Is tobacco still a good idea for investors?

For as long as it has been bad for your health, tobacco has been good for business. The big companies have been making steady profits and paying out rising dividends for years, but the good times are fast coming to an end. As governments crack down on smoking because of the high cost of medical care, and public smoking bans become more commonplace around the globe, how long can this continue to be the case? Are shareholders in tobacco companies about to have a rude awakening?

Michael Smith of JP Morgan thinks so. After four years' outperformance, relative to the overall market, he believes the global tobacco sector is about to enter a period of underperformance. New health warning labels on tobacco are damaging the value of brands - having a a notice on your product that effectively says "if you do this you might die" is hardly good for brand loyalty. The rate of increase in global excise tax and so-called sin taxes is accelerating. Public smoking bans are steadily gaining "political momentum".

Overall, regulation is becoming one of the "key" drivers of industry cash flow. Consider, for example, the effect that a public smoking ban has had in Ireland. Cigarette sales in the Irish Republic have "plummeted" in the six months since smoking was banned in offices in March, says Sean O'Neill and Ingrid Mansell in The Times. Smokers in Ireland will purchase 500m fewer cigarettes in 2004 than they did last year if the decline continues at the current rate. Gallaher, which has half of the Irish market, says it sold 100m fewer cigarettes in the first six months of this year compared with the same period of 2003.

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Add to this the growing hostility to smoking in pubs and bars, points out Michael Jivkov in The Independent. Mitchells & Butlers, owner of the All Bar One chain among others, has unveiled plans to transform its outlets into "primarily non-smoking ventures", with restricted and "progressively reduced" smoking areas. Smoking will be banned at the bar by the end of next year and, within five years, 80% of all floor space will be non-smoking. Both Gallaher and Imperial Tobacco's profits sagged on the news. They fell again when John Reid, the UK health secretary, indicated that the Government would soon be taking action to prevent smoking in all public places. No wonder. As long as regulation rises, revenues will fall.

But the possibility of losing revenue is only the start of the sector's problems. There's also a cost problem. The US Department of Justice is seeking $280bn which, it says, was earned through fraud by tobacco companies because the dangers of smoking were covered up, says Lex in the FT. If it manages to get the payouts, they could "effectively bankrupt" the entire industry. That seems unlikely, but it is entirely possible that there will be a middle-ground outcome that doesn't quite threaten company survival, but does hit the sector hard enough to affect its "creditworthiness". If so, the worst affected of the big tobacco companies would be Altria (formerly Philip Morris) because it has the biggest share of the US market. The bond market, historically a better judge of risk than the equity market, is nervous: Altria's bonds are already trading in line with junk bonds. Equity investors should be nervous too.

Overall, the only real argument for holding tobacco stocks today is the yields they offer, but even that isn't really enough. Not only are the yields on the big shares seriously at risk - note that Morgan Stanley lists 11 legal events for the sector for the remainder of October alone - but you can get better shares elsewhere without the headache. Tim Price of Ansbacher Wealth suggests the following: British Vita (4.76%); HSBC (4%); Kelda Group (5.08%); Severn Trent (5.38%) and United Utilities (8.06%).