Why tobacco stocks’ downturn is likely to go up in smoke

When tobacco stocks are tumbling, buy tobacco stocks. I did.

After Philip Morris International Inc. reported its first-quarter financial results on Thursday morning, its shares slumped a head-spinning 14.6 per cent.

According to Bloomberg News, that marked the worst one-day slide in a decade for the company that sells Marlboro cigarettes, and other brands, outside the United States.

The sell-off dragged down others in the sector. British American Tobacco Industries fell 11.5 per cent. Altria Group, which sells Marlboro cigarettes and other brands within the United States, fell about 6.1 per cent (full disclosure: I own this stock and bought additional shares midday on Thursday).

The reason for the widespread panic? While Philip Morris reported a relatively stable profit and raised its full-year profit forecast for 2018, its cigarette shipments fell 5.3 per cent.

Just as alarming, shipments of what’s known as heated tobacco, using a proprietary device called iQOS, were disappointing. Although sales doubled during the quarter, the increase in Japan was slower than projected.

Philip Morris management said that the market for heated tobacco may require more time – ugly words for investors expecting quick gains.

Clearly, the sector-wide sell-off reflects concerns that the rate of traditional smoking – in decline for many years in North America – is now approaching some sort of tipping point, where rising prices will no longer offset a declining market. And heated tobacco offers an unclear solution.

That’s great news for anyone who abhors smoking, an activity that accounts for about 480,000 deaths in the United States each year, according to the Centers for Disease Control and Prevention. The CDC reports that the smoking rate among U.S. adults declined to 15.5 per cent in 2016, down from 20.9 per cent in 2005.

But all this butting out is not so great for investors who can handle the murky ethics of essentially aligning themselves with a business that profits from nicotine addiction.

So have we really turned a corner, where tobacco companies will no longer generate the gargantuan long-term returns they’ve been known for?

I don’t think so, which is why I bought Altria – a sister company to Philip Morris – on the dip. My refusal to believe that conditions for tobacco companies have changed significantly rests on three assumptions.

One, there have been sell-offs before where investors have doubted the staying power of tobacco companies, and they have all been great buying opportunities.

Most notably, under the tobacco master settlement agreement of 1998, tobacco companies agreed to pay billions of dollars to offset U.S. health care costs, raising concerns about the tobacco sector’s viability. Stocks were hammered. Twenty years later, though, these companies continue to thrive.

Two, while smoking rates are falling, it is not clear that rates will ultimately hit zero. They could easily plateau at some low-ish number, giving tobacco companies the ability to rise along with population growth and price increases.

Rising heated tobacco use is a bonus, of course. But if its acceptance takes more time, I’m okay with that.

And lastly, the biggest attraction to tobacco stocks is their dividends – big, steadily rising dividends − and they aren’t going anywhere. Altria distributes about 80 per cent of its adjusted earnings to shareholders, for an annualized payout that is now US$2.80 a share.

After Thursday’s sell-off, the yield on Altria shares is now about 5 per cent, which suggests the shares are cheap. The yield on Philip Morris shares is similarly attractive.

“We believe the severe selloff in PM’s stock today is very overdone,” Bonnie Herzog, an analyst at Wells Fargo, said in a note.

Even if Philip Morris has to trim its 2018 profit forecast − and just to be clear, profits are expected to rise − Ms. Herzog said that the downside risk “is more than priced in and encourage long-term investors to use today’s extreme weakness as an entry point in the stock.”

Not convinced? Then wait for Altria to report its first-quarter results on April 26, which should provide more information about the sector − and its potential rewards.