Light up Your Portfolio With These Tobacco Stocks

Dividend stocks are different from most other investments, where you don't realize a profit until you sell. Even if the stock price does not soar, an investor still gets some cash to pay the bills with from time to time. However, most investors find it boring to invest in dividend stocks--it is far more exciting to speculate on the rise and fall of stock prices. However, dividend stocks offer several advantages over non-dividend stocks.

First of all, dividend stocks are typically mature and stable businesses that can afford to share profits with shareholders. Dividends serve as an important component of the total return. To put this into perspective, dividends have accounted for roughly 40% of the U.S. stock market's return since 1930. Moreover, dividend stockholders can also ride out short-term price fluctuations without selling off shares. I suggest that long-term investors choose consistent dividend-providing companies with strong balance sheets and rising cash flows.

Some of these companies are tobacco stocks, including Lorillard (LO.DL), Altria (MO 0.49%), Reynolds American (RAI) and Philip Morris International (PM 0.68%). These companies have provided good returns to investors over the last three years through steady revenue growth and operating leverage, in addition to shareholder-friendly activities like dividends and share repurchases.

Lorillard, Altria, and Reynolds American all yield more than 5%, while Philip Morris offers a dividend yield of 4.30%. Does that make Philip Morris less attractive? Let's study the dividend yields and payout ratios that make up the dividends of these companies to find out.

We can see that although Philip Morris has the lowest dividend yield among these companies, it also has the lowest payout ratio. It is important to note that Altria and Reynolds American have very high payout ratios. This simply means that these companies are paying a higher portion of their earnings to their shareholders, and thus the sustainability of such high dividend yields is uncertain. Lorillard on the other hand looks impressive based on these comparisons. Lorillard's payout ratio is similar to the ratio for Philip Morris, but Lorillard still provides a highly-attractive 5.10% dividend yield. 

However, it is essential to look at the valuations to analyze which of these stocks are trading for less than they are worth. The following table summarizes the valuation metrics (forward P/E and price-earnings-growth ratio) of these tobacco companies.

We can see that Lorillard trades at more than a 10% discount to Reynolds American, Altria Group and Philip Morris. Even if we use a PEG basis, Lorillard looks highly undervalued with respect to its peers with a PEG ratio of just 1.08. Last year, Lorillard diversified its portfolio by acquiring Blu e-cigs, and its electronic-cigarette market share has expanded to 40% in the last quarter. The revenue from electronic cigarettes represents a small fraction of its overall revenues, but in my opinion the rising popularity of electronic cigarettes could be a potential game changer.

While Reynolds American and Altria look expensive, Philip Morris looks fairly priced. Emerging markets like Asia, with its expansive and growing population, represent a tremendous opportunity for the company. Specifically, countries like China (the largest tobacco market in the world), Indonesia (Asia's second largest tobacco market with a 32% smoking prevalence rate) and the Philippines (fast growing market where Philip Morris has a more than 90% share) should prove to be the engine of growth for years to come.

The Bottom Line

I think Lorillard is the best bet among tobacco stocks. The company's highly attractive dividend yield is not merely a result of a high payout ratio, as we have seen with Altria Group and Reynolds American. The company has huge potential for future growth with a strong hold on the growing electronic cigarette market and represents a good bargain at current levels. Philip Morris is also a good bet given its international exposure, better expected growth rate than its peers and the strong hold of the Marlboro brand in the global market.