BOSTON: Anne Gudefin does not smoke, but the fund she manages ranks among the best performers because Russian, South Korean and Chinese smokers light up More than one billion Cigarettes a day.
Her $12.3 billion Franklin Mutual Discovery Fund has about 10 percent of its assets in tobacco stocks, six times the amount in the Morgan Stanley Capital International world index. Its biggest holdings are British American Tobacco and the South Korean cigarette maker KT&G.
"Tobacco stocks are undervalued," said Gudefin, co-manager of the fund, from the Short Hills, New Jersey, office of Franklin Resources' Mutual Advisors unit. The number of nicotine addicts is growing, so "if you're hooked up, you're hooked up and that's it," she said.
The Mutual Discovery Fund returned 24 percent in the past 12 months, placing third of 174 funds whose managers buy companies they view as inexpensive. It rose at an average annual rate of 15 percent since 2002, compaRed with a 6 percent gain for the Standard & Poor's 500-stock index.
While the number of smokers is declining in the United States, it is rising in emerging countries, said Gudefin, who manages the fund with Charles Lahr. The companies also have increased cigarette prices in developed countries in recent years.
As many as 100,000 children start smoking every day around the world, and about a third of the male adult population have picked up the habit, according to data compiled by the World Health Organization. Tobacco companies sell 15 billion Cigarettes every day.
About two-thirds of Chinese and South Korean men smoke, compaRed with 24 percent in the United States, according to statistics from the WHO and the American Heart Association.
Tobacco companies, including Altria Group, once known as Philip Morris USA, agreed in 1998 to settle with 46 U.S. states and Washington, D.C., by paying about $210 billion over 25 years and limiting advertising.
"Litigation risk is nonexistent outside the U.S.," Gudefin said.
The Franklin fund owns shares of Altria, which trade at about 16 times earnings, compaRed with 18 for the average stock on the S&P 500 index. British American is priced at about 17 times earnings and KT&G is at 16.
The fund's managers "aren't afraid to have a portfolio that doesn't look like anyone else's," said John Coumarianos, an analyst at Morningstar in Chicago. "They are looking for things that have some negative sentiment."
The top-performing "value" fund of the past year was T2 Partners' $12.8 million Tilson Focus Fund, up 27 percent. Its three largest holdings are Warren Buffett's Berkshire Hathaway, the fast-food chain McDonald's and the software maker Microsoft. The Kinetics Paradigm Fund ranked second, gaining 26 percent as shares of NYSE Group and the Chicago Mercantile Exchange climbed.
Franklin's fund has a three-year Sharpe ratio of 2.01, higher than the 1.23 ratio of similar funds. The greater a fund's Sharpe ratio, the better its risk- adjusted performance. Morningstar gives the fund four stars, its second- highest ranking.
The Franklin fund's tobacco investments have paid off as cigarette prices increased. The cost for a carton, or 10 packs, has risen 12 percent in the United States since 2001 to $32.83, according to Information Resources, a market research company in Chicago. In Britain, the average price for a pack of Benson & Hedges Cigarettes is $5.33, up 37 percent from 2000, according to the Tobacco Manufacturers' Association.
"Pricing power trends are positive for the sector, especially in Europe and Japan," Michael Smith and Erik Bloomquist, analysts at J.P. Morgan Chase, wrote in a report to clients last week.
The Franklin fund began building its tobacco stake 10 years ago as governments in Europe sold state-owned cigarette makers to companies including British American and Imperial Tobacco Group. British American purchased Ente Tabacchi Italiani of Italy in 2003. Italy has ranked as the second- largest European cigarette market by volume after Germany.
Shares of British American, the fund's largest position at 2.2 percent of assets, have climbed every year since 2000 and returned 23 percent in the past year. The maker of Lucky Strike Cigarettes has luRed investors with a dividend yield of 3.3 percent and annual stock buybacks of about ?500 million, or $990 million. The S&P 500's dividend yield is 1.78 percent.
Takeover speculation has lifted the stocks. Mergers and acquisitions in the industry totaled $24.6 billion last year, up from $8.4 billion in 2005.
The Morgan Stanley Capital International world tobacco index has gained at an average annual rate of 20 percent since the end of 1999, beating the 2.4 percent advance of the MSCI Europe, Australasia and Far East index.
Shares of Altadis, based in Madrid, rose to a record this month on media reports that Imperial Tobacco may offer to buy the company for в‚¬10 billion, or $12.9 billion. Officials at both companies have declined to comment. The Franklin fund holds shares of both.
"There is potential for cost savings because they were fat companies before," said Gudefin, who has degrees from the Institut d'Etudes Politiques in Paris and Columbia University in New York.
Shares of Japan Tobacco, another holding, have risen 63 percent in the past year. The tobacco company agreed to buy Gallaher Group of Britain for ?7.5 billion in December. The takeover makes Japan Tobacco the leading distributor of Cigarettes in Russia.
Shares of KT&G rose 23 percent in the period. The company in August agreed to pay shareholders $2.9 billion through a stock buyback and dividend increase after the U.S. investor Carl Icahn and the hedge fund manager Warren Lichtenstein pressed the company to improve returns.
KT&G also sells ginseng, an herb mostly found in Korea, China and Siberia. It may help improve the survival of cancer patients, according to a study in March by the Vanderbilt-Ingram Cancer Center in Nashville, Tennessee.