Warning: Tobacco Shares Best Suited to Industry Loyalists

Tobacco stocks -- long despised by the public and a disappointment to investors -- have bottomed in recent weeks. Shares of Philip Morris (MO Quote) and Loews (LTR Quote), for example, hit their three-year lows in February and March and since then are up 21% and 6%, respectively. R.J. Reynolds (RJR Quote) is up even more, close to 50%.

But if you're jazzed up about the recent strength, take a closer look. You'll see a business that's less than thoroughly compelling.

The proximate cause of the rally is proposed legislation in Florida to remove the threat of bankruptcy facing the cigarette makers from a class-action lawsuit filed there. A six-member jury has ordered the industry to pay $12.7 million in compensatory damages to three sick smokers in the Engle case -- a class-action suit named for one of the plaintiffs, a Miami Beach pediatrician with emphysema.

But the millions in compensatory damages are nothing compared with the possible punitive damages the judge in the case could hit the companies with. Wall Street analysts have pegged these damages in the stupefying range of $100 billion to $300 billion. (To put that into context, the market capitalization of Philip Morris, the industry giant, is about $55 billion.) If the companies were forced to post a gargantuan bond to appeal the Engle case, the financial burden could force them into bankruptcy. ...