Tobacco stocks have been long-term winners for investors, but the companies that have been so successful in the tobacco business find themselves in a period of transition. With the adverse health impacts of cigarette smoking continuing to attract the attention of regulators and consumer advocates, even some of the largest tobacco companies in the world are looking at making the move away from traditional cigarettes toward alternative products that they hope will offer the same appeal to their customers but without some of the risks associated with smoking. At the same time, tobacco companies have looked to diversify their businesses, adding exposure to other industries to offer some protection in the event of a worst-case scenario for their core tobacco units.

Investors seeking the best tobacco stocks have some options in deciding how to get exposure to the sector. With only a handful of major tobacco companies in the U.S. market, you won't find any exchange-traded funds that concentrate solely on tobacco, and the one ETF that specifically includes tobacco stocks in its investment objective is relatively small and has a lot of other holdings in its portfolio.

Fortunately, for those who are comfortable taking on individual company risk, putting together your own portfolio of tobacco stocks isn't as hard as many people might think. We'll go through each of these investing options in much more detail below.

Tobacco farm with person standing in a row, on a stormy day.

A tobacco farm. Image source: Universal.

Tobacco backlash and ETFs

The exchange-traded fund universe has gotten huge, with thousands of different ETFs vying for investment capital. ETFs track a certain index of stocks based on a common attribute and trade on a major stock exchange. ETFs are available to invest in stocks, commodities, and bonds, and have some of the properties of mutual funds and some properties of common stock. You can find an ETF for just about every niche of the stock market, ranging from funds with thousands of holdings seeking to match the performance of the broadest market benchmarks to sector-specific investment vehicles with as little as a dozen stocks in their portfolios.

It's therefore a bit surprising to find that there aren't any ETFs specifically designed for tobacco investors. Although there are ETFs that hold tobacco stocks, you won't find a pure-play tobacco ETF that restricts its holdings only to tobacco stocks.

In fact, the trend is very much against tobacco stocks in the ETF universe. In late 2018, leading index provider MSCI came out with a suite of indexes that were specially designed to exclude stocks of companies that are involved in the tobacco industry. The indexes were tailored for those following environmental, social, and governance-related investing philosophies, and the head of MSCI's ESG index division noted that "there is growing demand for exclusionary indexes globally, including interest among the world's largest pension and endowment funds for tobacco exclusion benchmarks." The iShares Developed World ex Tobacco Index Fund, an open-end mutual fund, now tracks one of those indexes, and other ESG mutual funds and ETFs have taken a broader approach that excludes not only tobacco companies but also other attributes that ESG investors find objectionable.

However, there are some ETFs that hold an array of companies in the tobacco, alcohol, and casino businesses. Dubbed "sin stock" ETFs, these funds offer different allocations to these industries, with the exact percentages varying across the fund universe.

One sin stock ETF that offers significant exposure to tobacco companies is AdvisorShares Vice (NYSEMKT:ACT). Among its holdings , you'll find shares of tobacco giants Philip Morris International (NYSE:PM), Altria Group (NYSE:MO), and British American Tobacco (NYSE:BTI), as well as smaller players in the space like Vector Group (NYSE:VGR) and Turning Point Brands (NYSE:TPB). More than a quarter of the fund's assets are invested in tobacco stocks, with the remainder split across companies in the alcohol, cannabis, and restaurant and entertainment businesses.

AdvisorShares Vice points to the high profit margins that both alcohol and tobacco companies still command. Even though the ETF provider admits that the number of smokers has been in decline, it believes that the risk-reward prospects for the industry are still strong. Moreover, with the new growth opportunities available from cannabis production -- including not only new companies specializing in marijuana but also existing tobacco producers looking to expand into cannabis -- the target areas for AdvisorShares Vice seem more lucrative than ever.

So far, however, AdvisorShares Vice hasn't delivered the performance it had hoped. Since its inception in late 2017, the fund has badly lagged the broader market, as the various industries under its purview have seen considerable volatility. That's been a big contributor to why AdvisorShares Vice has only $14 million in assets under management -- putting it in danger of not being economically viable over the long run. Currently, the ETF provider is offering a large fee waiver to keep expenses down to 0.60% per year, but if the fund can't attract more assets soon, it might not be around much longer.

