Traders Sometimes Ignore News
You probably know that cigarette smoking may be hazardous to your health. A warning to that effect has been required on the packages since 1966 in the United States. That year, the US became the first nation to require a health warning on cigarette packages. Now, almost all nations require a warning.
The warning has evolved over time. For the first few years, it was relatively benign. At first, they were just a caution that smoking may be hazardous.
In 1970, that was upgraded to a warning that smoking is dangerous and now the packages include graphic warnings of harm. The effort has had some impact. The percentage of adults who smoke has declined sharply over time.
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Like many smokers, Wall Street has long ignored the warnings. Investors also seem to have ignored the trend in the number of customers. They seem to be counting on growth from markets overseas or higher prices for consumers to keep profits growing.
Their decision to ignore the risks of the product have resulted in spectacular gains for some tobacco stocks. The chart of Altria Group (NYSE: MO) is shown below.
Altria Group, manufactures and sells cigarettes, smokeless products, and wine in the United States. It offers cigarettes primarily under the Marlboro brand; cigars principally under the Black & Mild brand; and moist smokeless tobacco products under the Copenhagen and Skoal, Red Seal, and Husky brands.
The company also produces and sells varietal and blended table wines, and sparkling wines under the Chateau Ste. Michelle, Columbia Crest, and 14 Hands names; and imports and markets Antinori, Torres, and Villa Maria Estate wines, as well as Champagne Nicolas Feuillatte in the United States.
In an attempt to diversify, the company also provides finance leasing services primarily in aircraft, electric power, railcar, real estate, and manufacturing industries.
Years ago, the company spun off its international sales of cigarettes to Philip Morris International (NYSE: PM). That makes MO a pure play on tobacco sales in the US.
More Regulation Is On the Way
On Friday, the US Food and Drug Administration announced a plan for tobacco and nicotine regulation, which seeks to lower nicotine in cigarettes to non-addictive levels. The press release’s headline indicates the agency intends to make significant changes, “FDA announces comprehensive regulatory plan to shift trajectory of tobacco-related disease, death.”
The FDA will complete a comprehensive review of tobacco industry regulations. Its initial goal will be to encourage the development of new products that are less dangerous than cigarettes. The FDA will be reviewing the role of menthol and other flavors in tobacco products.
This press release came as a surprise to traders. Although it is likely that the tobacco companies will fight new regulations, there is likely to be at least some change on the horizon. The surprising news and the potential for new regulations pushed shares of tobacco stocks down significantly.
MO, with its focus completed on the US market, was the hardest hit stock in the sector. The stock fell more than 10% after news of the FDA announcement.
Trouble for an Overvalued Stock
MO has been a wonderful stock for its shareholders. But, the company has not been growing for some time. Over the past seven years, sales have grown an average of 1.3% a year. Gross income has grown an average of 2.1% a year over that time.
Gross income is found by subtracting the cost of goods sold from a company’s revenue. It is an accounting measure of how well a company is performing. Investors usually focus on earnings per share (EPS) rather than gross income.
When measured by EPS growth, MO looks better. Over the past seven years, EPS growth averaged 24.8% a year, better than the growth reported by 82% of all publicly traded companies. The EPS growth is due to share buybacks, gains from transactions in foreign exchange and other accounting standards.
MO is trading a price to sales (P/S) ratio of 6.7 and a price to book (P/B) ratio of 10.6. The market average P/S ratio is 2.1 and the average P/B ratio 2.8. MO is well above these averages and the company is growing at a below average rate.
Analysts expect EPS growth of 8% a year. This pace of growth places MO in the 29th percentile of all publicly traded companies with earnings estimates.
The premium for MO is due to the company’s dividend. The stock offers a yield of about 3.7%. This is well above the market average. MO is considered to be an income stock and it pays out about 80% of its earnings to shareholders in the form of dividends.
That payout ratio is also higher than average, at the 85th percentile for companies paying dividends. MO pays out so much in dividends because it is not reinvesting much in the business. However, the cash flow that secured those dividends is now at risk.
Fair Value For MO Could Push the Stock Lower
While MO is valued for its divided, based on the dividend yield, MO is overvalued. Over the past seven years, MO has traded with an average dividend yield of 5%. This average can be used to find the stock’s fair value.
Fundamental ratios like the dividend yield tend to be mean reverting. That means they will move above and below the long term average which acts like a magnet for the ratios. That principle is the basis of Nobel Prize winning economist Robert Shiller’s popular CAPE ratio valuation model.
MO’s current dividend is $2.44 per share per year. Dividing the current dividend by the long term average dividend yield ($2.44 / 0.05) provides a price target of $48.80. Based on the fair value, there is significant downside in the stock.
But, traders still seem to be ignoring the risks because, despite a 10% drop in the stock, options prices remain fairly low. From a technical perspective, this is because the implied volatility factor in the pricing models remains low. That fact makes buying options a better choice than selling options.
A Trading Strategy
To benefit from a potential decline in value, traders can buy put options. However, because MO is a relatively high priced stock, the options are still relatively pricey. A long term put option, expiring in January 2018 with an exercise price of $65, near the stock’s current price, costs about $3.70.
A put expiring on August 18 with an exercise price is trading at about $1.20. Buying that put option would require $120 in trading capital since each contract covers 100 shares. This ignores the cost of commissions which should be small, totaling less than $5 at a deep discount broker.
Being long a put is a simple strategy with the following risk and reward profile.
This diagram is taken from The Options Industry Council web site. The diagram shows that risk is limited to the amount paid to buy the option. In this case, the option loses 100% of its value if MO closes above $65 on August 18.
If MO closes below that, the option will have a value equal to the exercise price less the closing price. For a close at $63, for example, the option would be worth $2 and the put would deliver a gain of 67% in less than one month.
When this put expires, traders can enter another trade to maintain exposure to MO. This will accomplish the same objective as a long term option, such as the one expiring in January, but will do it at a lower cost. That could benefit smaller traders wanting to benefit from long term trends.