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The dip in tobacco stocks over the past six months might be as bad as it gets.Lisi Niesner

Investors have done very well with tobacco stocks, even as smoking rates steadily decline. But an obstacle is now emerging in the form of rising bond yields.

Are tobacco stocks still worth owning after tumbling nearly 9 per cent since the summer? You bet.

Of course, you have to get around a thorny ethical issue before starting any discussion about tobacco stocks. Smoking kills about 100 Canadians each day, according to Health Canada. Infants also die from the effects of second-hand smoke, making tobacco stocks the No. 1 enemy of anyone who prefers ethically sound investments.

But if you can look beyond this issue, tobacco stocks have one compelling feature: They deliver awesome returns over the long term – and there is no reason to believe that this trend is about to unwind.

The shares of Altria Group Inc., the go-to name in the sector and owner of the Marlboro brand of cigarettes, have risen 228 per cent over the past decade (to the end of November), versus 57 per cent for the S&P 500.

Add in dividends, the best feature, and Altria's gains over this period expand to 455 per cent. Over 20 years, total returns balloon to an incredible 2,162 per cent.

What's remarkable is that smoking rates, and the actual number of smokers, has been declining. This week, the Centers for Disease Control and Prevention reported that the number of U.S. smokers dropped below 40 million for the first time since it began tracking the data 50 years ago. From 2005 to 2015, the smoking rate shrank to 15 per cent from 21 per cent.

For just about any business, this would cause a big dent in profits – but this is the tobacco business, where addiction and brand identity give companies the luxury of raising prices, more than offsetting a shrinking market. Just last month, Altria hiked prices on its cigarette brands between 2 per cent and 3 per cent.

Altria has also been snapping up rivals – including Canada's Rothmans Inc., in 2008 – and diversifying into wine, beer, cigars and vapour cigarettes.

The impact since 2008, after Altria spun off Philip Morris International Inc. and its stake in Kraft Foods, is profound: Revenue rose more than $3-billion (U.S.), to an expected $19.4-billion in 2016, according to Bloomberg. Profit on a per-share basis has grown almost threefold.

Rivals have enjoyed similar success amid frenetic consolidation. Reynolds American Inc. – which owns the Camel brand – have risen 480 per cent over 10 years. The company recently snapped up Lorillard LLC in a $27-billion (U.S.) deal in 2015, and is now the subject of an unsolicited $47-billion offer from British American Tobacco PLC.

But the great years for shareholders coincided with falling bond yields, which made dividend-paying stocks especially attractive. As a result, dividend yields went down, down, down – hitting a low of 3.2 per cent, in the case of Altria in mid-2016, down from more than 6 per cent in 2008.

Altria's dividend increased over this period, but share prices rose even faster.

Now, though, bond yields are rising. The yield on the 10-year U.S. Treasury bond rose above 2.4 per cent earlier this month, up dramatically from just 1.4 per cent in July, as investors anticipate faster U.S. economic growth, rising interest rates and higher inflation. Suddenly, tobacco dividends look less attractive, which is why share prices have sold off.

This looks like an opportunity, for two reasons.

First, the move in bond yields is anticipating changes that haven't actually occurred. While the Federal Reserve is expected to raise its key interest rate in December, rosy forecasts of economic growth and inflation must overcome a global economy that continues to plod along. The dip in tobacco stocks over the past six months might be as bad as it gets.

Second, tobacco companies are generous with their dividends. Altria has raised its dividend 50 times over the past 47 years, and currently distributes about 80 per cent of its profit to shareholders. Since 2008, the company has doubled its quarterly dividend.

If the pace continues, which is a reasonable assumption, the rising payouts should offset concerns about higher bond yields.

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