2 Reasons Why Philip Morris Belongs In a Well-Diversified Portfolio

Source: Thinkstock

Source: Thinkstock

Philip Morris (NYSE:PM) has missed out on the outsized gains that we have seen in the tobacco space this year, and there are a couple reasons for this—both of which stem from the fact that the company operates exclusively overseas. The first is that the consolidation between Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO) make the competitive landscape in the United States easier to navigate. With fewer players competing for the same market each player will have more pricing power and fewer marketing strategies to worry about.

The second reason is that the company earns its profits in foreign currencies—especially in emerging markets—and many of these currencies have been weak against the dollar year over year. This makes the company’s earnings look worse by comparison.

As a result the stock is actually down about 3 percent for the year even though the rest of the sector has easily beaten the S&P 500.

Now an initial glance at the company’s Q2 earnings show why the stock is underperforming—net income fell 13 percent. But if we correct for currency fluctuations and one-time items the company actually reported a 9.5 percent increase in income. If we adjust earnings per share we see a 20 percent gain—thanks to an aggressive stock repurchase program. If we adjust revenues for currency fluctuations we see a gain of 1.5 percent. In short we see a company with modest growth and successful cost cutting measures.

Generally I think this is a bad way to look at things. After all we can make all sorts of adjustments to any company’s earnings in order to bias the bullish or bearish case. But I think we need to take a look at the disparity between the company’s actual vs. adjusted numbers in the context of the stock’s performance, and what you want to achieve in owning shares of Philip Morris.

It seems that investors are largely uninterested in the “adjusted” numbers, and as a result their bearishness stems from a similar stance on the currencies that the company is exposed to. But for investors who either (a) are bullish of foreign currencies and/or bearish of the U. S. dollar, or (b) want an investment vehicle with relatively stable cash-flow that gives them foreign currency exposure Philip Morris stands out as an excellent choice, and a solid alternative over foreign bond funds which not only have relatively low coupons but which are taxed at a higher rate than the capital gains rate.

In short, Philip Morris is a diversified foreign bond fund with favorable tax treatment so long as you hold the stock for more than a year in order to lock in the capital gains rate. Of course the bears might counter that the tobacco industry is slowly dying as people smoke less. This is certainly true in parts of the world. But there are a couple of problems with this argument. First, one place where this is true is the United States, and the American tobacco companies have been performing well, and they trade with a 20 percent premium on a price to earnings basis to Philip Morris.

Second, Philip Morris has exposure to several growth markets. Smoking doesn’t come with the same social stigmas in many developing countries—especially Asia—that we have in the United States. In fact it is a sign of wealth and prestige because smokers have disposable income with which to buy American-designed products.

With this in mind Philip Morris certainly doesn’t have the upside potential that an exciting biotech stock has. But it does have strong cash-flow and shareholder friendly policies that make it similar to a bond. With a price to earnings multiple of about 16.5 it is similar to a bond that yields 6 percent with the potential to grow and with exposure to foreign currencies. Given these points Philip Morris shares make sense in a well-diversified portfolio, especially now that the stock is out of favor.

[mediagraph-partner content_url=”9806dd68f898175e62a83da6″]

Disclosure: Ben Kramer-Miller has no position in Philip Morris or in any of the stocks mentioned in this article.

More From Wall St. Cheat Sheet: