Please ensure Javascript is enabled for purposes of website accessibility

Why Are You Still Buying U.S. Tobacco?

By Chris Baines - Oct 9, 2012 at 9:53PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Who wants the regulatory risk in a declining industry?

This really puzzles me: Right now Altria (MO 2.09%) and Lorillard (LO.DL) are five-star picks on Motley Fool CAPS, our online community of investors. And Reynolds American (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 (PM 1.80%).

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

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Altria Group, Inc. Stock Quote
Altria Group, Inc.
$43.40 (2.09%) $0.89
Philip Morris International Inc. Stock Quote
Philip Morris International Inc.
$103.40 (1.80%) $1.83
Reynolds American Inc. Stock Quote
Reynolds American Inc.
Lorillard, LLC Stock Quote
Lorillard, LLC

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 06/27/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.