Tobacco Stocks: Watch Your Ash!

By The Sizemore Letter

Victory for Big Tobacco investors

I like the occasional cigar after a hard week at the office, though I can hardly call myself a connoisseur.  And I’ve always been impressed by experienced smokers who can smoke their cigars down to a perfect ash without it crumbling off and landing in their laps.  I’ve seen ash still perfectly intact at 2-3 inches.

That’s impressive.  Though you’d never think for a moment that it was sustainable.  Eventually, the ash will break and fall to the floor.

This is how I feel when I look at tobacco stocks today.  And I say this as a long-time bull in sin stocks in general and tobacco stocks in particular.  Some of the best investments I have ever made have been in tobacco stocks.  But at current prices, I prefer to sit in the no-smoking section.

Over the past month, dividend-focused sectors such as utilities, MLPs and REITs have all trended down as investors worry about higher dividend taxes coming in 2013.  Yet Big Tobacco continues to drift higher like a smoke ring (another party trick I was never able to do).

Something is amiss here.  Tobacco is a zero-growth business.  Your only realistic source of return is from the dividend.  I would go so far as to say that tobacco stocks are the most-dividend-focused stocks of any sector or subsector.

I understand the appeal of tobacco stocks.  They are a defensive consumer staple and they represent stability in a volatile market.  And in a world where bonds yield less than 2% and savings accounts yield nothing, a 3-5% dividend can seem pretty attractive.

Yet the same arguments can be (and are) made of REITs and MLPs, and these also have far better potential for capital gains.  If investors are concerned about the fiscal cliff and dividend taxes, then they should be selling tobacco stocks along with their utilities and other income-oriented stocks.

Tobacco stocks are also shockingly expensive. Altria (NYSE:$MO), the maker of Marlboro among other brands, currently trades at 17 times earnings—significantly higher than the broader S&P 500.  Philip Morris International (NYSE:$PM) has a significantly lower dividend yield than chip juggernaut Intel (Nasdaq: $INTC).

Remember, we’re talking about tobacco here.  The substance that requires warning labels and gruesome graphics on the side of package…and a substance that fewer people use every passing year.  Tobacco stocks should trade at a discount to the broader market, and they generally do.  In fact, this chronic underpricing has been a major driver of returns over the past several decades.  But without the underpricing, I cannot consider tobacco stocks worthy of purchase.

Investors hunting for yield would be better off buying a basket of quality MLPs and REITs or even a dividend-focused ETF like the Vanguard Dividend Appreciation ETF (NYSE: $VIG).

Are tobacco stocks about to go up in smoke?

Maybe, maybe not.  As long as yields stay low, tobacco stock prices could stay high.  Still, the divergence from other dividend-focused sectors is a major red flag for me.

My recommendation: If you do not already own tobacco stocks, stay away.  If you do own highly-appreciated tobacco stocks, consider selling.  Or at least tighten your stop losses.  Sizemore Capital has sold most of its tobacco positions, but we have two long-term positions in Altria and Philip Morris International that we have held for multiple years.  But even on these positions, we are tightening our stop losses and preparing to sell at the first sign of weakness.

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