Investors should get hooked on tobacco stocks’ earnings growth and pricing power, MSIM writes

Tobacco stocks have amassed a mixed record thus far in 2017, and the Food and Drug Administration’s July announcement that it would lower the nicotine levels in cigarettes to nonaddictive levels was seen as adding a new layer of uncertainty for the sector, but they may be well-positioned in the event of a broader market pullback.

Pricing power, as well as the opportunity represented by next-generation products — such as e-cigarettes — could support the group going forward, helping it extend a lengthy period of strong earnings growth.

That view is according to Morgan Stanley Investment Management, which dismissed the potential downside of the FDA’s recent move. “Our view is that any action is likely to be many years away, and is arguably balanced by the opportunity in next-generation products for those who are well positioned,” it wrote in a report exclusively provided to MarketWatch.

See also: Wells Fargo: FDA plan to lower nicotine could be opportunity for Altria, Philip Morris

There has been a huge divergence in the performance of tobacco-related stocks so far this year. While Philip Morris International Inc. PM, -0.61%  is up more than 21% in 2017, a gain that’s nearly twice the 12.9% rise of the S&P 500 SPX, +0.22% Altria Group Inc. MO, +0.75%  shares have lost 7% over the period. Altria, which owns the Marlboro brand of cigarettes, has been pressured this year by some weaker-than-expected earnings, among other factors.

U.S.-listed shares of British American Tobacco PLC BTI, -0.42%  are up 10.8% on the year; in July, the company completed an acquisition of Reynolds American.

The Consumer Staples Select Sector SPDR ETF XLP, +0.11% — which counts both Philip Morris and Altria as top 10 holdings; they comprise a combined 15.9% of the portfolio — is up 4.2% this year.

Despite the mixed records of their share prices, tobacco companies are expected to continue seeing profit growth and increased demand. Philip Morris is forecast to report full-year earnings of $4.84 a share in its 2017 fiscal year, up 8% from 2016, according to data from FactSet. In 2018, profits are seen growing to $5.43 a share. The company’s sales are seen growing 7.2% in 2017 from 2016, and 9.2% in 2018.

Altria Group is expected to grow its full-year profits by 7.6% in its 2017 fiscal year, and growing another 9% in 2018. Revenue is seen up 2.1% in 2017, and 1.9% between full-year 2017 and 2018.

The tobacco industry overall, according to data from Morgan Stanley Investment Management, has seen compounded earnings growth of 7% a year over the past decade, with a yield of 4%, compared with the earnings growth of 0.5% posted by the MSCI World Index, which also has a lower yield.

“The sector’s price-to-earnings multiple can be volatile… but over the long term the relentless compounding has driven strong share price outperformance,” read the report, which was co-written by William Lock, head of the international equity team at Morgan Stanley Investment Management.

Lock credited this to pricing power. “Combining a concentrated industry with limits on advertising in most markets to constrain new entrants, along with a taxation regime that gives cover to price rises, makes for a perfect environment to raise prices steadily.” They added that such increases can be on the order of 5% annually, and “it is important to note that the industry’s compounding has happened in the face or regulatory pressure that has steadily reduced the volumes of cigarettes sold in developed markets.”

The report added that some of the regulation, “such as the rising weight of taxation and advertising bans, have actually helped boost pricing power,” and it didn’t see the FDA’s announcement on nicotine levels as “a break with the model of the last 40 years of regulation.”

Morgan Stanley Investment Management didn’t give specific company recommendations, though it said “it is becoming more important to be selective” when it comes to investing in the sector. The distinguishing issue it sees are the company’s positions within next-generation products. It noted that Philip Morris International’s IQOS is the market leader in the “heat-not-burn” product category, and that it will be licensed to Altria in the U.S. Meanwhile, British American Tobacco’s Glo product line also has a notable market share.

“Our view is that the world is a profoundly unpredictable place at present, and that this unpredictability is not reflected in a market,” the report read. “As a result, we favor quality compounders, which can grow earnings steadily at high returns on operating capital. We put tobacco companies in that category, despite the regulatory noise.”