolio go up with it.

Put the fire out with great small companies the market's ignoring. Want to find out which stocks could shock the Street with big returns? All the information you need is in our popular free report: "3 Middle-Class Millionaire-Makers Wall Street's Too Rich to Notice."

Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbainesChris' stock picks and pans have outperformed 96% of players on CAPS. He owns no shares of the companies mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 09, 2012, at 11:27 PM, charukjamie wrote:

    Blah blah blah Altria's doing Great Peeps don't listen to this Quak Philip Morris is Great to what ever one you pick you can't lose. There booth same business One isn't going to do much better than the other so don't let this guy play head games with you newbees

  • Report this Comment On October 10, 2012, at 12:07 AM, SuntanIronMan wrote:

    "But really, there's no point in reaching for yield. Great and growing businesses like Coca-Cola or Budweiser offer the steady returns of U.S. tobacco without the risk."

    Coca-Cola certainly regulatory risks. The New York City 16oz and above soda ban illustrated that. Not to mention the parts of Obamacare that target sodas.

    Sugar water is becoming the new tobacco in the eyes of government regulators. And of course liquor has its regulatory risks as well.

    If anything, regulatory risks associated with tobacco are obvious and known events. Unless something truly unpredictable habit, like going down the prohibition road again (this time with tobacco) and have an outright ban on tobacco, it seems like investors are well aware the risks of owning a tobacco stock.

    That said, I avoid tobacco stocks for personal reasons.

  • Report this Comment On October 10, 2012, at 12:18 AM, SuntanIronMan wrote:

    Correction:

    *Unless something truly unpredictable happens,

  • Report this Comment On October 10, 2012, at 3:56 AM, quaternion2 wrote:

    With MO I am up 30% + dividends since I bought it in June 2011.

    There may be something more than what has been said. Just delve into it.

  • Report this Comment On October 10, 2012, at 10:23 AM, runningoutofcash wrote:

    >>> The "Author" is truely a "FOOL" <<<

    + you fail to mention that "Altria Group - MO" controls 25%+ of SABMiller (2nd largest beer company in the world).

    +And possible news pending after the elections that BIG-MO will be venturing into the "MEDICAL marijuana business" with the "GOVT".

    + it takes 10cents to make a pack of cigs...and costs $5/pack...GO Figure...its about making "ROI" ..........i dont advocate smoking....but its all about business !!

  • Report this Comment On October 10, 2012, at 6:04 PM, chris293 wrote:

    If I did not sell some PM, my dividend would over 20 percent. Hind sight is a sad thing but at least I held onto part of my holdings of PM and I am happy I did. This PC crowd can really mess some questionable subjects up with I wonder what is their real intent?

    Emotions, politics, and business are best kept seperate. Power ruins all kinds of people from the poorest to the richest no matter what they do.

  • Report this Comment On October 11, 2012, at 12:43 AM, raskew wrote:

    I bought 1100 shares at 500 share increments at a average price of 20.50. giving a base cost of $22,550.00

    With dividend re-investments I now have over 1250

    shares worth $41,141.56 today in an 18 month period giving me a 82.4% increase.(NOT BAD)

    I quit smoking forty years ago and am getting my money back!!

  • Report this Comment On October 11, 2012, at 2:18 AM, mansourg54 wrote:

    If we believe that tobacco consumption declines by 4% annully then no one in the US would be smoking because we have been hearing the same for many years. What about KO? People drink more water and less sugary softdrinks. Per your logic KO must be declining. MO is changing and is doing so to increase its revenues and profits to benefit shareholders. It owns 28.3% of SABMiller Beer, it has wine operation, it is in smokeless tobacco, it sells cigars and pipes and it has financial division. All divisions are profitable and MO controls 51% of the US tobacco market, 55% of the smokeless market and is the 6th or 7th largest wine company. MO sells its wine, smokeless tobacco and pipes inside and outside the US. MO is developing nicotine based chewing gum with a Japanese company. All other tobacco comanies are not as diversified as MO. MO is more profitable than PM.

  • Report this Comment On October 11, 2012, at 2:26 AM, mansourg54 wrote:

    I own MO since 1997 and sold the PM and KFT spin-offs and bought more MO. In early 2009 when the market crashed I added another 33000 share of MO at a price $15 -$17. Now I sit on 105000 shares of MO which pay me over $180k in dividends. Just today 10/10/12 MO paid me more than $45k. I reinvested half the money and bought more of MO shares.

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