Tobacco is one of the most unloved sectors of the stock market, but it is a great option for dividends. We analyze the pros and cons of investing in tobacco.
- Risks of Investing in Tobacco
- Pros of Investing in Tobacco
- How to Invest in Tobacco Companies
When it comes to controversial sectors, tobacco is one of the first that come to mind. The idea of making money selling cigarettes may sound appalling to many investors.
On the one hand, smokers are adults perfectly capable of taking their own decisions. They are all aware of the harmful health effects of tobacco, given that information is plentiful.
But on the other hand, the idea of investing in tobacco may cause some rejection in many investors. In a way, we do not want to sponsor a company selling something that is not good for society. Alcoholic beverages or fast food can cause a very similar reaction.
Additionally, many institutional investors decided a long time ago that they did not want to own any investments in tobacco companies. Both ethical reasons and government regulations contributed to that.
However, and as we will see below, there are arguments both for and against investing in tobacco. And what may seem negative for shareholders at first can turn out to be very positive.
Risks of Investing in Tobacco
Let us first discuss the many risks involved in investing in tobacco:
Government Regulation as a Risk
The biggest risk tobacco companies face in the 21st century is regulation and fines. Although it is already a highly regulated industry, which raises vast amounts of money in tax revenues, things can always get worse.
And since tobacco is very harmful for people’s health, there would be very little popular opposition if government decided to impose additional taxes, or even outright bans.
The society of the 21st century is very diverse. But certain trends can be observed across the different socioeconomic groups.
One of those trends is that the amount of young people who smoke has been steadily going down for many years. There is more awareness about health, and healthier habits are embraced.
As a result, it is likely that demand for cigarettes will decrease in the future, thereby reducing overall revenue and profits for tobacco companies.
The main reason why many investors are reluctant to invest in tobacco companies are ethical considerations. We do not want to feel like we may be contributing to the spread of a harmful and addictive substance.
Consequently, investor demand for tobacco stocks is lower than what we would expect for a sector with the profitability and defensiveness of the tobacco sector.
It is worth highlighting that many institutional investors, such as large pension funds, divested from the sector many years ago. However, as we will discuss below, that can be interpreted in a positive way.
Nevertheless, for many investors investing in shares of a tobacco company does not mean that they endorse or supports the product. It is simply a pragmatic decision. Since the company will continue to exist and workers will continue to smoke, they just decide to take advantage of that.
Pros of Investing in Tobacco
Next, we discuss the reasons why it may be a good idea to invest in tobacco. All these reasons have to do with the nature of the sector, and the ethical and legal issues surrounding it:
Many Institutional Investors Can’t Invest in Tobacco
For a few decades now, many institutional investors can no longer invest in certain economic sectors.
Originally, this was about ethical choices. But this became outright prohibitions later on, as new regulations were introduced.
Regardless of how we got there, many large institutional investors, such as pension funds and foundations cannot invest in tobacco. And even many fund management companies have taken measures to prevent their fund managers from investing in this sector.
For example, there are no longer any ETFs focusing on the tobacco sector.
This all results in less competition when it comes to investing in tobacco companies, which makes their stock prices artificially low.
Unloved Sector by many Investors
Leaving aside those investors who cannot invest in tobacco companies, many investors who can prefer not to.
Such a preference may be due to moral issues. But there is also a large part of the investment community that is afraid that governments will impose additional restrictions on the sector, thereby causing losses.
The result is the same as in the previous point: the existing demand for these shares is artificially low, driving their prices lower.
The consequence of the two points we have just discussed is obvious. If the number of potential investors is much smaller than for other sectors, the amount of money that will flow to tobacco companies will also be smaller.
Less demand leads to lower prices. And lower prices for profitable companies translate into very attractive valuations.
The truth is that tobacco shares trade at very cheap valuations. If we look at metrics such as the P/E ratio or the price to sales ratio, we will realize that these stocks look like real bargains relative to companies in other sectors, or the general stock market.
An easy way to see this is by comparing the levels of profitability, margins, growth, or debt of companies in different sectors. If we do, we will realize that tobacco stocks are so cheap because of the simple fact that they sell cigarettes, instead of sneakers or industrial machinery.
Another positive aspect about investing in tobacco companies is that they are able to generate extremely stable profits, regardless of the state of the economy.
This makes it a defensive sector, not affected by the economic cycle. After all, smoking is an addiction. One of the first thing smokers will spend their money on is cigarettes.
If we take a look at the income statement of most tobacco companies, we will see that they have been able to generate consistent and uninterrupted profits for many decades.
For this reason, adding tobacco stocks to our investment portfolio can cushion the drop that other sectors may suffer in the event of an economic crisis and an increase in unemployment.
Due to the consistency of their profits and the fact that there are not many opportunities for these companies to grow their business, apart from raising prices or expanding into new countries, tobacco companies are the perfect candidates to pay very solid dividends to their shareholders.
I personally think obsessing over dividends is not helpful. At the end of the day, what we investors want is not companies that necessarily pay a lot of dividends, but that generate large profits. Profits can then be distributed to the shareholders or reinvested.
However, what stands out about these companies is that their dividends are very high and at the same time look sustainable. We can find several companies with a dividend yield above 7%.
Government Regulation as a Pro
It may come as a surprise that we mention government regulation as a positive aspect for investing in tobacco. But it is really something that can play in our favor.
This is because it is precisely the regulations imposed by the government that make it difficult for new companies to enter the sector. That keeps competition within the sector artificially low, so companies can maintain high prices for their cigarettes.
At the same time, because governments do not allow advertising in virtually any way, these companies do not spend any money on marketing. And, since what they sell is addictive, sales will happen anyway.
All this means that it is government regulation in the first place keeping these companies’ margin high and their profits so robust.
How to Invest in Tobacco Companies
For those who want to invest in tobacco companies, they may be wondering how to do it. And, because there is no ETF that invests exclusively in the sector, the only option is to buy shares of individual tobacco companies.
If we want to invest in the sector, but we want to limit our exposure to any one company, we can buy shares of several of these companies, making our investment in tobacco more diversified.
Some of the most prominent companies of the sector would be British American Tobacco, Imperial Brands, Philip Morris, Altria, and Japan Tobacco.
Investing in tobacco is not for everyone. On the one hand, there are ethical issues for which many people prefer not to do it, even if they can see that they present an attractive investment opportunity.
On the other hand, because they are companies in a mature sector, and with little growth, it is very difficult to achieve extraordinary returns in the short term. Therefore, many investors would find them boring.
But for those pragmatic investors, who simply think that the world is not perfect and are respectful of other people’s choices, tobacco can be a great investment. It can generate us very attractive returns over the long run with limited risk to negative economic shocks.
As always, my goal is not to give you any investment advice, but to make information available to you, so that you can take the best decisions for yourself.
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