Tobacco Stocks: They’re Still Smoking’

After getting off to a slow start in January, tobacco stocks are making up lost ground in a hurry.

Click to EnlargeOf the major American tobacco stocks, all but Reynolds American (NYSE:RAI) are beating the S&P 500 after dividends are taken into account. And even Reynolds beat the S&P 500 for the month of February.

Big Tobacco has been one of the few bright spots in recent years. With investors legitimately fearful about the state of the economy and the on-again/off-again volatility that has been roiling the stock market, stable and defensive sectors have been a popular refuge. And given that bonds pay so little these days as to be worthless — the 10-year Treasury note currently yields less than 2% — the high and growing dividends have made the sector attractive to income investors.

But as the risk of a eurozone meltdown continues to fade and investor risk tolerance starts to thaw, are tobacco stocks still an attractive investment? Or should investors rotate into more aggressive, cyclical sectors?

I know you want a simple “yes/no” answer here, but the truth is a little more complicated. The attractiveness of Big Tobacco depends on your time horizon.

I love Big Tobacco and “Sin Stocks” in general, and I have made several Sin Stocks — among them Altria (NYSE:MO), Philip Morris International (NYSE:PM) and Diageo (NYSE:DEO) — core recommendations of the Sizemore Investment Letter.

Over time, Big Tobacco stocks have massively outperformed virtually all other investments because of the stability of their businesses and the large dividends they typically pay. As Jeremy Siegel explained in The Future for Investors, the outperformance of tobacco stocks over time is due almost exclusively to the compounding effects of reinvested dividends.

But herein lies the key. Tobacco stocks are great long-term investments. A dividend reinvestment strategy takes years to fully realize, the last few years of stellar short-term gains notwithstanding.

But in any given short-term period (say, six months to five years), tobacco stocks are by no means a lock to outperform. They, like all other stock sectors, fall in and out of favor with changing investor sentiments.

With all of that said, I don’t believe that tobacco stocks will be big outperformers in 2012. I see 2012 favoring two broad sectors:

European stocks that took a beating last year; Europe is full of solid blue chips ripe for the picking, trading at prices we might never see again. More speculative sectors, such as emerging markets, technology and lower-quality “junky” stocks.

As investors rediscover their risk appetites, I see them chasing the sectors that promise higher immediate returns.
Does this mea
I’m selling my Big Tobacco stocks? Not a chance.

My standing recommendation is that investors build a core portfolio of rock-solid companies that pay high and rising dividends, of which tobacco stocks are a natural fit. This should be the bedrock of your portfolio for the next five to seven years, or at least for as long as other income alte
atives — such as bonds — are unattractive. I will not be recommending that my readers sell their tobacco any time soon.

But once the core portfolio is in place, investors can allocate new monies to more speculative areas of the market, such as Europe and emerging markets. As a rule of thumb, I would put 50%-70% of your assets in the core portfolio and use the remainder for shorter-term tactical trades.

In the meantime, sit back and continue to collect those Big Tobacco dividends.