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Tobacco Stocks: Not for the Nervous Investor

Richard Widows

In a turbulent investment climate such as this, one of the oldest hedges against economic downturns emerges -- it also happens to be among the most maligned of businesses. Smokes. But those seeking relatively high dividend yields by investing in tobacco stocks should be aware that their returns come at a price.

Tobacco products, because of their addictive qualities, remain a relatively unscathed market even in uncertain economic times. And with the market ups and downs, these businesses could even see an increase in sales from smoking clientele looking to quell their nerves.

However, the steady cash returns from tobacco stocks come with some tradeoffs:

• They offer limited growth prospects, especially as tobacco customers die off (as smokers tend to suffer greater death rates actuarially than nonsmokers).
• These stocks represent investments in what some refer to as a "sin" sector, eschewed by "socially responsible" portfolio managers.
• These stocks' companies stand in the crosshairs of some former-customers-turned-angry-plaintiffs as well as tax-hungry legislators.
• Anti-smoking forces have been taking aim at retail distribution of cigarettes as well as venues for smoking and advertisements that they claim are targeting youth to replace the base of mature smokers.

These built-in risks, not to mention the currently treacherous stock market, should be enough to compel any investor interested in investing in tobacco stocks to first consider carefully their investment.

Still, if an investor is unbothered by moral arguments against tobacco and is willing to test the roily investment waters, some arguments exist for considering tobacco stocks. While growth in tobacco usage in the U.S. has stalled, possibly forever, the industry traditionally has been considered extremely resistant to economic downturns.

The resistance by smokers to forgo their tobacco products could provide an island of certitude in the current economic terra incognita. In addition, investors could decide that steady dividend checks from tobacco companies might help smooth the volatility in their other holdings.

Despite all of the negatives, tobacco remains as a large industry with a tenacious ability to survive the persistent anti-smoking onslaught. And the anti-tobacco forces recently took a hit when U.S. Supreme Court justices were said to edge closer to the industry's side in a case involving state lawsuits over deceptive advertising of "light" cigarettes.

Cigarettes and tobacco products expand beyond Philip Morris' (PM Quote) iconic Marlboro man, however. The following table highlights a pair of stocks with dividend yields of more than 7% and the highest grades from TheStreet.com Ratings for members of the tobacco industry.

First up is Vector Group (VGR Quote), a holding company engaged in the manufacture and sale of cigarettes in the U.S. via its Liggett Group subsidiary. The firm developed and markets the low-nicotine and nicotine-free Quest cigarette products through its Vector Tobacco division.

Founded in 1873 as Liggett & Myers, Vector's Liggett Group is the fifth-largest manufacturer of cigarettes in the U.S. in terms of unit sales. Liggett makes Pyramid, Jade and Eve 120's branded-discount products as well as Liggett Select in the deep-discount category. The company also produces a number of private-label and distributor-exclusive brands for a total of more than 240 brand styles.

Relatively small by tobacco-company standards with a market capitalization of just $1.06 billion, Vector's stock yields about 9.37%.

Next up is Reynolds American (RAI Quote), a holding company whose subsidiaries include R.J. Reynolds Tobacco, Scott Tobacco and various other companies.

Shares of Reynolds, which has a total market capitalization of $13.42 billion and a dividend yield of 7.43%, was recently trading at less than 10 times next year's projected earnings.

Reynolds' largest operating segment, RJR Tobacco, manufactures Camel, Kool, Pall Mall, Doral, Winston, Salem, Misty and Capri cigarette brands. Those brands, and its other brands, including Salem, Misty and Capri, are manufactured in a variety of styles and marketed in the U.S. to meet a range of adult-smoker preferences. RJR Tobacco also manages contract manufacturing of cigarettes and tobacco products through arrangements with British American Tobacco (BTI Quote).

RAI's Conwood division is a smokeless-tobacco manufacturer whose primary products include moist snuff brands, Grissly and Kodiak. Conwood also distributes a variety of other tobacco products, including Winchester and Captain Black little cigars.

The unique and controversial nature of the tobacco industry makes the standard warning to carefully consider the appropriateness of it as an investment all the more crucial. As with any investment, you can lose money. So, please remember to carefully monitor your holdings and/or place stop-loss orders to help protect you from sudden moves against your positions.