Tobacco Stocks May Thrive Despite FDA Regulation

Cars, alcohol and fatty foods also kill a lot of people every year, but Washington reserves its real wrath for cigarette makers.

President Barack Obama, who smokes the occasional cigarette himself, last week took the fresh air of the Rose Garden to sign the second anti-smoking law of his young administration. It gives the Food and Drug Administration power to regulate cigarettes for the first time, and imposes some new restrictions on marketing. An earlier law raised the federal tax to $1.01 per pack from 39 cents.

These laws may actually prove a net positive for tobacco stocks.

Why?

First, uncertainty surrounding the effects is keeping many shares cheap. Institutional investors in particular tend to shy away from stocks in these kinds of uncertain situations. As a result, tobacco stocks are languishing and dividend yields are hefty. Marlboro parent Altria yields 7.9%. Reynolds American stock yields about 9% - more, remarkably, than the bonds: Its 2016 bonds are yielding about 7.5% to maturity, the 2018 bonds, 8.3%.

Second, the new laws may help the big players by reducing independent competition. Adam Spielman, industry analyst at Citigroup, says industry profits have been held back in recent years in part by small, independent makers of cut-price cigarettes. He expects a lot of those companies to respond to the new regulatory burdens by closing up or selling out. A major beneficiary may be Britain’s Imperial Tobacco, which has been building market share at the discount end with brands like USA Gold and Sonoma.

Third, while the new laws may spur some people to quit smoking, many people have been trying to quit anyway -- they have been for years. That trend hasn’t hurt the industry because the companies’ profits have rises faster than their volumes have fallen. Cigarettes have still been a solid investment, because the companies generate so much cash and the shares have been cheap. Some numbers: If you had invested $100 in a broad stock market index fund at the start of 1985, you’d have about $1,100 today. If you’d invested that money in tobacco stocks, according to FactSet, you’d have more than $16,000.

Fourth, FDA regulation may actually help legitimize the industry - and further reduce the rapidly diminishing litigation risk.

Rising cigarette taxes will spur some people to trade down to cheaper cigarettes. But quitting - as the President’s own story shows - is a lot harder than it sounds . (From my own experience, I suggest reading Alan Carr’s “The Easy Way to Stop Smoking”. It worked for me).

The riskiest stock in the pack is probably Lorillard, because nearly all its profits come from menthol brand Newport. It is possible, in theory at least, that the FDA might ban menthol cigarettes. Analysts think it highly unlikely. But any investor who is nervous could buy some insurance against a total collapse in the stock. How? By purchasing “put options,” a type of contract that only pays out if a stock falls a long way. Lorillard stock is about $69. The January 2011 $40 put options, which will pay out if the stock falls below that level, cost about $2.10 per share.

Many people feel uncomfortable about the idea of investing in tobacco stocks and “profiting from smoking.” But if you benefit from any government services you already are. Average state, local and federal taxes come to about $2.14 per pack. Big government and big tobacco are increasingly hard to distinguish. That, too, may reassure investors.