They call it the evil weed, but returns sure are good

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Good people sometimes do bad things, like invest in cigarette companies. But can you blame them?

Tobacco stocks are renowned for their rising dividends, high yields and steady earnings, which have tended to make even vehement non-smokers look upon them with a certain longing.

Recently, though, they have been looking attractive for another reason: Share prices have been on a winning streak, driven to record highs by recent legal and regulatory decisions and concerns about inflation - and some observers believe the trend will continue.

The S&P 500 tobacco index of four stocks - Altria Group Inc. , Lorillard Inc. , Philip Morris International Inc. and Reynolds American Inc. - has gained 121 per cent over the past five years to the end of March, after factoring in dividends. Over the same period, the S&P 500 has risen a mere 14 per cent.

These tobacco stocks have also outperformed the broad index year-to-date and over the past 12 months, by a factor of three.

As a shareholder in Altria and Philip Morris, I have mixed feelings about these gains: I like what they've done to my portfolio, but I suspect that I'm amassing some bad karma in the process.

Fortunately, I share this burden with a number of analysts and fund managers, not to mention U.S. law courts that have tended to side with tobacco companies in recent rulings.

Florida's Supreme Court threw out a $145-billion (U.S.) class action lawsuit against tobacco companies in 2006, and an individual lawsuit last month ruled that the plaintiff was 90-per-cent responsible for his cigarette-related illnesses.

"Ten years ago at this time, it was just the opposite," said Jack Russo, an analyst at Edward Jones. "I think what some of the courts are now ruling is that we've known for a long, long time that this product is bad for you. There have been ample warnings."

In March, a much-anticipated report from an advisory committee to the U.S. Food and Drug Administration slammed menthol cigarettes but stopped short of advising an outright ban on the product, which was seen as a victory for tobacco companies.

This shifting legal and regulatory backdrop does not lift the ethical concerns about investing in this sector, but it does suggest that tobacco companies are unlikely to be legislated into bankruptcy.

Meanwhile, tobacco stocks are seen as being immune to some of the top concerns facing many other industries - and not just an economic slowdown.

"When you think about what everyone loses sleep over, tobacco companies are a hedge against those risks," said Nik Modi, an analyst at UBS.

"Tobacco companies don't really have a lot of inflation risk because they have so much buying power versus their supplier base. People are also concerned about pricing power. Well, we know that tobacco stocks have pricing power."

Indeed, the price of an average pack of smokes has surged about 70 per cent over the past decade. Yes, smoking rates are nowhere near where they once were. However, Mr. Modi believes that rates have levelled off in the United States over the past several years, and these price increases ensure that the industry is more profitable than ever.

But with tobacco stocks up so much, can investors expect more gains ahead?

Jeff Middleswart, manager of the USA Mutuals Vice Fund, puts things into perspective: He believes that the broader market - which has surged over the past two years, partly due to stimulus efforts from the Federal Reserve - will struggle to live up to its long-term average return of 9 to 10 per cent a year. However, tobacco stocks should be able to deliver those sorts of gains easily.

A typical dividend yield on a tobacco stock gives investors 6 per cent, companies are buying back at least 1 per cent of their shares every year and earnings are growing at a 2-per-cent clip through cigarette price increases alone.

Add these numbers up and "now you're at a 9 -per-cent return without these companies doing anything," Mr. Middleswart said. "Given their consistency in maintaining this hidden-growth, total return story, I think you're still going to get a 10- to 12-per-cent return out of these things."

How can good people resist?