SWMAY - Tobacco Trifecta: Go Where The Yields Are With Altria Philip Morris And British American Tobacco

Summary

• I've been getting reader requests lately for where to find yields better than the roughly 5% rate that cash is expected to pay in 2023.
• Well, here's one approach. Tobacco stocks are perennially cheap and feature hefty dividend yields.
• MO, PM, and BTI are 3 tobacco stocks with yields of 8.4%, 5%, and 7.1%, respectively.
• A lot of high-yield investments carry hidden risks and gotchas, but the tobacco industry's risks are known unknowns and priced into the stocks. Furthermore, most of this risk can be diversified away.

It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty."

- Warren Buffett, on the tobacco industry.

Reader requests/questions often make good articles. After a brutal 2022, the main theme this year from reader questions has been where to find safe yield. The main answer, of course, is in money market funds, now paying nearly 4.5% and soon to pay about 5%. But for investors comfortable with taking some risk in exchange for higher returns, tobacco stocks offer a nice risk-reward setup due to their high cash flows, relative unpopularity with investors, and low valuations.

Should you bet the farm on tobacco stocks? I wouldn't go all in. However, tobacco stocks are nearly unrivaled for how low the valuations they trade for, how much they're willing to pay out to shareholders, and for how good their businesses are compared with other low-multiple stocks.

• Altria ( MO ) trades for 9.3x earnings and an 8.4% dividend yield.
• Philip Morris International ( PM ) trades for 17x and a 5% dividend yield.
• British American Tobacco ( BTI ) trades for 8.1x and a 7.1% dividend yield.

This isn't rocket science - buy now and collect dividends in cash for the next 20-30+ years, whatever they may be.

1. Altria

Altria (formerly known as Philip Morris) is the granddaddy of tobacco stocks. Altria is famous for being the highest-return stock in the S&P 500 (when counting dividends) over the last 100 years. Despite this, it's perennially cheap and currently trades for about 9x 2023 earnings estimates. That's good for an earnings yield of about 11.1%, of which 8.4% is paid out as a dividend.

Of course, if somebody gave you $1,000,000 yesterday you could park it in a money market fund like Vanguard's Federal Money Market Fund ( VMFXX ) and get 4.5% risk-free on the way to 5% with more Fed hikes. But you could just as easily peel off a little money and put it in Altria and get 8.4%. The math is fairly favorable here- if you put $10,000 in MO stock, you've bought yourself $840 in annual income- and if you put $10,000 in a couple of other tobacco stocks you'd be up to about $2,000 in annual recurring dividends. Granted, it's a small piece of your overall investing puzzle, but companies have a very strong tendency to continue paying dividends, so I'd view your odds of recovering your initial investment as high as long as people keep smoking. Tobacco volumes had fallen in the years before COVID, but they shot right back up during the pandemic. Volumes are likely to fall somewhat going forward, but with the average pack of cigarettes costing $6-7 (and most of this is tax), there's some room to offset volume declines with price increases.

The earnings stability is quite solid here, analysts expect $5.00 in earnings for 2023 against $3.76 in dividends, and earnings should grow to $5.24 in 2024, giving some room to hike the dividend a bit. You're probably asking "what's the catch?" which is a sensible thing to ask. First, tobacco stocks have always been cheap, and investors have always underestimated how resilient cigarette sales are to policy changes. Second, Altria went big a few years back on acquiring part of the infamous e-cigarette maker Juul and cannabis company Cronos Group ( CRON ). Neither acquisition worked out well for the company, causing them to take big write-downs, most recently for a few hundred million dollars on some Cronos warrants .

The Juul acquisition cost them $13 billion for very little return, so investors have put MO stock in the penalty box with a low valuation. MO also owns a 10% stake in Anheuser-Busch ( BUD ) which the company can raise cash from in the future if needed. Warren Buffett once joked about wanting to buy companies that could be run by a ham sandwich , because someday they would be. Fortunately, if you sell cigarettes, a ham sandwich could run your business. Altria currently makes about $12.2 billion before interest and taxes each year, so if you subtract about $1.1 billion for interest, that's about $11.1 billion in pretax profit. Altria's market cap is only $80 billion, and profit is expected to rise this year. Subtract some taxes and everything comes out in the wash to make MO trade for about 9x 2023 EPS.

