Some readers may be surprised that (Altria) is a top performer for investors in the face of the onslaught of government restrictions and legal actions that have cost the firm tens of billions of dollars and threaten the cigarette manufacturer with bankruptcy. But in the capital markets, bad news for the firm often is transformed into good news for investors. Many shun the stock in the company and fear that its legal liability for producing a dangerous product--cigarettes--will eventually crush the firm. This aversion to the firm pushes down the price of (Altria's) shares and raises the return to investors who stick with the stock. As long as the firm survives and continues to be very profitable, paying out a good fraction of its earnings in the form of dividends, investors will continue to do extraordinarily well.
--- "The Future For Investors," Jeremy J. Siegel explaining why Altria (MO) "has been the golden company that beat the market by 9 percent per year over the last half century and left every other firm far behind in the race to be number one (through 2003)."
In Siegel's now somewhat dated book, readers learned of the magnificent returns one could garner by holding a solid dividend-paying company that is continuously pressured with uncertainty through both the ups and downs of its share price. The reinvested dividends during the troughs of a firm's stock price often find a way of propelling the overall return of that stock to meaningful outperformance when the shares ultimately reach new highs during optimistic times. We tend to agree with Siegel on this point and believe Altria Group to be a core position on our Best Ideas list.
As we had outlined previously in our take on the FDA's recent action to put new, larger warning labels on the packaging and advertising of cigarettes come fall of next year, we don't expect such new labeling to have a material impact on the domestic cigarette-making industry. For one, cigarette smoking in the US has already been in decline for years (see chart below), and the FDA's projections for the number of those that will likely quit as a result of the new, larger warning labels is but a drop in the bucket compared with the 46 million Americans who currently smoke.
(Click chart to expand)
If Altria's share price begins to face pressure in anticipation of the impact of such new labeling next year, we'd be looking to increase our exposure to the firm. Not only would it then garner a higher yield than today's levels of about 5.7% under that scenario, but any market overreaction would further enhance our total return via reinvested dividends at the bottom should the stock return to new highs. Altria is currently targeting roughly an 80% payout ratio, and with expectations for the firm to earn nearly $2.20 per share by 2012, we could see as much as 15% dividend growth in two years to an annual payout of over $1.70 per share, which represents a projected yield of 6.5% based on its current share price. We also think Altria is undervalued on a discounted cash-flow basis, and we have made our valuation model template available, if investors would like to derive their own estimate of Altria's fair value.
Given the uncertain economic climate and the defensive characteristics of the tobacco industry, we have also added Reynolds American (RAI) to our watch list. The firm boasts a similar yield (5.7%) and target payout ratio (80% of earnings), and its innovative capsule technology is driving share increases in Camel's menthol category, a trend perhaps overlooked by the investment community. With expectations for the firm to earn about $2.84 in 2012, the company has a projected yield of just over 6% at current share price levels, slightly below that of Altria. We continue to watch this firm opportunistically.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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