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Smoke Signals

By Sam Stovall New this week to the list of industries with top Standard & Poor's Relative Strength rankings: Tobacco. These stocks are followed by S&P analyst Rick Joy, who has a positive near-term outlook for the industry. Joy says things are improving for Big Tobacco on the litigation and regulatory fronts. Also, investors have renewed their focus on defensive stocks -- those that they think will continue to do well even in a weak economy -- in the midst of another round of market turmoil.

Tobacco, a classic defensive group, has held true to form. The S&P Tobacco index gained 8.3% year to date through Feb. 15, vs. a 4.3% decline in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600). This industry index gained 5.7% in 2001, vs. an 11.8% decline in the S&P 1500.

While tobacco litigation has given investors cause for concern in recent years, Joy believes the risks faced by the industry are much less daunting than a year ago, and he believes the legal environment should continue to improve. The most important near-term litigation threat to the industry, notes Joy, is the Engle class-action case in Florida, which resulted in a $145 billion damage award against the industry. Joy views the enormous award as "an aberration" and believes it's likely to be overturned on appeal.

FRIENDLY ENVIRONMENT. Given that there is a Republican in the White House, Joy believes the industry will benefit from a more tobacco-friendly regulatory environment over the next few years. He thinks it is likely that the federal government will drop its lawsuit against the industry. Also, Joy says the risk of increases to the federal excise tax has diminished.

Smokers are feeling the effect of the 1998 Master Settlement Agreement with states' attorneys general as cigarette manufacturers continue to push through price hikes to fund litigation and settlement payments. Manufacturers raised prices three times in the past year, with the most recent hike adding 6%-7% to the price of a pack of cigarettes. Since a price hike typically doesn't have much of an effect on the number of cigarettes sold, tobacco companies' earnings should show decent growth in coming quarters. With S&P's expectation for annual declines in domestic cigarette consumption of 1%-2%, long-term earnings growth will likely have to rely heavily on price increases and continued growth abroad, says Joy.

Industry leader Philip Morris Cos. (MO) has diversified beyond cigarettes and recently announced that it would change its corporate name to Altira to reflect its broader mix of businesses. In an effort to bulk up its already huge food business, Big Mo completed the $19.2 billion acquisition of Nabisco Holdings Corp. in December, 2000. The company completed the initial public offering of 16% of its newly merged Kraft/Nabisco foods unit in June, 2001.

S&P Relative Strength Rankings

These industries carry six-month relative strength rankings of "5" as of Feb. 15, 2002 -- meaning that they're in the top 10% of the 115 industries in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600) based on prior six-month price performance.


Largest Company (Market Cap.)


Air Freight & Couriers/Industrials

FedEx (FDX)


Casinos & Gaming/Consumer Discretionary

Park Place Entertainment (PPE)


Catalog Retail/Consumer Discretionary

Lands' End (LE)


Computer & Electronics Retail/Consumer Discretionary

Best Buy (BBY)


Fertilizers & Agricultural Chemicals/Materials

IMC Global (IGL)


Homebuilding/Consumer Discretionary

KB Homes (KBH)


Industrial Gases/Materials

Praxair (PX)


Meat, Poultry & Fish/Consumer Staples

Tyson Foods (TSN)


Metal & Glass Containers/Materials

Pactiv Corp.(PTV)


Tobacco/Consumer Discretionary

Philip Morris (MO)


Water Utilities/Utilities

Amer. Water Works (AWK)


* S&P's ranking system for the appreciation potential of stocks over a 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief sector strategist for Standard & Poor's

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