What tobacco stocks can teach investors

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You can hate tobacco stocks, but don't hate the sound investing strategies they represent.

Many investors see tobacco stocks as a clear violation of their ethical principles: Owning them is tantamount to aligning yourself with cancer and addiction.

Fair enough. But these stocks also embody time-tested approaches to successful investing that appear especially important today, when stock valuations are at their loftiest since the 1990s and investors are enamoured by high-risk concepts such as marijuana stocks and bitcoin.

Tobacco stocks have endured it all – and dazzled for decades by generating enormous profit and dividends. For example, Altria Group Inc. (I confess: I recently bought this stock) has delivered a return of more than 1,800 per cent over the past 20 years, including dividends, making it one of the best-performing stocks in the S&P 500 over this period. And this return doesn't include the substantial benefit of the Kraft Foods Inc. spinoff in 2007.

Even strict ethical investors should marvel at that and perhaps glean some takeaways that can be applied to more wholesome sectors of the market.

An unpopular stock is not a bad stock

No one really likes tobacco companies, even smokers. What's more, the sector is in decline as more people become aware of the health risks associated with smoking.

According to the U.S. Centers for Disease Control and Prevention, 15.1 per cent of American adults smoked in 2015, down from 20.9 per cent a decade earlier. But is any of this a problem? Not at all.

Through diversification, consolidation with rivals and steady price increases, tobacco companies have thrived.

Altria – one of the few remaining publicly traded tobacco companies – offers a particularly clear illustration of this success. The owner of the Marlboro brand of cigarettes reported a profit (after adjusting for some divestments) of nearly $5.8-billion (U.S.) in 2016, up from about $4.2-billion in 2011 – a 38-per-cent increase in five years. The current goal is to increase profit at a clip of 7 per cent to 9 per cent a year.

Valuation matters

Amazon.com Inc. has a price-to-earnings ratio of 348. The P/E for Netflix Inc. is 232. If something goes wrong here, there's a long way to fall.

But since tobacco stocks are the opposite of trendy – they're often vilified – valuations tend to be held in check rather than swing wildly. Altria trades at 22.6-times trailing profit, while Philip Morris International Inc. trades at 24.3-times profit.

Are they cheap? Not exactly. But in a runaway bull market, they look reasonable. And some analysts believe tobacco stock valuations are compelling given the tailwind of U.S. tax cuts.

Perhaps more important, stocks with low or stable valuations suggest limited downside risks if anything goes wrong – and plenty of upside opportunity if profits continue to rise.

Dividends rule

Investors stick with tobacco stocks for the dividends: Altria has increased its distribution 51 times in 48 years and the quarterly payout has doubled since 2009, to 66 cents a share.

These steady increases have been giving the share price a nice boost. And they provide a pleasant cushion if there is a selloff, since dividend yields rise as share prices fall.

Not every company needs to pay a dividend to succeed with investors. But as Altria's long-term performance shows, it sure helps.

Brands are moats

The massive size of big tobacco companies gives them an efficiency that's hard to match by newcomers. More importantly, strict new regulations on marketing and advertising cigarettes raise the value of established brands, since upstarts now have a hard time getting the word out about their own.

This makes the top cigarette brands, from Marlboro to Newport to Camel, fit nicely with Warren Buffett's preference for companies that are surrounded by enduring "moats," or entrenched competitive advantages that ensure high returns for years to come.

Long-term performance is what matters

Tobacco companies are constantly being bashed by near-term issues. On Thursday, a panel advising the U.S. Food and Drug Administration raised concerns that an electronic tobacco device made by Philip Morris might not lower the risk of smoking-related illnesses. The news briefly skewered the share prices of Philip Morris and Altria and it dashed hopes that their iQOS device could offset declining smoking rates.

But tobacco companies have faced innumerable setbacks before. Large tobacco companies agreed in 1998 to pay U.S. states more than $200-billion over 25 years, they've had severe marketing restrictions placed on them and they are facing nicotine limits imposed by the FDA in order to make cigarettes less addictive.

However, investors who have tuned out the noise and remained invested through the challenging times have been rewarded with outstanding returns. You don't have to be a tobacco investor to appreciate the benefits of staying invested for the long run.