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The Virtue of Sin

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You won't find Philip Morris (NYSE:MO) in the holdings of the relatively new crop of socially responsible mutual funds due to the fact the company is a major player in the tobacco and alcohol (through Miller Brewing Company) businesses. If MO had a stake in adult entertainment, they would have a lock on the "Big Three" marketable sins - hence the fact that it is commonly referred to as a 'Sin Stock'. Despite its politically unfavorable nature, discerning investors would do well to seriously consider the stock as an addition to their investment portfolios.

The big issue confronting the stock in recent years has been the rash of smoker-related lawsuits, which threaten billion-dollar udgments against the company. While some of these suits have actually resulted in judgments against the company, the amounts of the actual awards have been (and will likely continue to be) chump change compared to the piles of cash MO brings in and awards to its shareholders in the form of beefy dividends. That's right...dividends. Long time readers may be shocked to hear me utter that word, especially since we can't have a piece of that action through the purchase of LEAPS...or can we? More on that a little later.

An important point overlooked by many investors is that MO's business consists of far more than just smokes and booze. Heavily involved in the food business through its Kraft unit, MO derives income every time I get a craving for Oreos, Cheeze-Its or need to cover up that indiscretion with a couple of Altoids, those "curiously strong mints". How about Grey-Poupon mustard? A1 Steak sauce and the Bulls-eye BBQ concoction? Yep, they get a piece of that action as well. And even after the recent Kraft IPO, MO retains over 97% ownership of its Kraft division.

Of course, we can't forget the company's Financial arm, which invests in leveraged and direct finance leases, along with other tax-oriented and third-party financing transactions. As of the end of 2000, total assets of this division were $8.4 billion. That's nothing to sneeze at!

The point is that MO makes the bulk of its income through methods that J. Paul Getty would have loved. The wealthy industrialist once said that the road to wealth is to sell products that either go up the smokestack, down the drain, or out the tailpipe. While he was referring to industrial America, MO has applied that advice to the billions of "biological factories" that are walking around this little ball of dirt we call Earth. The company provides the products to keep us fueled up in our day-to-day lives, as well as satisfy whatever legal vices we each may happen to have. And the best part is, we keep coming back for more!

Demand for MO's products are relatively insensitive to gyrations in the economy too. Have you noticed that your concerns about the economy have you purchasing fewer boxes of Kraft Macaroni & Cheese? How about your smoker friends? Have they cut back their use of this dangerous and controversial product over the past couple years -- a period of time which has seen the price of a pack of cigarettes increase by nearly 100%? Of course not. And that demand side of the equation is what keeps MO's cash flow on the rise. The company consistently delivers a portion of that cashflow to its investors in the form of dividends. This morning, MO delivered their usual dividend increase to shareholders, raising the annual dividend to $2.32. That equates to a dividend yield of 4.88% at the stock's recent price of $47.50.

Which brings me back to the subject of dividends and the fact that we don't get to participate in them as LEAPS investors. But that doesn't mean we can't profit from a stock BECAUSE it has a hefty dividend. As the economy has continued to weaken, investors have fled equities and much of that money has been finding its way into the bond market. What is the current yield on the 5-year government bond? 4.36%! Even the 10-year bond is yielding only 4.79%, and only the 30-year bond is yielding more than 5%. Corporate bonds will yield a greater return, but at an increased risk...just like the risk/reward dynamic in equities.

So we have a company that is providing a stable and growing revenue stream in an economic slowdown (ok, I know it is REALLY a recession...). How many earnings warnings has MO issued in the past 18 months? Answer:none. And the yield from dividends is at least competitive with interest rate vehicles. That means MO is a likely safe haven for investor dollars in the current environment. How does it help us? I thought you'd never ask!

The stability in MO's revenue stream and dividend yield limit the downside risk in the stock, making it both an attractive LEAPS candidate during a sharp pullback (like we got a few weeks ago), and a lucrative Covered Call play (as we see setting up at this time. This allows us to profit from near-term directionless movement (rangebound between $43-53), as well as our expectation for long-term appreciation.

Here's the MO entry we took in the Portfolio back on July 30th.

Weekly Stochastics were looking a bit weak, but the daily was looking like it was near a bottom and we got a nice solid bounce from the $43 support level. Given the solid fundamental picture we took the position and were almost immediately rewarded.

Three days later, we got a shot at taking in some premium by selling the August $47.50 call, although this was a fairly aggressive entry. But we're setting up for another opportunity to sell calls as of this writing. The aggressive approach will be to sell the September $47.50 (actually in the money right now) or the October $50 call, which is likely to expire worthless due to significant overhead resistance.

This is another sedate LEAPS covered call play for your consideration, with relatively cheap premiums, making it an attractive prospect due to the ease with which we can work our cost basis down to zero in the months ahead. The advantage of MO over several of the other plays we have talked about in recent weeks is the underlying fundamental picture, which should help to support the stock, giving us a nice steady appreciation in the LEAP over the longer term.

So maybe there is some virtue to sin -- at least for discerning investors. There are always attractive investment opportunities. With the current economic weakness, we just have to dig a little deeper to find them.

Questions are always welcome!

Mark Phillips
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