Leaf tobacco hanging from racks.

Image source: Getty Images.

Investing in individual tobacco stocks

It's because of the dearth of good ETF options for those looking for an investment manager to pick the best tobacco stocks that many tobacco investors end up going it alone and choosing top tobacco investments themselves. Especially for beginning investors, that can be a scary proposition, as it requires in-depth analysis of the players in the industry and introduces the risk that a bad pick could jeopardize a significant portion of your entire portfolio.

However, choosing tobacco stocks for a portfolio isn't as hard as it might sound. Moreover, making your own choices gives you the ability to select the tobacco companies that fit best with your particular views on the industry and goals for your investments. If you ask yourself the following five questions below, you'll be able to select the tobacco stocks that meet your needs the best -- and put yourself in position to benefit if the tobacco industry's current transformation proves successful.

1. Do you just want one tobacco stock?

Some investors like to keep things simple, and it doesn't get much simpler than buying just one tobacco stock for your portfolio. Obviously, if that the only stock you're going to own at all, buying a single tobacco stock is recklessly dangerous from a portfolio concentration standpoint. However, many investors choose to allocate only a modest percentage of their total investments to tobacco, and if that percentage is relatively small, then going with a single stock can make a lot of sense.

British American Tobacco (NYSE:BTI) is a natural choice for those seeking complete exposure to the tobacco industry in a single stock. Within British American Tobacco's business, you'll find traditional cigarette products sold around the world, as well as cutting-edge alternative tobacco products and vaping platforms. Most importantly, you won't have to pick a market, because British American sells cigarettes both in the U.S. and in most major markets across the globe.

You might not be familiar with the British American name as a consumer. But you might know Reynolds American, which includes brands like Newport, Winston, Camel, and Natural American Spirit. British American had owned a sizable minority stake in Reynolds American for years, and recently, it moved forward to buy out the remainder of Reynolds American that it didn't already own. That completed BAT's consolidation of its global tobacco business, putting it in a unique position within the industry.

BAT's business encompasses not only every major geographical region on the planet but also a host of different product categories. The U.S. is BAT's biggest market, but Europe, Africa, Asia, and the Americas outside the U.S. all contribute to the tobacco giant's overall success. Some efficiency advantages in U.S. operations have boosted the company's margin levels domestically, but overseas growth looks more attractive. In addition, and as we'll see in more detail below, British American has moved into alternatives to traditional cigarettes, with its Vype and Vuse brands giving the company a piece of the growing e-cigarette market and its glo heated-tobacco unit offering a different choice for customers. With oral tobacco pouches, nicotine replacement therapy, and other products, BAT aims to provide an all-inclusive product lineup.

Nine cigarettes in a five-and-four pile.

Image source: Getty Images.

Investing in British American gives tobacco investors exposure to the worldwide tobacco market along with a healthy dividend. That makes the stock a natural for those looking for an easy way into the industry and wanting a company that's committed to doing what it takes to stay relevant in a rapidly changing business.

2. Do you want to balance U.S. and international exposure?

The problem with using British American as your sole tobacco stock is that you're stuck with its mix of business between the U.S. and international markets. If you want to tailor your own allocation, then the easiest thing to do is to use pure-play stocks that focus on each of those two geographical markets. Fortunately, that couldn't be easier: Just choose an allocation between Altria Group (NYSE:MO) and Philip Morris International (NYSE:PM).

The history of these two companies tells you everything you need to know. Prior to the late 2000s, Altria Group's tobacco exposure looked a lot like British American's does now, with worldwide exposure through its Philip Morris USA and Philip Morris International segments. It was only when Altria spun off Philip Morris International as a separate and independent company that tobacco investors got to decide exactly how much of both stocks they wanted to own.

Altria Group is the giant of the U.S. tobacco industry, with larger market share than any of its rivals. The company has the exclusive right to use the Marlboro brand in the U.S., and it also has a host of other cigarette brands that it uses to flesh out its primary smokable tobacco products division along with lines of cigars under the John Middleton and Nat Sherman business brands. It also offers two of the most popular brands of smokeless tobacco in the U.S. market, Copenhagen and Skoal.

