Why the tobacco sector's flickering back to life

With all the difficulties facing the tobacco industry - including a growing number of countries introducing smoking bans - why have share prices been so strong recently? The answer is to be found in the US.

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Invest in the tobacco industry? Landmark lawsuit thrown out

The answer is to be found in the US, where last week the Florida Supreme Court threw out a multi-billion-dollar award for punitive damages against cigarette-makers. The sector had been facing a massive $145bn bill, resulting from a successful class action suit in 1994, which decided that the tobacco industry was guilty of misleading consumers about the dangers of smoking. It was the largest jury award in US history and would have resulted in a raft of problems for tobacco firms, bankrupting some. But the highest court in Florida rejected the 1994 judgement, saying that the damages awarded were "excessive". Of course, the tobacco industry hasn't rid itself of legal challenges. Individual smokers can still sue tobacco firms, but the financial impact will be negligible compared to the Florida class action verdict that was hanging over the industry.

This is just the latest of a number of setbacks for America's anti-smoking lobby. The US Supreme Court recently ruled against the US Justice Department, which had been seeking to seize up to $280bn from tobacco companies in a racketeering case. The markets lit up after the news was released. Shares in Altria, the owner of Philip Morris, leapt 7%, while both Reynolds American and Carolina Group, the tracking stock for Lorillard Tobacco, hit record highs.

In the UK, BAT, Imperial Tobacco and Gallaher all rose strongly. Suddenly, the pall that had hung over the sector has vanished and the markets are not only optimistic that large compensation payments will be avoided, but that an industry shake-up, like the proposed break-up of Altria, will now be able to take place.

Invest in the tobacco industry? Smoking bans set to spread

However, it's not all good news for tobacco firms. The US surgeon general, Richard Carmona, recently called for smoking to be banned from more public spaces, citing the effects of second-hand smoke on children, while the general trend in the Western world continues to be away from smoking. But for every reformed smoker in the West, there is a new convert in developing markets, especially in China and eastern Europe. Firms have responded by introducing new product lines of light' cigarettes that have lower levels of nicotine and tar, which now account for 87% of cigarette sales. And new products, such as Philip Morris's Taboka pouch tobacco' small sachets of tobacco that users place inside their cheeks are able to circumvent smoking bans. As the sector also enjoys high yields, it's clear that it is unlikely to run out of puff soon.

The three best ways to play the sector

The Invesco Perpetual High Income Fund is a highly successful fund that has a high exposure to tobacco. Half of the fund, run by Neil Woodford, is invested in utilities, tobacco and other defensive stocks. British American Tobacco (BAT) and Reynolds American (RAI) account for more than 12% of the fund's holdings.  UK tobacco firm Gallaher (GLH) maker of the Benson & Hedges and Silk Cut cigarette brands is an attractive share in the sector. Both Britain and Western Europe may be mature markets, but the company is targeting eastern Europe, where growth is running at a highly respectable 20%, and is expanding into China and Africa. Gallaher has a record of strong organic growth and cost containment, while its shares currently trade around 13 times forecast earnings for 2007, with a 4.3% dividend yield. With valuations like this, it is a very attractive takeover target, and bid rumours circulate frequently.

In regards to the US Supreme Court ruling, BAT is the only stock on the UK market that has direct US exposure: a 42% stake in Reynolds American. BAT is the world's third-largest cigarette manufacturer, with a 15% global market share, and owns the popular Dunhill and Lucky Stripe brands. It has a dominant position in emerging markets, where volumes are improving and the company is rolling out programmes to drive down costs. It has also increased its marketing budget. Valuations of BAT are attractive (although not as attractive as Gallaher's), with the stock trading on a p/e ratio of 14 times and a yield of 3.8%.

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