Tobacco companies handed investors the best returns in the last decade when adjusted for volatility, and analysts at BNY Mellon Wealth Management and Janney Montgomery Scott LLC say that will continue as profits prove resilient amid economic turmoil.
The BLOOMBERG RISKLESS RETURN RANKING shows the MSCI World Tobacco Index had the highest return out of 67 groups in the MSCI World Index (MXWO) in the 10 years through 2011. The tobacco gauge, which comprises eight companies including Philip Morris International Inc. (PM) and Japan Tobacco Inc. (2914), advanced 13.3 percent after taking into account price swings, almost five times the gain of the broader measure.
Tobacco stocks brushed off surging volatility during the dot-com tumble, the worst financial crisis since the Great Depression and Europe’s debt crisis, because smokers are reluctant to scale back when cigarette prices rise or the economy struggles, so companies can give cash back to investors at a stable rate. The industry, which fended off multibillion dollar lawsuits over the past two decades, will weather more regulation and a review of whether to ban menthol, said Murray Kessler, head of Lorillard Inc. (LO), maker of Newport, the top- selling U.S. menthol cigarette.
“Will there be increased smoking restrictions and new rules? Yes,” Kessler said in an interview from Greensboro, North Carolina, where his company is based. “Underneath it all I expect a very stable cash flow and an ability to reward our shareholders.”
Tobacco’s risk-adjusted return over the past decade was 3.6 percentage points more than the next best performer, Internet and catalog retailers, and 4.2 percentage points more than the No. 3 industry, road and rail companies. The MSCI World Index returned 2.8 percent on that basis.
The risk-adjusted return, which isn’t annualized, is calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk. While Internet retailers produced the highest total return over the past decade, their volatility was more than 50 percent greater than that of tobacco stocks.
“Investors are willing to pay a premium for stability,” James Hallisey, a New York-based consumer analyst at BNY Mellon (BK) Wealth Management, which oversees about $168 billion, said in a telephone interview on Jan. 24. “Tobacco stocks with their strong, stable free-cash flow and high dividend yields are attractive” in an environment with “geopolitical risks, commodity inflation and currency fluctuations.”
The Chicago Board Options Exchange Volatility Index, or VIX, rose to a 29-month high of 48 last year on Aug. 8 after Standard & Poor’s cut the U.S.’s AAA credit rating. Volatility reached a record in November 2008 after Lehman Brothers Holdings Inc. (LEHMQ) collapsed, resulting in the biggest U.S. bankruptcy.
A higher volatility means the price of an asset can swing dramatically in a short period of time, increasing the potential for unexpected losses compared with a security whose price moves at a steady rate.
Cash flow from operations at tobacco companies has gained at a more stable pace than at peers. Cash flow from operations growth in the non-tobacco companies in the past 5 years was almost twice as volatile as in the tobacco industry, according to data compiled by Bloomberg.
They were also more profitable and returned more money to investors. Tobacco companies globally with at least $1 billion in market value had a median dividend yield of 5.1 percent in their latest fiscal years, compared with 1.5 percent for non- tobacco companies. The gross margin was 45 percent for the tobacco companies, and 34 percent for others.
The global tobacco gauge more than tripled in the last decade on an absolute basis, even as the S&P GSCI Index (SPGSCI) of 24 raw materials surged 281 percent and the global economy suffered a contraction in 2009. The MSCI World, which tracks equities in developed nations, advanced 18 percent during the same time, excluding dividends, the fourth-smallest return in a 10-year period since 1970, Bloomberg data show.
Bears say valuations are stretched and prices may become vulnerable. The tobacco index’s price-earnings ratio is 15.9, compared with the full measure’s multiple of 13.4. The group rallied 27 percent last year as investors sought dividend-paying stocks insulated from Europe’s debt crisis, according to Christopher Growe, an analyst at Stifel Nicolaus & Co. in St. Louis.
‘Not as Cheap’
“It’s hard to sit here and argue that” tobacco stocks are cheap, Dmitry Khaykin, a New York-based fund manager who helps oversee $4.5 billion for the Large-Cap Value Strategy Fund at Clearbridge Advisors, a unit of Legg Mason Inc. (LM) “They’re still very attractive given the stability of the business and compared with the alternatives in the marketplace but they’re certainly not as cheap as they used to be.”
