Tobacco Stocks: A Classic Defensive Play

S&P says industry fundamentals and stock momentum trends signal strong price performance ahead for shares in the group

Only three Standard & Poor's 500-stock index subindustries posted an increase in average price performance during the 11 market declines associated with recessions since World War II: Alcoholic Beverages, Household Products, and Tobacco. I guess that's the reason for the old Wall Street Saying "When the going gets tough, the tough go eating, smoking and drinking."

Since we all know that what worked in the past may not work again in the future, how have these groups held up during the equity market decline since Oct. 9, 2008? We see that two did relatively well, while the third did not. From Oct. 9, 2007 through Jan. 25, 2008, the S&P 500 Tobacco subindustry index rose 5.3%, vs. a 15% stumble for the S&P 500. In fact, only two other S&P 500 Consumer Staples subindustries posted positive results during this downturn: Agricultural Products (up 25.6%) and Hypermarkets (up 5.6%). The Household Products & Brewers groups also performed well on a relative basis, falling 6.9% and 10.6%, respectively. The Distillers & Vintners group did not outperform the broader market, however, as it fell 16.9%.

Tobacco Outperforms Market

Tobacco is the Consumer Staples subindustry with the highest average S&P STARS ranking, at 4.9 out of 5, implying the greatest potential price appreciation on a market-cap weighted basis. It also has a high 12-month relative strength ranking and a positive fundamental outlook by an S&P equity analyst. Year to date through Jan. 25, the S&P 1500 Tobacco Index fell 2.4%, compared to a 9.4% decline for the S&P 1500 Index. In 2007, this group rose 14.6% vs. a 3.6% rise for the S&P 1500.

Take a look at the accompanying chart of the Tobacco subindustry index's rolling 12-month price performance compared with that for the S&P 1500. Any point above 100 indicates sector outperformance vs. the S&P 1500 over the prior year, while points below 100 show sector underperformance. The red line is a rolling nine-month moving average, while the two green bands are one standard deviation above and below the index's average relative strength.

Esther Kwon, CFA, covers the tobacco subindustry for S&P Equity Research, and has a positive fundamental outlook for the group for the next 12 months, reflecting improvement in the litigation environment and positive pricing trends. Also, Kwon sees an easing of the competitive pressures in the U.S. cigarette market.

Litigation Successes

In September, 2004, a $280 billion Justice Dept. case against the industry commenced. In October, 2005, the $280 billion disgorgement claim was eliminated by the U.S. Supreme Court. S&P thinks elimination of the disgorgement claim and subsequent reduction in the monetary remedies in the Justice Dept.'s case was very positive for the tobacco industry. However the verdict, which awaits appeals, was against the industry, banning practices such as the use of "lights" in brand names.

Another significant win for the industry occurred in December, 2005, when the appeal of the Price/"Lights" class action was dismissed by the Illinois Supreme Court. A third major legal hurdle, the review of the $145 billion Engle verdict, resulted in dismissal by the Florida Supreme Court in July, 2006. More recently the U.S. Supreme Court ruled on the Williams case. In this second review, the court gave further guidance limiting excessive punitive damage awards. This review could have a far-reaching impact not only for the tobacco industry but for other consumer industries facing product liability litigation.

Closing the Discount Gap

Since late 1998, when cigarette manufacturers raised prices sharply as a result of the Master Settlement Agreement, deep-discount cigarette producers saw their market share rise from about 2% in 1998 to over 13% in 2003, on a 45% price discount to premium brands. Kwon thinks market-share growth for deep-discount brands has been declining since 2004, however, due to narrowing price gaps and aggressive marketing by the majors.

Despite S&P's expectation for a 2% to 3% decline in domestic consumption for the next two to three years, Kwon believes industry operating profits will rise modestly, as cost-saving efforts and merger synergies offset larger investment in focus brands. For the longer term she sees domestic cigarette consumption falling 1% to 2% a year.

So there you have it. From fundamental and momentum perspectives, S&P believes this subindustry index should continue to see strong price performances in the period ahead.

S&P's top pick in the subindustry is Altria Group (MO; $75.23). On Jan. 30 Kwon looks for the company's board to announce the timing for its planned spin-off of Philip Morris International, which she believes will be a catalyst for unlocking value in the stock. Kwon thinks an independent international unit, freed of U.S. regulatory and litigation constraints, will be able to accelerate growth. She has a 5 STARS (strong buy) ranking on the stock, and maintains an $85 price target.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of subindustries in the S&P 1500), along with a stock with the highest S&P STARS (tie goes to the highest market value).

Subindustry Company (Ticker) S&P STARS Rank Price (1/25/08)
Agricultural Products Archer-Daniels-Midland (ADM) 2 $42
Coal & Consumable Fuels Peabody Energy (BTU) 3 $56
Commodity Chemicals Georgia Gulf (GGC) 3 $6
Construction & Engineering Fluor (FLR) 4 $121
Construction & Farm Machinery Cummins (CMI) 4 $49
Diversified Metals & Mining Freeport-McMoRan Copper (FCX) 3 $84
Education Services Career Education (CECO) 5 $19
Fertilizers & Agr. Chem. Monsanto (MON) 3 $108
Health Care Services LabCorp (LH) 5 $74
Industrial Gases Air Products (APD) 3 $89
Internet Retail (AMZN) 2 $78
Oil & Gas Drilling Noble (NE) 5 $45
Oil & Gas Equip. & Svcs. Baker Hughes (BHI) 5 $72
Oil & Gas E&P Swift Energy (SFY) 5 $41

Source: Standard & Poor's Equity Research

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