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Tempted to invest in a U.S. tobacco stock? For Canadians, now's the time

If you’ve been wondering what to do with those hefty Canadian dollars rattling around your pockets, now could be an ideal time to invest in a U.S. tobacco stock.


If you've been wondering what to do with those hefty Canadian dollars rattling around your pockets, now could be an ideal time to invest in a U.S. tobacco stock.

The loonie is trading at about 79 cents against the U.S. dollar, up about 6 cents since the start of May, following hawkish comments from the Bank of Canada and a quarter-percentage-point rate hike last week.

That means you can now get more bang for your buck when shopping for U.S. stocks, and two stocks in particular look worthy of a closer look, given their big dividends, inspiring long-term performances, international diversification and competitive advantages: Philip Morris International Inc. and Altria Group Inc.

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Many investors steer clear of tobacco stocks because smoking is deadly. They believe that owning a tobacco stock would bring them far too close to tobacco profits, making them complicit in an unhealthy activity. These investors should read no further.

Others, though, may recognize that the performance of tobacco stocks is hard to ignore. Since Altria Group spun off Philip Morris in 2008, separating the domestic U.S. business (Altria) from the international operations of Philip Morris, the latter's shares have returned 249 per cent, including dividends. That is nearly double the return for the S&P 500 over the same period. Altria shares have performed even better, returning 428 per cent.

Both stocks have also outperformed the benchmark index since mid-November, when the market began to anticipate U.S. interest-rate hikes, raising concerns about dividend-generating stocks.

The gains have pushed the valuation on Philip Morris shares to more than 24 times estimated profit, which looks expensive given that smoking rates are declining.

But according to Bonnie Herzog, an analyst at Wells Fargo Securities, the stock is a deal given its ambitious foray into smoke-free tobacco products – branded iQOS – that some experts believe could be less harmful than traditional cigarettes.

"We believe [Philip Morris's] outperformance reflects in part the market starting to attribute some value to iQOS and its significant growth potential," Ms. Herzog said in a note, adding that iQOS looks and feels similar to a traditional cigarette.

She believes Philip Morris shares are worth $140 (U.S.) a share, based on the cash flows of its various operations, implying a gain of nearly 18 per cent from the current price of $119.

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She believes that iQOS alone should account for $35 of the $140 target, given the product's strong growth prospects. However, the smokeless division is currently being valued at just $14 a share – and this is what drives the attractiveness of the stock.

Over the next decade, Ms. Herzog expects iQOS will accelerate the company's operating profit to a cumulative annual growth rate of 15 per cent, displace up to 30 per cent of traditional combustible cigarette volume in developed markets and hand Philip Morris a 20-per-cent share of the market by 2025.

She believes that iQOS – developed by both Altria and Philip Morris – stands to be so successful that it could be a catalyst for reuniting the two companies, as part of a global consolidation trend among tobacco companies.

This thesis has been floating around for a couple of years, and shot down by management. However, it is now being fuelled by British American Tobacco PLC's $49-billion takeover of Reynolds American Inc. in January, which puts additional competitive pressure on rivals.

In other words, betting on Philip Morris or Altria could amount to the same bet some day.

Neither stock is cheap, and dividend yields are lower than they were before the financial crisis triggered a rush for yield. Philip Morris has a dividend yield of 3.5 per cent; Altria's is 3.3 per cent. Both were higher than 5 per cent as recently as 2010, before share prices began to rise considerably faster than dividend increases.

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But payouts are rising every year, so this shouldn't be a deal-breaker. And with the Canadian dollar substantially higher over the past several months, the stocks are now on sale.

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About the Author
Investing Reporter

David Berman has been writing about business and investing since 1995. He has written for a number of magazines, including Canadian Business and MoneySense. He worked at the Financial Post as an investing writer and daily columnist before moving to the Globe and Mail in 2008. More


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