If there is one sector of the stock market that consistently draws scrutiny, it is big tobacco. After all, it is always under the threat of punitive action from the U.S. Food and Drug Administration (FDA), municipalities, past cases and other threats to the business. The most obvious is the fact that smokers are quitting the habit in record numbers. According to the Centers for Disease Control and Prevention (CDC), smoking is the number one preventable cause of death. With the odds seemingly stacked against them, can the big tobacco companies continue to flourish? Analysts at UBS A.G. (NYSE: UBS) think so.

For the first time in 10 years, tobacco underperformed the broader market and consumer staples in 2012. The shadow of rising taxes on dividends contributed to that underperformance, especially in the fourth quarter as portfolio managers rotated out of many dividend stocks. But if the team at UBS is right, tobacco pricing should improve in 2013 and help drive share prices higher.

Volatility always exists in the tobacco arena. This year alone, the FDA is expected to consider reports from advisory committees on as many as four separate areas: 1) menthol cigarettes, 2) new product development, 3) regulations on other tobacco products, and 4) likely review of e-cigarettes.

In terms of price performance, the top UBS pick is Lorillard Inc. (NYSE: LO). This maker of top-selling menthol cigarette Newport closed Friday at $117.87 and could be poised for a 27% rise to $141. However, UBS favors cigarette giant Altria Group Inc. (NYSE: MO), makers of the iconic Marlboro brand, which closed Friday at $32.54, as their number one overall pick. The estimate for Altria is an 11% price gain in 2013 to $36.12.

So why not go for the bigger upside in Lorillard? After more than a year of waiting and debate, the FDA is expected to publish its report on menthol cigarettes in the first quarter of this year. While it remains very unlikely that the agency will ban menthol, the chatter ahead of the report could push down the share price.

Both stocks are a total return investor’s dream, raising their dividends almost every year. Lorillard currently pays a 6.2% dividend quarterly. Altria pays a 5.40% dividend quarterly. In addition to capital appreciation and dividends, investors also can sell covered calls on their stocks.

There is always a degree of risk in owning stocks where the product can ultimately kill the consumer. Tobacco companies frequently are targeted in individual and class-action lawsuits. But there is one hidden aspect in these stocks that tends to balance that risk. The Tobacco Master Settlement Agreement (MSA) was entered in November of 1998 between the four largest tobacco companies and 46 states. The companies agreed to pay a $206 billion settlement over the next 25 years. This is in addition to lower annual payments in perpetuity for medical-related costs to the states.

How does this hedge the risk? The states in their never-ending search for revenue packaged large parts of these settlements and amortized the future payments in the form of tobacco bonds. Should litigation become too onerous on the companies, they can always threaten bankruptcy. If they filed bankruptcy and defaulted on their settlements, the states that already sold the bonds could have severe funding issues. Without the settlement payments, the states individual bonds could default. That would not bode well for states already facing current funding issues.

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