When even the Winston man starts telling people that smoking is a drag, you've got to wonder if the tobacco business is on its way out.

Aside from the health risks associated with the use of tobacco and the changing perception of smoking in U.S. society, the industry has been slammed in the past five years by a host of state and federal lawsuits.

So the stocks of these companies should be dogs, right?

Well, not this year anyway. For example, take a look at the world's biggest tobacco company,

Philip Morris

(MO) - Get Report

. The second-best performer on the

Dow this year (

Boeing

(BA) - Get Report

is first), the stock has slapped on a 70% gain since February and is now trading near its 52 week high.

Some of Morris' spectacular rally represents recovery from earlier litigation worries as tobacco companies have begun winning suits against smokers. Adding to the lift is the feeling that Republican

George W. Bush

favors a withdrawal of a

Department of Justice

suit against the company.

But, tobacco stocks have also benefited from the rotation out of richly valued tech stocks and into consumer staples -- food, tobacco and health care.

The

American Stock Exchange Tobacco Index

illustrates that beautifully. The index hit a low on March 10 of this year, the very day that the

Nasdaq

hit its all-time peak. Since then, the index has risen 84% as the Nasdaq has fallen 40%. The index includes Philip Morris,

R.J. Reynolds

(RJR)

,

British American Tobacco

(BTI) - Get Report

,

UST

(UST) - Get Report

and

Loews

(LTR)

.

That the index has risen so much this year does not come as much of a surprise. Consumer staples tend to benefit from a slowing economy because their earnings are less sensitive to changes in growth. And Philip Morris is a leader in the consumer staples category. In fact, it's the world's second-biggest food company, with its

Kraft Foods

and

Miller Brewing

. It's also just completed an acquisition of snack giant

Nabisco

(NGH)

. It plans an initial public offering of Kraft in the first half of next year.

Tobacco Stocks Burn the Nasdaq
They take off as the Comp takes a dive

After a nice, robust rally this year, some bears worry about the fate of tobacco stocks. Many investors fret that while the litigation picture has improved, tobacco could still be junked by unfavorable court decisions, that with such a big rally behind them, the stocks could be whacked by a presidential victory by either

Vice President Al Gore

or by Bush, and that rising expectations of an interest-rate cut threaten to

derail this year's run-up.

The bulls see it differently. They say the legal thundercloud is lifting, that neither a Bush nor Gore would leave much of a footprint on the industry and that it will take a while before investors begin to move back into tech stocks in earnest.

Even if a rotation back into tech is right around the corner, they argue, Morris and other tobacco stocks are protected by lower valuations relative to other consumer staple stocks. Finally, MO's business continues to show a lot of muscle, and its acquisition of Nabisco is expected to be accretive to earnings.

Risky Business

The tobacco bears worry that the long roster of cases against tobacco companies makes these stocks very unpredictable and fear that a recent Florida ruling may bode poorly for the high-profile Engle case.

The

Florida Supreme Court

(sheesh, they've been busy!) upheld a jury verdict against a tobacco company for the first time last month. Encouraged by that outcome, plaintiffs in the Engle case might try to challenge the $100 million bonding cap. A bonding cap is a limit on the sum that defendants must post in lieu of immediate payment of damages when it loses a certified class action suit until an appeal is heard.

A larger bond requirement might not be manageable by some of the defendants, or could damage their credit ratings.

A week and a half ago, Circuit Court Judge Robert Paul Kaye ordered defendants in the Engle trial to pay up, upholding a previous ruling that awarded Florida smokers $145 billion in punitive damages.

The Engle suit is important because it was the first smoking-related class action suit to come to trial and receive a verdict. In July 1999, a jury decided in favor of the plaintiffs and found U.S. tobacco companies liable for fraud, negligence and illnesses related to smoking.

"Philip Morris was a good stock before litigation. Now, if you get in at the wrong time, it can get halved," says Howard Barlow, vice president for

WHB/Wolverine Asset Management

.

Two cases remain this year and another nine court battles are scheduled for the first half of 2001.

But the bulls argue that the litigation picture is improving. Precedents rejecting group claims are growing -- individual claims are more costly for plaintiffs and less so for defendants -- and cases remaining this year are viewed as being relatively harmless.

Out of the 27 cases in which motions for class certifications have been decided, courts have denied certification in 24. Meanwhile, all class actions in the federal courts have been decertified or denied class certification, even though some have been allowed to continue in state courts.

Merrill Lynch's

Sandhya Raju says the fact that a challenge to the bond cap has not been filed in the Engle case yet indicates that the appellate courts are close to taking over that case -- which means the case would have no effect on the industry for another year.

Finally, the remaining two cases scheduled for this year are less pressing.

Morgan Stanley Dean Witter's

bullish analyst David Adelman calls them lesser cases because one counters direct appellate precedent while the other relies on "novel legal theories." Raju says the cases are likely to be postponed until next year.

Elections, Schmections

Another fear the bears hold is that investors could play the "buy-the-rumor, sell-the-news" game on a Bush win. If a Bush presidency is already priced into tobacco stocks, and investors overdid it, they might sell if and when he emerges as the winner, thinking the stocks have topped out.

Raju believes that the federal government's case against big tobacco wouldn't be helped much by Gore or hindered by Bush, since it already has plenty of financial and legal hurdles to overcome before 2003, when the trial is scheduled to start.

Rotation in Motion

Anyway, barring a disastrous reaction to the presidential election or a major court loss, it still looks as if Philip Morris might have a little more room to climb.

For one, the stock is still trading well below its all-time high of $58.13, set two years ago, before it spiraled down on litigation worries to around $40.

MO Stands for Momentum
Philip Morris is really smokin' this year

Even if the

Fed does change its bias to neutral at its Dec. 19 meeting -- convincing the market that an interest rate cut is around the corner -- a full-blown rotation into tech probably won't take place until tech starts beating earnings estimates again. In the meantime, Morris' earnings growth should exceed that of the

S&P 500 for the next five quarters, according to Merrill Lynch.

In the event of a rotation, Morris may be protected, anyway, by a lower relative valuation when compared to other consumer staples stocks. "Philip Morris trades at a 50% discount to its consumer-staples peers due to litigation concerns," says Raju.

At $40 a share, Philip Morris' forward

price-to-earnings ratio is at 9.9. That's not so bad considering the S&P 500's food group has a forward P/E average of 23.7.

Tim Swanson, equity analyst at

A.G. Edwards

agrees, saying that it's companies like

Pepsi

(PEP) - Get Report

,

Anheuser-Busch

(BUD) - Get Report

and

Coke

(KO) - Get Report

that would get hit first by rotation.

"Clearly, if there is a true change in bias and the Fed looks to potentially ease interest rates moving forward, then I think you can assume some sector rotation into a tech market that has been handily beaten-down," says Swanson. "But, Philip Morris is still trading at attractive multiples because of the litigation risks, and their litigation environment improving."

At least to some, Philip Morris looks like a pretty good stock. On Dec. 8, Merrill Lynch's Raju raised her earnings estimates for 2001 on Philip Morris to $5.22 a share and her five-year growth rate estimates to 14% from 12%.

"The stock has had a nice run up," she says, "but we continue to expect it to outperform due to the more defensive market posture, improving fundamentals and reducing litigation risk."