Why Are You Still Buying U.S. Tobacco?

This really puzzles me: Right now Altria (NYS: MO) and Lorillard (NYS: LO) are five-star picks on Motley Fool CAPS, our online community of investors. And Reynolds American (NYS: RAI) (to which I've given a bearish CAPscall) somehow gets a respectable three stars.

Why? What is it, exactly, that draws you Fools to these stocks?

Is it their amazing track record of shareholder returns? Past performance, as the saying goes, is not indicative of future returns.

Is it their big, fat 5% dividends?

You do realize that the dividend is -- at most -- your entire expected return here? This is because these companies are now paying out all of their free cash flow in dividends (and share buybacks, in Lorillard's case) with de minimis reinvestment.

This is to be expected, as declining businesses have little need for free cash flow. But this does mean that the dividend yield (plus buybacks for Lorillard) likely overestimates what your future annual return will be. U.S. tobacco volume continues to fall by about 4% per year, which isn't surprising considering fewer people are smoking and those who smoke are smoking less. At some point, price increases won't offset volume declines, and the dividend, which, again, is your whole expected return here, will have to be cut.

So, for taking on tons of regulatory risk, interest rate risk (they're basically perpetual bonds), and a business in decline, you're getting an expected return of less than 5%. Does that sound rational to you? Sounds like a nasty case of dividend addiction to me.

If you really, really, insist on yield -- which is never advisable -- then go with junk bonds. They offer just as much growth opportunity (read: none) and a higher yield at 7%, with less risk than U.S. tobacco equity. The SPDR Barclays Capital High Yield Bond is an easy way to play 'em in a stock portfolio.

But really, there's no point in reaching for yield. Great and growing businesses like Coca-Cola or Budweiser offer the steady returns of U.S. tobacco without the risk. Or head overseas for the much superior Philip Morris International (NYS: PM) .

At some point, U.S. tobacco could go up in smoke. Don't let your portfolio go up with it.

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The article Why Are You Still Buying U.S. Tobacco? originally appeared on Fool.com.

Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbaines. Chris' stock picks and pans have outperformed 96% of players on CAPS. He owns no shares of the companies mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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