Meanwhile, Philip Morris International has become a global powerhouse in tobacco. With operations just about everywhere in the world except the U.S., Philip Morris International still gets the lion's share of its overall revenue from conventional cigarette sales. It has the rights to the Marlboro name internationally, but it also has an even wider array of brands, many of which are specific to certain local markets.

By incorporating both Altria Group and Philip Morris International into your tobacco stock portfolio, you're in control of how well you think the U.S. and international markets will perform compared to each other. If you prefer the prospects for the U.S. tobacco market, then skewing your portfolio by making a larger investment in Altria might pay off for you. If you favor international investing, then investing more in Philip Morris International is consistent with that philosophy. You can choose whatever allocation fits your needs -- giving you more flexibility than a one-stock solution like British American Tobacco can offer.

3. Do you want a tobacco stock with exposure to the cannabis industry?

One area that many investors are examining very closely is how tobacco companies can use their expertise to take advantage of new opportunities in the cannabis industry. With hemp cultivation now legal in the U.S. federally, many companies are looking at expanding operations to make more cannabis-derived products like CBD. Marijuana investors hope that eventually, federal law will allow state governments to make up their own minds about to what extent they legalize the use of cannabis, as that would open up a huge new area for business expansion and investment.

Hand holding marijuana leaf in front of a large number of cannabis plants.

Image source: Getty Images.

Among major tobacco companies, Altria Group has made the biggest move into cannabis with its $1.8 billion investment into cannabis cultivator Cronos Group (NASDAQ:CRON). That money bought Altria a 45% stake in Cronos, and the two companies hope to use each other's expertise to find whatever opportunities they can to build up their respective businesses. Some believe that Altria paid too much for its Cronos stake, especially given the challenges that Cronos and many of its Canadian cannabis peers have had in ramping up production to meet new demand from recreational users in the Great White North. Nevertheless, if legal rules get relaxed in the U.S., having Cronos on its side will give Altria an edge over some of its peers.

Beyond the big tobacco producers, Turning Point Brands (NYSE:TPB) also has some exposure to the cannabis industry. As you'll see in greater detail below, Turning Point specializes mostly in alternatives to traditional cigarettes, but it's also using its expertise in electronic cigarettes and vaping products to try to incorporate cannabis-derived products. Between its Nu-X line of flavored liquid CBD products and its Riptide vaping platforms with CBD e-liquids, Turning Point hopes to benefit from increased interest in cannabis as well.

Obviously, if you want to invest in cannabis, there are pure-play marijuana stocks you can use. But tobacco companies do have a lot of expertise in the areas of distribution and marketing that could be of benefit in the budding cannabis industry, and Altria and Turning Point are both trying to use their strengths in tobacco to make a profitable entry into the marijuana space as well.

4. Do you want to focus on alternatives to traditional cigarettes?

In the U.S., cigarette smoking has been in a secular decline for decades. Altria has been able to adapt by raising prices by a large enough margin to preserve revenue and profit growth, but each price hike puts its pricing power to the test, and many tobacco companies seem to see the writing on the wall for cigarettes in the not-too-distant future.

It's because of that fact that even the largest and most successful tobacco companies are looking at alternatives to traditional cigarettes. Consider the following moves from some of the biggest players in the industry:

  • Altria spent $12.8 billion to buy a 35% stake in e-cigarette leader Juul Labs. The move came even after Altria had already made considerable internal investment in building out its own brands of e-cigarettes and other alternative products, but Altria saw the Juul partnership as an integral part of its broader strategic vision.
  • Philip Morris International has committed to a cigarette-free future, with a huge portion of its research and development dedicated to reduced-risk alternatives. Much of its attention in recent years has gone to its IQOS heated-tobacco system, which electronically heats up specially formulated tobacco to produce a nicotine-containing vapor. Because IQOS doesn't actually burn the tobacco, it doesn't produce the same harmful chemicals that result from tobacco combustion, and Philip Morris International has said to regulators that it believes the health impacts from using IQOS are dramatically reduced in comparison to regular cigarettes. Thanks to a partnership with Philip Morris International, Altria has the right to sell IQOS in the U.S. market once it's made available, and the two companies hope that early IQOS successes in markets like Japan will lead to equally strong sales domestically.
  • British American Tobacco has several lines of cigarette alternatives, ranging from its glo heated tobacco product to its Vuse and Vype e-cigarette and vaping products.
Two hands holding IQOS device.

