Sectors to Avoid in 2012: Tobacco

Tobacco stocks have excelled in 2011 thanks to their attractive combination of
low valuations, high dividend yields and ability to hold up well in a tough
economic environment. The Dow Jones U.S. Tobacco Industry ranked fourth of 98
industry groups year-to-date through Dec. 2, and seven of its 11 components had
posted double-digit returns for the year through Monday. The year-to-date
numbers for some of the leading names in the group are impressive: Altria Group
(NYSE: MO ) +17%, Philip Morris International (NYSE: PM ) +29%, Reynolds
American (NYSE: RAI ) +25% and Lorillard (NYSE: LO ) +33%. In comparison, the
S&P 500 is in slightly negative territory. Click to Enlarge Now, as we head into
2012, the sector is beginning to look a bit stretched based on historical
measures. While the fundamentals for this group remain solid, it might be time
to exercise some caution rather than betting on a continuation of the
yield/safety trade of 2011. In terms of valuations, the group no longer is as
attractive as it was a year ago. Looking at the major U.S.-based tobacco stocks
for which data is available, current P/Es sit at a combined premium of 16.6% to
their five-year average. The average trailing P/E of these five stocks is now
16.4, well above the 14.4 trailing P/E of the S&P 500 Index. Yields remain well
above the market average, but here too the picture has become much less
favorable. On average, the major tobacco stocks now yield 4.9%, well below their
February high of 6%. The yield on the S&P 500 was about 1.9% both then and now,
indicating that the yield spread for tobacco shares has gone from about 410
basis points to 300, a decline of 27%. As is the case with the utilities sector
, which presents a similar picture of high historical valuations and substantial
year-to-date outperformance relative to the broader market, tobacco isn't a
market segment that looks primed for a substantial downturn anytime soon. After
all, this is a group populated with slow, steady growers with low betas and
above-market dividend yields. Instead, the message is that these stocks have
risen to levels where investors no longer can blindly throw cash at them and
expect outperformance. A revival of investors' animal spirits, a rotation
toward cyclicals or a rise in Treasury yields or a more likely outcome, the
combination of all three likely would send tobacco stocks down the performance
charts in short order. The bottom line: Popular support for high-dividend
tobacco stocks has become almost universal. A look at the headlines for Philip
Morris on Yahoo! Finance shows no fewer than 15 articles, in the past week
alone, that cite the stock favorably because of its high dividend. At a time of
nearly unanimous positive sentiment, it appears a contrarian stance might be in
order. So think twice before you follow the breathless advice on tobacco shares
or you just might see your performance go up in smoke. As of this writing,
Daniel Putnam did not hold a position in any of the aforementioned stocks. Check
out InvestorPlace.coms other looks back at 2011 and ahead to 2012 here .