The Most Promising Dividends in Tobacco

Dividend payers deserve a berth in any long-term stock portfolio. But seemingly attractive dividend yields are not always as fetching as they may appear. Let's see which companies in the tobacco industry offer the most promising dividends.

Yields, and growth rates, and payout ratios, oh my!
Before we get to those companies, though, you should understand just whyyou'd want to own dividend payers. These stocks can contribute a huge chunk of growth to your portfolio in good times, and bolster it during market downturns.

As my colleague Matt Koppenheffer has noted: "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."

When hunting for promising dividend payers, unsophisticated investors will often just look for the highest yields they can find. While these stocks will indeed pay out the most, the yield figures apply only for the current year. Extremely steep dividend yields can be precarious, and even solid ones are vulnerable to dividend cuts.

When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors:

  • The current yield

  • The dividend growth

  • The payout ratio

If a company has a middling dividend yield, but a history of increasing its payment substantially from year to year, it deserves extra consideration. A $3 dividend can become $7.80 in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.

Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. That money can fund the business's expansion, pay off debt, buy back shares, or even buy other companies. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.

Peering into tobacco
Dividend investors typically focus first on yield. On that count, Vector Group (NYS: VGR) stands out, recently yielding 9.3%. But it's not necessarily your best bet, as it's paying out far more than it's earning, and has taken on a lot of debt, leaving its dividend in danger of being cut. The company specializes in selling discount cigarettes in the U.S., where the base of smokers is shrinking, and increased regulations and rising taxes are making life more difficult for tobacco companies. Altria (NYS: MO) , yielding 5.1%, is in a similar situation, though it has far more brand power, such as with Marlboro. Altria is also growing its smokeless tobacco business, and has a big stake in alcohol company SAB Miller.

Instead, let's focus on the dividend growth rate first, where British American Tobacco leads the way, with a five-year average annual dividend growth rate of 15%. But its recent yield is just 2.5%, considerably lower than other tobacco dividends. Lorillard (NYS: LO) and Philip Morris International (NYS: PM) , for example, recently yielded 4.9% and 3.4%, respectively, and both had average annual growth rates of nearly 14% over the past four years.

Philip Morris has attracted many investors -- its stock is up some 35% over the past year -- because it avoids many of the problems facing U.S.-focused tobacco companies. It does face headwinds from Europe's financial crises, but it also serves fast-growing Asia. Its stock may not seem a bargain at the moment, but it does seem a reasonable value.

Lorillard, meanwhile, has impressed many, exhibiting six out of eight traits of a perfect stock, and growing its revenue and earnings faster than the overall industry. Its main drawback at the moment is a sizable debt load, but it does generate a lot of free cash flow, which makes the debt less worrisome. It has expanded into the promising electronic-cigarette field, and it owns the second-largest cigarette brand in the U.S., Newport.

Tobacco wholesaler Universal (NYS: UVV) , recently yielding 4.1%, also looks attractive, but its dividend growth rate has been growing more slowly, at 2.1%. Its revenue and earnings have generally been shrinking recently, too, though its last quarter showed some improvement. Management pointed to lower prices and oversupply as factors, but sees that turning around in the near future.

Some tobacco-related companies, such as Alliance One International and Star Scientific, don't pay dividends at all. That's because smaller or fast-growing companies often prefer to plow any excess cash into further growth, rather than pay it out to shareholders.

Just right
As I see it, Philip Morris, Altria, and Lorillard offer the best combination of dividend traits, sporting some solid income now, and a good chance of strong dividend growth in the future.

Of course, as with all stocks, you'll want to look into more than just a company's dividend situation before making a purchase decision. Still, these stocks' compelling dividends make them great places to start your search, particularly if you're excited by the prospects for this industry.

Do your portfolio a favor. Don't ignore the growth you can gain from powerful dividend payers.

If you're searching for solid dividend payers and would rather avoid the stigma of big tobacco, we've put together a special free report outlining nine top dividend-paying stocks. Access your copy today at no cost! Just click here.

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Longtime Fool contributorSelena Maranjian, whom you canfollow on Twitter, holds no position in any company mentioned.Click hereto see her holdings and a short bio. The Motley Fool has adisclosure policy.

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