For its part, MO trying to grow. The company is obviously aware of the rise of e-cigarettes, and while their first try with Juul didn't pan out, they've entered into a joint venture with Japan Tobacco ( JAPAY ) to sell e-cigarettes (more on this from Altria's last quarterly conference call ). Altria reports earnings next on February 1st, which should give more clarity as to their plans going forward. All that has to happen for you to profit handsomely from owning MO stock is for management to not actively screw things up. Typically, things actually work out with these as long as the underlying business is sound. I've had success buying Bank of America ( BAC ) and Exxon Mobil ( XOM ) after they made bad acquisitions and got relegated to the investor penalty box, but in fairness, I also liked MO when it was more expensive. For what it's worth, they should be able to turn things around, but the best defense against management screwups is not hope, but diversification. Hence, why you should buy multiple tobacco stocks and not bet it all on MO management, even though I think you're getting more than enough compensation from MO's low valuation. How much money is MO going to make over the next 20-30 years? And how much does it trade for now? Likely far, far less than it will make. This is an easy hand to bet.

2. Philip Morris International

Philip Morris International is Altria's sleeker, international cousin, legally based in America but run out of Lausanne, Switzerland. Philip Morris sells boatloads of cigarettes in markets like Indonesia, Japan, Turkey, and the various countries of the EU. Since there is strong population growth in emerging market countries and because tobacco is so ubiquitous, PM is much more of a growth stock than MO, and it's removed from many of the political considerations that constrain the amount of growth that MO could have in the US.

Philip Morris International does not sell cigarettes in the US but is in talks to buy a stake in Juul, and bought the rights to sell its IQOS vape technology in the US from Altria as well. PM is a great pair to Altria because of its broad geographical diversification and emphasis on different areas of business. Generally, when cigarette volumes are seen as decreasing, a chunk of this is simply going to e-cigarette sales. PM has a dividend yield of 5% vs. MO's 8.4%, but if you split it down the middle, you get a combined yield of 6.7% and a combined PE ratio of 13. This to me is more attractive than either company in isolation because you combine the value of MO with the growth of PM. Another nice way these stocks complement each other is with respect to changes in the US dollar. MO is domestic, while PM is international, so if the US dollar weakens or strengthens, the effects should roughly cancel out for shareholders who own both stocks. PM is taking a hit from its decision to exit the Russian market, but other markets are pulling through very well for them, as should their investment in Swedish Match ( SWMAY ).

So is PM better than MO overall? Some will argue that MO is better because of its low valuation and higher yield, while others will argue that PM is better due to its international positioning and superior growth prospects. PM is another easy hand to bet. PM has good growth prospects, a reasonable valuation, and a dividend that pays you to wait on what they can do with getting their smokeless tobacco approved in the US.

3. British American Tobacco

Third and last is British American Tobacco, the quieter cousin to MO and PM. BTI sports a dividend yield of 7.1% and a PE ratio of 8.1x, even lower than Altria. BTI lacks the depth of analyst coverage that Altria and Philip Morris International have, but they've been around the block, known for brands such as Lucky Strike, Camel, and Newport. Like Philip Morris International, BTI sells globally but also has exposure to the US. The company has a sensible strategy for smokeless tobacco and is more conservatively run than Altria.

The main issue for BTI is that the dividend is paid in British pounds, so it lacks the "stability" that investors look for when buying the 8.4% yield that MO has. However, if the US dollar takes a dive, then you might get a higher yield with BTI. Seeking Alpha author Dividend Sensei has suggested that the yield could be as high as 9.5% if the GBP recovers to where it was in early 2021. If you want certainty, your choice is easy, I'd just put your money in a money market fund and call it a day. But if you want to make a bet on a cash-flow-rich business, BTI seems to be giving you enough compensation for your risk, and then some. BTI has similar demographic exposure to Philip Morris and actually outsells PM in terms of revenue despite having a lower market cap. Take value where you see it here and buy some BTI if you own PM or like tobacco stocks.

Conclusion

By taking a bit of exposure to Altria, Philip Morris International, and British American Tobacco, you can create a type of mini-portfolio (like a poor man's ETF) that diversifies away most of the geographic and management risk of owning any one tobacco stock in isolation. Do tobacco stocks have a place in your portfolio? They're not for everyone. I personally don't smoke but don't mind if others do. With dividend yields ranging from 5-9% in tobacco stocks, adding a dose of MO, BTI, and PM to your portfolio can help boost your dividend yield and diversify your portfolio against a weakening economy. Heads you win, tails you don't lose much - I'd throw some money in now and take the dividends in cash over the coming decades.

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