The four largest U.S.-based tobacco companies -- Philip Morris, Altria Group Inc., Reynolds American Inc. (RAI) and Lorillard -- have slumped an average 5 percent this year. Valuations of tobacco companies going forward will depend on factors including whether interest rates will rise, damping the relative appeal of dividend-paying stocks, Khaykin said in a telephone interview on Jan. 24.
The MSCI World Tobacco Index returned 1.7 percent last year when adjusting for risk, the highest of all groups and about twice as much as the next best group, health-care technology. The MSCI World declined 0.2 percent last year on a risk-adjusted basis.
The companies’ financial strength has been underestimated by rating firms, data compiled by Bloomberg show. Altria Group Inc. (MO) and Reynolds American are the two most underrated companies in the Standard & Poor’s 500 Index, based on the difference between assessments from credit-rating companies and those given by Bloomberg. Altria’s one-year credit rating is A2, Bloomberg data show, while its long-term credit rating in the market is BBB. Lorillard is the 12th most-underrated.
Tobacco “is so reviled and under-owned by investors,” said Tom Russo, who manages more than $4 billion, including shares of Philip Morris, British American Tobacco Plc (BATS) and Altria, for Gardner Russo & Gardner in Lancaster, Pennsylvania. “The pressure from critics has made the industry more practical and pragmatic.”
U.S. cigarette makers will increase prices by about 15 cents a pack this year to mute shipment declines of about 3.5 percent, said Growe at Stifel Nicolaus. He recommends buying shares of Philip Morris and Lorillard and rates Altria and Reynolds as “hold.”
He projected industrywide per-share earnings growth of 10 percent, helped by stronger demand for smokeless tobacco and “aggressive share repurchase activity.” International tobacco earnings will outperform the U.S. industry this year, spurred by price increases and a slowdown in the rate of shipment declines, Growe said.
International sales made up 41 percent of Japan Tobacco’s sales in 2011 compared with 30 percent in 2006. Revenue from Asia, the Middle East and Africa more than doubled from 2006 to 2010 at British American Tobacco. Europe accounted for 34 percent of its sales in 2010, down from 41 percent in 2006.
Nearly one in five adults in the U.S. smoke, according to the Washington-based Campaign for Tobacco-Free Kids. The percentage is 28 percent in China and 35 percent in India, according to the group’s website.
Philip Morris, spun off by Altria in 2008, has spent $20.3 billion to repurchase 399.6 million shares since that time. The New York-based company, which makes all of its sales outside of the U.S., has increased its quarterly dividend by 67 percent since the spinoff while more than doubling its free cash flow to $2.8 billion as of Sept. 30.
“We are a tremendous cash-flow generator,” Philip Morris Chief Financial Officer Hermann Waldemer told analysts on a conference call Oct. 20. “Philip Morris is a company that has been able to deliver in the good and in the bad times.”
Waldemer and Chairman and Chief Executive Officer Louis Camilleri declined to be interviewed for this story, said Yuri Omelyanenko, a company spokesman in Lausanne, Switzerland.
The MSCI World Tobacco Index (MXWO0TB)’s dividend rate of 4.1 percent compared with the full measure’s 2.8 percent payout and 10-Year U.S. Treasury’s 1.79 percent yield will continue to lure investors, according to Hallisey.
“They are known to be steady, if not spectacular, investments,” Mark Luschini, chief investment strategist with Janney Montgomery Scott in Pittsburgh, said in a Jan. 25 telephone interview. “In difficult economic times, for people who smoke, it’s a simple pleasure at a time when you have to sacrifice other things.”
Luschini’s firm oversees about $54 billion in assets, including shares of Philip Morris International and British American Tobacco.
Kessler, a former Campbell Soup Co. (CPB) executive who went to work for smokeless tobacco maker UST Inc. in 2000, said even with the prospect of tighter regulation, a lot of the uncertainty facing the industry 10 to 15 years ago has been removed.
“I came into kind of a war zone” when joining UST, Kessler said. “The legal environment is always volatile, but frankly, it has improved over the past decade a lot.”