British American Tobacco

Politically correct investors, look away now. Cigarettes are bad for your health, but if you’re a shareholder in British American Tobacco (“BAT”), they’ve certainly not been bad for your wallet. Investing in addiction is a proven way to make money, and a good way to do this is to buy shares in tobacco companies, which boast an enviable track record as reliable performers.

A focus on cost control and the ability to raise prices even in a harsher economic environment has enabled BAT to deliver higher profits in more challenging trading conditions. It’s taking £800m out of the business between now and 2012 by streamlining back office functions, improving buying processes and shutting factories. That suggests it has even more scope to improve its already impressive 32% operating profit margin, nearly double the level of just five years ago. Furthermore, with a large proportion of earnings derived overseas, the tobacco majors are poised to reap the benefit of a weaker sterling.

Over the past five years, BAT has delivered compound growth of 15% in earnings per share and 19% in dividends per share, while rewarding shareholders with a capital return of 97% compared with 3% for the FTSE 100.

And amazingly after all that out-performance, because of the business it’s in, BAT is still cheap. It’s on a forward p/e ratio of just 12.23x, which is a lower rating than the overall market.

Even better, the prospective yield is near 5.5%.The beauty of a mature business such as BAT is that capital spending can be low, so most of the masses of cash generated can be paid straight to shareholders as dividends.

On that basis we rate the stock a strong buy.