Are Sin Stocks Diageo Plc (LSE:DGE), Imperial Tobacco Group Plc (IMT) & British American Tobacco Plc (LSE:BATS) Undervalued?

There’s a strong belief in investing that shares in so-called sin stocks are often undervalued as asset managers and retail investors alike steer clear of them for moral reasons. But does that hold true for these three companies?

On the right track

Shares of global spirits juggernaut Diageo Plc (LSE: DGE) have not been feeling the Christmas spirit this holiday season, with prices dropping 7% from the beginning of December. Investor worry has been centered on growth being constrained by saturation in developed countries as well as the slowdown in emerging markets, which account for roughly 40% of overall sales. However, it’s this exposure to emerging markets, while restraining sales for the time being, that holds the key to Diageo’s potential to produce large returns to shareholders over the long term.

The management team has been shedding non-core assets such as its wine business and smaller beer holdings in order to focus on the spirits and Guinness beer brand that make up the heart of the business. These divestments have also happened alongside the goal of increasing margins by 1% (to reach 29%) and returning to growth in 2017. It all shows that Diageo has attractive growth markets ready to tap for decades to come. It also has a focused business plan and the benefits of being a defensive play, since people buy alcohol in good and bad economic times alike. Given these qualities, I believe Diageo and its 3.12% yield is certainly an attractive investment for long-term investors, despite trading at a relatively-pricey 19 times earnings.

Dinosaurs or dynamic?

Tobacco companies such as Imperial Tobacco Group (LSE: IMT) and British American Tobacco (LSE:BATS) present something of an ink blot test for investors. Some view them as decrepit dinosaurs plagued by increasingly restrictive regulation, high debt levels and little prospects for growth. Meanwhile others see high dividends, the ability to continually increase profitability by cutting costs, and resilience in the face of 40 years of regulations.

Imperial investors have certainly fallen into the latter category, with shares rising nearly 25% year-to-date on talk of a possible takeover by rivals BATS and attaining nearly 10% control of the highly-profitable American market through acquisitions. With net margins a miserly 7.5% compared to BATS’ 31.62% there’s certainly room for increased profitability even if revenue grows slowly. The shares currently sport a 4% yield and with the higher margin US business set to begin lifting profits, plus the acquisition of market-leading e-cigarette brand Blu, Imperial has understandably been an investor darling.

Imperial’s larger rival BATS also offers a heady 4% dividend and with high margins and a globally diversified presence, it has been a stable recommendation for several years. However, both companies face stagnant organic revenue growth and thus cannot be said to be undervalued much as they’re trading at roughly 20 and 17 times earnings, respectively, going into the New Year.

Despite their high dividends, I believe Imperial and BATS offer little room for growth for long-term investors. Such investors would be better served by looking at a company such as Diageo that has both a solid dividend and high growth potential.

In fact, Diageo is one of the recommended companies in this Motley Fool report titled Five Shares to Retire On.

This completely free report details some of the Motley Fool’s favourite shares with the potential to grow for decades to come and all you have to do to read this report is follow this link.

Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.