A Naughty Stock for the Christmas Season

What industry has comparable price returns to the S&P 500 Index but more than double the dividend yield and half the volatility?

I'll give you a hint. It happens to be one of the most despised industries in the world but sells a product that its users cannot seem to live without.

I'm talking, of course, about cigarettes.

In past articles I have written that “sin stocks”—i.e., publicly traded companies involved in producing guilty pleasures such as alcohol, tobacco and gaming—make good investments because the social stigma associated with the companies tends to depress their share prices, thus allowing investors with no such moral qualms to buy them at attractive prices.

Thus, sin stocks tend to behave like value stocks, much to the benefit of patient investors. This is why the Vice Fund (VICEX), which invests only in “naughty” stocks, has thoroughly trounced the S&P 500 Index during its short life.

THE GOOD SIDE OF BEHAVING BADLY

Generally, the benefits of a vice portfolio are only obvious after several years of compounding and reinvesting dividends. But this year, tobacco stocks are some of the best performing of all stock market sectors. It is not hard to understand why.

After taking a beating during the 2008 meltdown in financial stocks that, in retrospect, they did not fully understand, investors are attracted to the simplicity of tobacco. This is an industry that is older than the United States itself and has survived lawsuit after lawsuit and a secular shift away from cigarette smoking in popular culture.

Perhaps more important, with bonds yielding practically nothing these days, investors are hungry for income. Tobacco stocks pay some of the highest and most reliable dividends to be found. Tobacco companies also have a long history of increasing their dividends year after year.

MY PICK

My recommendation this week is Lorillard Inc. LO, the third largest manufacturer of cigarettes in the United States and the oldest continuously operating tobacco company. Newport, Lorillard's premium menthol-flavored cigarette brand, is the top-selling menthol and second largest selling cigarette in the United States.

In Lorillard, we get a company trading at a bargain price of less than 12 times projected 2011 earnings that yields a very respectable 5.4 percent in dividends. Lorillard increased its dividend by 12.5% in 2010, and further increases are expected in the years ahead. This is one reason the shares recently pushed through to new all-time highs and show little sign of slowing down.

So long as the Fed maintains its aggressive monetary policy, income-oriented investments such as Lorillard should continue to outperform.

Action to take: Buy shares of Lorillard at market. Plan to hold for a minimum of six to 12 months or for a total return of 30 percent

CAVEAT EMPTOR

I see political and litigation risk as the primary threats to this investment. The FDA has made noise about regulating or even banning menthol cigarettes—which, needless to say, would wreck Lorillard's business model.

I suspect that the FDA will resist any such urges given the importance of tobacco taxes to cash-strapped state governments, but in the event that I am wrong, use an initial stop loss of 10-15%.

Charles Lewis Sizemore, CFA

This article originally appeared in SFO Weekly.

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