To many people, it's hard to justify investing in companies that make such unloved products as tobacco, weapons or even alcohol. But income investors can find lots of reasons to like tobacco and alcohol stocks, namely their defensive nature and the fact that they typically perform quite well.
Despite well-known health hazards, there are still plenty of people who smoke and drink, making demand for these products quite reliable. In addition, many of these stocks pay enticingly rich dividends. That's because, like gambling and adult entertainment, tobacco and alcohol stocks fall into a stigmatized niche of the investment universe known as "sin stocks."
Because of the social stigma attached to sin stocks, many endowments and pension funds shy away from owning them. Few institutional holders help to keep the prices of these stocks reasonable and dividend yields high. The fact that sin stocks often have all the best characteristics of a value stock makes these excellent long-term investments.
Here are four sin stocks whose steady performance and generous yields are nothing to be ashamed of...
1. AmBev (NYSE: ABV)
AmBev is the leading brewer in Canada, Brazil and most of Latin America. Its portfolio of globally-recognized brands includes Brahma, Skol, Antarctica, Quilmes, Labatt, Pilsen and Pacena. This company is benefiting from the rise of a middle class in Latin America and the increasing appetite of these consumers for premium beers.
AmBev is owned by the much larger Anheuser-Busch InBev (NYSE: BUD), but trades separately as an American depositary receipt (ADR). The company has more cash than debt and generates enormous cash flow totaling $6.8 billion during the past 12 months.
Return on equity is impressive at 34%, and earnings and dividend growth are reliable. In the past five years, AmBev has produced 17% yearly earnings per share (EPS) growth and 36% annual dividend growth. Payout is reasonable at 43% of cash flow. AmBev currently pays a $1.44 annual dividend that yields almost 4%.
2. Altria Group (NYSE: MO)
Altria Group owns Phillip Morris and Marlboro brand cigarettes, which is the United States' top-selling brand, with a greater than 40% market share. The company also owns smokeless tobacco brands Skoal and Copenhagen, Chateau Ste. Michelle and Columbia Crest brand wines, as well as a 27% stake in brewer SABMiller, which owns the Miller and Coors beer brands.
Altria Group plans to grow profits by repositioning its premium cigarette brand for long-term growth. The company launched its new Marlboro Black brand in December and has already garnered a 1% market share. Altria Group is also stepping up investment in new smokeless tobacco products, while reducing overall costs. A new restructuring program is expected to trim $400 million from annual expenses next year.
The company anticipates delivering 6%-9% earnings growth this year and targets long-term earnings growth averaging 7%-9% annually. Payout targeted at 80% means dividends should grow roughly in-line with earnings. Although recent dividend increases have been erratic, Altria Group has raised dividends 45 times in 42 years. The last was an 8% hike in August 2011 to a $1.64 annual rate, good for a yield of roughly 5%.
3. British American Tobacco plc (NYSE: BTI)
British American Tobacco (BAT) is the world's second-largest tobacco company, with a 38% global market share. The company's four global brands -- Dunhill, Kent, Lucky Strike and Pall Mall -- cover the premium and value-priced segments, which grew by 8.5% last year.
BAT enjoys broad exposure to emerging markets, which account for 60% of profits. While tobacco use has been steadily waning in Western countries, it is on the rise in Asia and Africa.
In the past five years, BAT has improved earnings 11% a year and raised dividends at an 18% annual pace. The company is hugely profitable and boasts a trailing 12-month return on equity of 37.5%. Cash flow is also robust at $9.2 billion, nearly twice the amount of stated earnings the company has posted during the past two years.
BAT is also less volatile than the overall market. Shares carry a beta value of less than 0.5, meaning it is half as volatile as the broader market. BAT pays dividends twice a year, with payout at 65% of earnings. The last dividend increase was in February to a new forward annualized rate of $5.71, yielding almost 6%.
4. Reynolds American Inc. (NYSE: RAI)
Reynolds American is this country's second largest tobacco company, with a 28% share of the U.S. market. This company owns three of the five top-selling U.S. cigarette brands -- Camel, Pall Mall and Winston.
Because of declining tobacco use in the United States, recent earnings growth has been modest at just 4% a year, but the company has been implementing aggressive plans to boost profits by strengthening its core cigarette brands, streamlining operations and entering new higher growth tobacco product categories. As a result, Reynolds now owns the industry's fastest-growing premium cigarette brands (Camel and Natural American Spirit), the No. 1 value brand (Pall Mall, which BAT makes internationally) and the fastest-growing snuff brand (Grizzly). Analysts say Reynolds American can nearly double annual earnings growth to 7% for the next five years.
Reynolds has raised its dividend every year since 2005 and this month hiked payments 5% to a $2.24 annualized rate. Payout is high but manageable at 68% of cash flow and the yield is attractive at roughly 5.5%.
Risks to Consider: AmBev and British American Tobacco are ADRs that pay dividends in foreign currencies, which could bring risk from currency fluctuations. Also, dividends from foreign companies are typically taxed at much higher rates, often 25% or higher. U.S. investors can file for a foreign tax credit from the Internal Revenue Service on shares held in a regular brokerage account, but can't recover withheld foreign tax from shares held in a tax-deferred account.
Action to take --> All of these four companies offer safety and high dividends, but my top picks are AmBev and British American Tobacco because of their expanding and strong presence in faster-growing emerging markets. Reynolds American and Altria Group are suitable investments for those who look for high yields and more of a turnaround story.