Judge Tobacco Stocks by Their Cover

by Charles Sizemore | July 16, 2013 9:19 am

Last month, I wrote that Australia’s plain-packaging law was one of the worst setbacks for Big Tobacco in decades because it attacked the companies’ single most valuable asset: their brands[1].

Big Tobacco has strong enough moats to survive high taxes, punishing lawsuits and an aging and declining customer base intact. But plain packaging threatens the industry at its very core, and this is something underappreciated by investors in the sector.

Longtime chain smokers light up for one very obvious reason: They are addicted to the nicotine. But for casual smokers — those who light up while drinking, for example — the experience matters, too.

I call it the “Rebel Without a Cause effect” … the devil-may-care image that goes along with smoking is part of what makes it pleasurable.

There is a certain appeal to Altria’s (MO[2]) familiar Marlboro logo. But there is most certainly no romance in a plain white box with a picture of a diseased lung on the flip-side.

If you think I’m making this up, consider the recent grumbles coming out of Australia. Following the implementation of the plain packaging law at the beginning of this year, Aussie smokers have complained that their cigarettes taste different[3].

The Australian health minister, quoted by The New York Times, insisted that there had been no change to the cigarettes themselves, but that “people being confronted with the ugly packaging made the psychological leap to disgusting taste.”

I’m not a cigarette smoker, though I do enjoy the occasional cigar. And I would insist that a cigar does indeed taste better when the smoker is wearing a suit and sitting in a comfortable leather chair surrounded by wall-to-wall shelves of old books. The very same cigar smoked in a plastic lawn chair while wearing Crocs just isn’t the same (and shame on any grown man for wearing Crocs outside of the pool, but I digress).

Rational? No. But nonetheless true.

It remains to be seen whether plain-packaging laws spread outside of Australia; they are being considered in Canada, India, the U.K. and in the European Union as a whole. Big Tobacco will argue that the ban violates their trademarks and seizes their intellectual property, and they might find a few sympathetic judges. But given the history of the anti-tobacco movement, it’s a lot more likely that Big Tobacco will fight a rearguard action for years before ultimately losing.

So, if the future is bleak, does this mean that you should avoid tobacco stocks like Altria, Reynolds American (RAI[4]) or Lorillard (LO[5])?

Not necessarily. As I’ve written before, industries in decline can be fantastically profitable investments under the right set of conditions[6]. But the most important condition is price, and on this count Big Tobacco looks far from attractive. Altria, Reynolds American and Lorillard trade for 17, 19 and 15 times earnings, respectively. Their dividends, while high by broad market standards, are all lower than 5%, with the stocks trading near multiyear or even all-time highs.

Dividend income is a major consideration in my investment process, but I am avoiding Big Tobacco at this time. I can get higher yields with comparable dividend growth rates in select REITs and MLPs[7], and I can get a much higher dividend growth rate in Big Tech names like Microsoft (MSFT[8]), Intel (INTC[9]) and Cisco (CSCO[10]).

Do I expect Big Tobacco stocks to take a nosedive in the immediate future? No, I don’t. I expect the sector to more or less track the market in the short-term.

But Big Tobacco investors should be aware that the single biggest factor in the sector’s outperformance of recent years — price — is no longer in their favor.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management.  As of this writing, Sizemore Capital was long MSFT, INTC, and CSCO.  Click here[11] to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.

  1. their brands: https://investorplace.com/2013/06/big-tobacco-botches-the-e-cig-name-game/
  2. MO: http://studio-5.financialcontent.com/investplace/quote?Symbol=MO
  3. Aussie smokers have complained that their cigarettes taste different: http://www.nytimes.com/2013/07/11/business/global/law-spoils-tobaccos-taste-australians-say.html
  4. RAI: http://studio-5.financialcontent.com/investplace/quote?Symbol=RAI
  5. LO: http://studio-5.financialcontent.com/investplace/quote?Symbol=LO
  6. industries in decline can be fantastically profitable investments under the right set of conditions: https://charlessizemore.com/are-coke-and-pepsi-the-new-big-tobacco/
  7. select REITs and MLPs: https://charlessizemore.com/2013-second-quarter-investment-outlook-and-commentary/
  8. MSFT: http://studio-5.financialcontent.com/investplace/quote?Symbol=MSFT
  9. INTC: http://studio-5.financialcontent.com/investplace/quote?Symbol=INTC
  10. CSCO: http://studio-5.financialcontent.com/investplace/quote?Symbol=CSCO
  11. Click here: https://order.investorplace.com/?sid=OA8158

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