Will tobacco stocks increase in price in future?

Looking at tobacco stocks right now, they look really cheap to me.

For example, British American Tobacco yields 8.2% and sells at a price-to-earnings ratio of less than eight. Across the pond, it’s a similar story. Altria yields 8.1% and has a P/E ratio beneath 10.

Normally, seeing such juicy numbers, I would expect the share prices to improve in coming years to bring the yields and valuation metrics closer to the market as a whole. If that did happen, it could be doubly good for me – not only would I have locked in the BATS yield by buying it at today’s price, I would also benefit from the share price appreciation. But is this likely for tobacco stocks?

Long-term value destruction

It’s worth noting that UK tobacco stocks have fallen significantly in recent years. BATS, for example, has lost 9.7% over the past year. So, even allowing for the rich dividend, if I had bought the shares a year ago I would be in the red. Over five years it’s the same story, as BATS has lost 40%. It’s a similar situation at UK rival Imperial Brands. While it has moved up 3.9% over the past year, the past five years have seen the share price decline by 55% – and there was a substantial dividend cut to boot.

So, looking backwards, tobacco stocks haven’t been great value creators in recent years.

I think there are a number of reasons for that, some of which remain risks for the future. Continued concerns about declining smoking rates hurting revenues and profits is one. An increase in ethical investing has meant a lot of investors shun tobacco stocks, which can hurt pricing as supply outstrips demand. Additionally, the past few years have seen a bull market driven by growth shares. In such markets, defensive sectors such as tobacco often underperform.

Will tobacco stocks keep falling in price?

Past performance isn’t a guide to what will happen next. Will tobacco stocks keep declining? They could do but I don’t think they will. That is the reason I hold both Imperial and BATS in my portfolio.

Clearly, demand and regulatory issues will impose growing challenges for the industry in coming years and decades. But that doesn’t mean it will collapse. It may slowly fade away, but in the meantime there is still the opportunity for substantial cash flow generation. Tobacco valuations have been falling but I reckon they are now starting to level out. The modestly positive Imperial performance over the past year is an example of that happening. If there is a reassessment of the sector by investors, or a move into defensive sectors because of a falling market, I think that could provide the impetus for a rerating of tobacco stocks.

I’m buying tobacco stocks

That’s why I continue to hold tobacco stocks, as well as adding to my position. Not only do I think there may be long-term price appreciation, I currently get paid handsomely to wait in the form of high single-digit percentage dividend yields.

Christopher Ruane owns shares in British American Tobacco and Imperial Brands. The Motley Fool UK has recommended British American Tobacco and Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.