IQOS heated-tobacco unit. Image source: Philip Morris International.

Some newer players in the tobacco industry didn't even bother trying to build up a presence in the traditional cigarette business. Turning Point Brands got its start as a leveraged buyout that separated out Lorillard's cigarette-alternative division back in the late 1980s. Having just gone public about three years ago, Turning Point offers just about everything but traditional cigarettes. Those who like the regular cigarette experience can buy Zig-Zag cigarette papers and loose tobacco to roll their own cigarettes, or they can turn to its cigar wraps for a self-service cigar experience. Turning Point also offers pipe tobacco, moist snuff, and chewing tobacco.

Yet one of Turning Point's most interesting businesses is its vaping product line. The company offers a variety of different vaporizers and e-liquid products, with an eye toward meeting the diverse needs of customers seeking to use e-cigarettes as an alternative to traditional cigarette smoking. Turning Point has made strategic acquisitions to bolster its presence in this niche, and with distribution channels in both traditional retail stores and via the internet, the company is making great strides toward building a sustainable business model that can grow along with the industry it serves. It's also seeing significant sales growth and is consistently profitable -- giving shareholders confidence in the underlying business.

One hope that tobacco companies have is that e-cigarettes, heated-tobacco units, and other alternatives will escape the rigorous level of regulation that traditional cigarette production now involves. Based on recent regulatory efforts, that hope might prove to be in vain, because some believe that e-cigarettes and other alternatives have harmful effects of their own. Nevertheless, some investors feel more comfortable with companies that focus outside the regular cigarette arena, and these stocks are at least making an effort toward keeping up with the times.

5. Do you want tobacco stocks with diversified business exposure?

Finally, because of the risky nature of the tobacco industry, some investors feel uncomfortable with any company that essentially is making a pure-play bet on the long-term sustainability of their original business models. Companies like Philip Morris International and British American Tobacco are looking at alternatives to traditional cigarettes, but they don't seem to want to have significant exposure to businesses outside the tobacco area entirely.

By contrast, Altria has done a good job of trying to cultivate diversification among its holdings. The company has a modest-sized wine business, Ste. Michelle Wine Estates, which helps to give Altria the benefit of exposure to the alcohol industry. Even more valuable is Altria's roughly 10% stake in Anheuser-Busch InBev, which stemmed from the tobacco company's long-held investment in the since-acquired beer business of SABMiller. The beer industry has gone through its own ups and downs, but having it under its corporate umbrella gives Altria at least some exposure to a business other than tobacco.

Some companies have gone even further. Consider what the following smaller tobacco players have done with their businesses:

  • Universal (NYSE:UVV) has a primary business of growing leaf tobacco that it then sells to industry giants like BAT, Philip Morris International, and Altria. Yet Universal has also built a valuable testing program that not only allows for chemical and smoke testing for tobacco companies but also assistance in optimizing growth of fruits and vegetables commercially.
  • Vector Group (NYSE:VGR) is an important player in the discount cigarette industry, providing a number of popular budget cigarette brands in the U.S. market. Yet it also has its New Valley real estate subsidiary, which notably owns real estate brokerage giant Douglas Elliman Realty. That holding gives Vector direct exposure to the valuable New York metropolitan area real estate market, and direct investments in projects in both New York and California show just how diversified this company is.

Of course, if you want to invest in different industries, you can also simply make investments in pure-play stocks in those areas rather than look for hybrid exposure. Whichever way you choose, it's still useful to understand the efforts that tobacco companies have made to try to protect against the tough conditions in their core businesses and to capture relevant and achievable growth opportunities when they arise -- even if they don't necessarily have anything to do with tobacco.

Invest in tobacco stocks the right way for you

There's no one perfect way to invest in the tobacco industry, but there are a host of good options to consider. If you're looking for the consistent growth and dividend income that tobacco stocks offer, then putting together your own custom portfolio is the best way to ensure you'll get the exposure you want.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.