Very Undervalued Stock Yielding 5% Plus A 7.3% 'Special Dividend'

Pretty much all investors seem to be nervous right now. Some are nervous that the economy is getting too strong and the Fed will taper off asset purchases (See my article here), others are nervous that the global economy is in for a "hard landing". Either way, whether an investor thinks the economy is too strong or not strong enough, he or she still needs to be cautious about buying stocks right now.

With that in mind, this is the first article in what I hope will be a short series of articles about stocks with attractive valuations, strong dividends, and great opportunities to hedge your purchase and earn extra return via options. (Note that this article isn't about options, and you don't need to be interested in options for this to be a good investment. The options piece is strictly optional.)

I think a reasonable set of criteria investors should be looking at for stocks right now include some combination of attractive dividend yield; a stock price close to fair value based on FCF, net debt or cash, and assets; and a reasonably defensible moat for the firm. If possible stocks should also load up strongly on the priced factors in the Carhart 4 factor model (See my blog here for more details). Going through the firms that meet these criteria, one that stood out to me was Altria (MO).

Altria of course is the holding company for Phillip Morris USA which is the largest manufacturer of cigarettes in the world. It also has subsidiaries that make wine and smokeless tobacco, and the firm owns about 27% of SABMiller plc which makes alcohol.

Altria is a great stock first of all because they are effectively in bed with the US government. The state and federal governments have an enormous vested interest in seeing Altria continue doing exactly what it is doing right now - making and selling cigarettes. Cigarette taxes are a significant source of revenue for many states and so while politicians will always harp on about the evils of smoking, in fact they have every incentive to make sure Altria and its competitors keep selling cigarettes and sending the tax payments to the government. This fact, combined with a strong portfolio of brands gives Altria a powerful moat.

Further, while people have known that cigarettes are bad for their health for more than a decade (and perhaps as much as fifty years if you go back to when doctors first start talking about tobacco use), people continue to smoke. Certainly over the last decade smoking rates have declined somewhat, but that decline has been very slow and at least partially offset by increased cigarette prices and greater use of other tobacco products like smokeless tobacco and e-cigarettes (more on these in just a minute).

Altria also sports a dividend around 5% and a pretty solid set of financials as shown below. All of these lead me to a fair value of about $40 on the stock which is slightly ahead of the firms historical P/E ratio of 15-16. With Altria trading at $35 a share, this makes the stock fairly attractive compared with many other firms out there.

Table above shows select Altria financials for the last 4 years. Figures are in millions unless indicated as being per share.

As the table above shows, Altria has kept roughly the same level of debt and assets over the last few years, but it has been able to increase its profits significantly as measured by EPS, Operating Cash Flow (OCF) per share, or Net Income. The firm's revenue has also risen somewhat, but perhaps most impressively from an income investors standpoint, its dividend has risen a whopping 28% over the last 4 years. This is especially impressive when one considers that this was all done during a period of recession and subsequent slow economic growth.

Further, what is probably not including in the stock's current price yet is the potential from eCigarettes. eCigarettes are small plastic devices that look like a regular cigarette. Most even have a light of some sort on one end that is meant to make them look more like a traditional cigarette. The device allows the user to orally take in nicotine without actually lighting or burning any tobacco. As a result these products get around the bans on public smoking and the issues of second hand smoke.

So far the FDA has not declared whether or not the products are harmful to the user, but regardless of what the agency decides, most smokers are very interested in any device that allows them to "smoke" and yet avoid having to be forced into a small area outside their workplace far from doors and anywhere non-smokers might walk, etc. Smoking has become an enormously stigmatized today because of the health problems associated with it, and as such any product that helps smokers avoid this stigma is likely to be very popular.

All of the major tobacco companies including MO are embracing the eCigarette niche because the category is growing very rapidly helping to offset the decline in numbers of regular smokers and giving companies an important source of growth. Combined the joint marketing efforts of all of the tobacco companies should help to make eCigarettes a more acceptable product for most smokers and help reduce the strangeness that many associate with the product.

Based on this, Altria looks like a reasonable value at current levels. Its stock has performed well over the last year, but it is off its 52-week highs as the chart below shows. As a result, Altria looks like a good addition for any investor looking for a solid consumer goods play with strong financials, strong brands, and a hefty dividend.

For those investors who want to go a step further though, Altria also offers a nice way to earn a "bonus dividend" through the use of call options. Again, investors don't need to use options for Altria to be a good investment - but in my opinion they make the investment even more attractive.

Unfortunately, far too many investors hear the word option and immediately assume that they entail a great deal of risk. Frankly that assumption is a lot like assuming fires carry a great deal of risk - an uncontrolled fire certainly does, but there is no reason whatsoever why a small campfire for example should be considered risky.

In this particular case, investors in Altria might consider buying the stock and then selling call options on it. By doing this, the investor is agreeing to sell their Altria stock to the buyer of the options at a set price called the strike price for a given period of time. (See my article here for more details about call options.)

Altria investors might consider buying the stock at around $35.50 per share now, and selling a call option with a strike price of $37 expiring in January 2014. Doing this earns the Altria investor an immediate premium about $1.10 per share (which effectively lowers the purchase price to $34.40). If Altria is above $37 in January, the investor gives the option's buyer his shares in return for $37 per share for a net profit of $2.60 plus dividends. This is equivalent to a 7.3% return in about 7 months plus the dividend yield of about 5%. All told the investor in this situation would earn a 12.3% return over a span of 7 months. Assuming Altria is below $37, the investor gets to keep his shares.

This seems like an attractive opportunity in my view given the stability of Altria and the run many stocks have already had this year. Of course, like any stock, Altria may be below the purchase price in January, but of course that could happen whether one sold a call option or not. All the call option has done is give up some upside potential in exchange for some downside protection in the form of the $1.10 per share call premium. Given the markets run of late and the general skittishness many investors are displaying, a little downside protection is probably a good idea.

(Note the shares could be called early resulting in the investor losing out on some dividends, but with a quarterly dividend of $0.44 vs. a call premium of $1.10, analysis using the Black Scholes derivation suggests this is unlikely. Again see my blog here for more details.)