At the end of last week, shares of U.S. tobacco giant Altria Group Inc. (MO, Financial) plunged nearly 20% after the Food and Drug Administration announced it was going to clamp down on nicotine levels in cigarettes. The aggressive reaction was surprising because Altria is considered to be a highly defensive stock. While there could be a chance the regulation will hurt the company, it is more likely Altria will change its products to conform to the new rules.
The enormous decline in Altria’s shares, when fundamentally nothing had changed nor will change for months, if not years, is a warning of the dangers high-frequency traders and a market dominated by passive investors poses. If a company with a market capitalization of over $150 billion can lose more than 20% of its value in a single trading day, due to nothing more than a warning, what does that say about the current state of the overall market?
Massive changes or just hot air?
There is actually little to suggest the FDA’s clampdown will impact Altria. Over the past several years, the company has been working with its former subsidiary, Philip Morris International Inc. (PM, Financial), to develop reduced-risk products, which have less nicotine and harmful substances. According to Bloomberg, this focus could give these two companies an edge as the “FDA's proposal could lead to higher sales of vapor products and more-favorable tax treatment.”
What exactly is the FDA proposing? The agency said at the end of last week it plans to lower nicotine in cigarettes to non-addictive levels, although it stopped short of saying how it was going to do that and putting a timeframe on the controls. There will be a comment period before any action is taken, during which it is likely big tobacco will lobby for watered-down regulations.
A complete ban on nicotine is highly unlikely and even if a reduction is enforced, what this means for the industry is not clear. Smokers may just smoke more to compensate.
While there may be no immediate, significant impact on big tobacco’s earnings, the FDA announcement has shaken investors’ nerves.
Disrupting the balance
Before the announcement, it looked as if the war against big tobacco had run out of steam. Regulators appeared to have backed off, and investors had flocked to the companies against the backdrop of a benign regulatory environment and steadily rising shareholder returns.
Demand from investors for trustworthy, low volatility, high dividend stocks is at an all-time high. Demand for these equities from low volatility and dividend ETFs is also at peak levels. This demand has pushed the valuation of tobacco stocks, namely Philip Morris and Altria as Reynolds American (RAI, Financial) is in a bid situation, to around 20 times forward earnings, putting them up there with the likes of Alphabet Inc. (GOOG, Financial) (GOOGL, Financial) and Facebook Inc. (FB, Financial). It used to be the case that tobacco stocks always traded at a discount to the wider market thanks to the regulatory risks surrounding their future. It now appears this risk has returned, and the valuations have been marked back down to more appropriate levels.
Is it time to buy into this dip?
The question now is after these declines, is it time to "buy the dip?" The answer to this question is complicated. Forgetting about the risk any possible FDA action may pose, now the regulatory risk has returned, big tobacco does not deserve the premium valuation it has attracted for the past two years.
Even after recent declines, shares of Altria trade at a forward price-earnings (P/E) multiple of 19 and only yield 3.7%. These multiples do not compensate for the extra risk taken and there are much better opportunities out there in sectors with less regulatory risk and brighter growth prospects.
Disclosure: The author owns no stock mentioned.
