Tobacco companies have produced great returns for shareholders.

If you’re looking for an investment that’s resistant to economic downturns, pays a reasonably high income and has a track record of increasing dividends, you might fancy having a look at the tobacco sector.

Many investors will refuse to invest in tobacco companies on ethical grounds. That is a perfectly understandable position since their main product, cigarettes, if used as advertised will harm the health of the vast majority of its users. It is incontrovertible that regular smoking takes several years off a person’s life expectancy and will be the primary cause of death for roughly half of all smokers. That’s a more than adequate reason for any investor wanting to have nothing to do with tobacco.

But tobacco is a perfectly legal product and will remain so for the foreseeable future, if only because the nation’s finances would be in an even more parlous state without the taxes that tobacco produces. So if you do not have an ethical objection to their business then tobacco companies are one investment that should definitely appear on your radar.
Cheap and Addictive

Warren Buffett once said “I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.” That sums up tobacco; your customers will keep coming back for more to feed their addiction. Sometimes customers buy cheaper brands, which are often produced by the same firm, or buy bootleg cigarettes imported from continental Europe for which the tobacco company has already been paid. Some smokers quit the habit but most just keep on buying, even when their income falls during a recession.

The quoted British tobacco sector contains just two companies, British American Tobacco (LSE: BATS) and Imperial Tobacco (LSE: IMT), both of which are in the FTSE 100 index. Neither firm is dependent upon the UK market; the vast majority of their sales coming from the rest of the world.

Company Historic Dividend yield Historic Price-Earnings Ratio
British American Tobacco 4.9% 13.7
Imperial Tobacco 4.0% 11.6

British American Tobacco can justify its higher P/E ratio because it has doubled its dividend in the last five years whereas Imperial Tobacco’s dividend has increased by 26%. BAT highlighted in its 2008 annual report that the compound annual growth in dividends and earnings per share in the last years were 13% and 11% respectively, which is an excellent return.

In early 2008 Imperial bought the Franco-Spanish firm, Altadis, the makers of Gauloises cheap cigarettes (one of the great symbols of French national identity). Its most recent six-month results showed that Imperial is experiencing a little indigestion with the costs of integrating this business, resulting in a loss. However, if we remove these costs to examine Imperial’s underlying businesses, earnings per share increased by 14% which is an excellent performance during a recession and highlights the defensive nature of tobacco shares. Analysts’ forecasts for the 2009 dividend are an increase of almost 11% to 70p per share.
Go West

Adventurous investors who are considering tobacco shares might consider looking abroad, particularly towards America. Whilst the unpredictable nature of the American courts used to make American tobacco companies extremely high risk investments, the passing of the “Tobacco Master Settlement Agreement” (MSA) in 1998 has meant that in 46 of the 50 states tobacco companies cannot be effectively sued by private citizens for any harm caused by tobacco. The MSA requires that the tobacco companies make payments to the states over a period of at least 25 years but, in theory, this is all priced into the shares.

The big three American tobacco firms are Altria, which used to be called Phillip Morris, Reynolds American and Lorillard, all of which have higher dividend yields and lower historic P/E ratios than their British counterparts.
Smoke and Politics

Sir Humphrey Appleby said in an early episode of Yes Prime Minister that smokers pay more in taxes than it costs the NHS to treat smoking-related illnesses (the current figures are that roughly £2 of tax is collected for every £1 spent on treatment). Sir Humphrey also pointed out that smokers also benefit society because they don’t collect the State Pension for as long as non-smokers, and that they provide a lot of jobs and income from exports. Sure, it’s an outrageous statement but it turns out to be the truth.

But the biggest risk with tobacco companies is political risk. Tobacco kills people; the future growth of tobacco firms depends on them spreading the smoking habit throughout the globe, particularly in the newly industrialising countries and the third world, which will increase their healthcare costs. The health lobby is a big worry for the tobacco industry, it is currently facing the possibility of restrictions on point-of-sale advertising (in Canada this was shown to have a minimal effect on sales).

Personally I can’t stand Marlboro cigarettes, but if others want to smoke them then that’s fine. Far too many people in today’s Britain want to ban any activity that they disapprove of. It’s worth noting that the smoking ban specifically does not apply to the bars and restaurants in Parliament. Clearly our MPs do not subscribe to the philosophy of Voltaire who said that “I disapprove of what you say, but I will defend to the death your right to say it.”

The history of prohibition tells us that banning smoking would be a particularly bad idea. Any politician who tried it would almost certainly be voted out of office and if it was banned, smoking would not drop significantly. Instead we’d end up with “smokeasies”, more organised crime and start looking for a new Elliot Ness to clean up the mess.

Whilst there has been a decline in the proportion of smokers over the last few decades in the developed world, the profits from tobacco keep on growing.
Summary

If you are looking for a relatively high and rising income that’s largely recession proof, and do not have any major ethical objections, tobacco companies are definitely worth some consideration.

source: http://www.fool.co.uk

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