Click to EnlargeWhat’s not to like about tobacco stocks? Almost nothing, if you listen to the analysts or follow the financial media.
It’s true that the tobacco sector offers the combination of stable growth, high dividends and the ability to hold up well through economic conditions. The problem is, the cat’s already out of the bag — at least if the 12-month returns of the four largest domestic tobacco companies are any indication:
| Company | Ticker | 12-month return |
| Lorillard | LO | +48.58% |
| Altria Group | MO | +26.50% |
| Philip Morris International | PM | +40.16% |
| Reynolds American | RAI | +24.47% |
It has been a phenomenal run for tobacco stocks, which haven’t looked back since their run of outperformance began in early 2011. However, one important result of these strong gains is that valuations are now well above historical norms:
| Company | P/E | 5-year average |
Premium | P/S | 5-year average |
Premium |
| Lorillard | 17.1 | 13.3 | 21.90% | 5.0 | 2.4 | 52.62% |
| Altria Group | 19.1 | 12.4 | 35.36% | 2.8 | 2.4 | 13.57% |
| Philip Morris International |
18.3 | 14.9 | 18.85% | 5.0 | 1.6 | 68.35% |
| Reynolds American |
17.5 | 14.5 | 17.43% | 2.8 | 2.0 | 28.93% |
In addition, their yields — while still very attractive compared with the rest of the market — have come down substantially compared to where they stood early last year. In February 2011, the average yield of these four stocks was 6.5%, or about 410 basis points above the 10-year Treasury. Now, their average yield is down to 4.5% — just 230 basis points above the 10-year. In other words, their yield advantage versus bonds is 44% lower now than it was a little over a year ago — an important consideration given that these stocks are being promoted as alternatives to low-rate fixed-income instruments.
The uptrend in valuations and corresponding slippage in yields can be seen in the charts below:
Another potential headwind to the sector is that all four stocks have climbed to levels that put them in line with, or above, their consensus price targets:
| Company | Mean Target | 4/5 close |
| Lorillard | $136.00 | $136.46 |
| Altria Group | $31.30 | $31.36 |
| Philip Morris International | $86.94 | $88.64 |
| Reynolds American | $42.60 | $42.07 |
At this point, it’s fair to ask how far these stocks can move above analysts’ targets before gravity begins to assert its influence.
Finally, the consensus is exceptionally positive even by Wall Street standards: Of the 58 analyst ratings on the four stocks, 54 are either strong buy, buy or hold.
The danger here isn’t that the tobacco stocks are going to experience significantly negative returns, absent a surprise event on the legal or regulatory front. Instead, the real problem is that even the most “defensive” stocks fail to serve their purpose once valuations reach levels where there is no longer much margin for error. A new buyer of a tobacco stock now is making the following assumptions:
- Investors will continue to pay up for tobacco stocks’ yields even with the narrowing gap relative to U.S. Treasuries.
- Treasury yields will fall or remain at current levels, with no danger of an upward spike.
- The shareholder base can still be trusted to act as “strong hands” through a change in trend.
- There will be no negative surprises of any kind. With the stocks at the top end of their historical valuation ranges, there is no longer room for anything but positive news flow.
The bottom line: Tobacco stocks still have a lot to offer investors on a long-term basis due to the compounding effect of reinvested dividends. However, as anyone who bought a house in the 2004-07 period can attest, long-term appreciation stops working if your initial purchase price is too high. Be patient and wait for a pullback if you don’t already own these stocks, and use this opportunity to boost your income by selling calls if you do.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
