These tobacco stocks are never going to light up your portfolio so it is time to get rid of both

Holding on to British American Tobacco and Imperial Brands is creating a headache for investors despite their healthy dividends

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This column would normally warm to an unloved stock that operates in an unloved industry and is quoted on a market about which fewer and fewer investors seem to care (London represents barely 4pc of the global stock market by value, down from 8pc a decade ago), especially when the earnings multiple is lowly and the dividend yield plump.

But holding on grimly to British American Tobacco (BAT) is creating such a headache, not to say financial pain, that it really does feel as if the only sensible thing to do is cut and run and redeploy the capital elsewhere.

This crystallises a nasty loss for those who bought after we backed the stock in 2017, although dividends paid over the holding period cover half the deficit, which is something.

With the benefit of hindsight, we should have paid more attention when BAT’S share buyback programme was halted a year ago. Such subtle shifts in momentum can be telling. (One of this column’s first – and best – mentors always used to say that during his days as a fund manager he sold a stock as soon as he saw the first earnings downgrade and, in this case, the conclusion of buybacks was effectively a downgrade to cash returns.)

It has been downhill all the way since then in terms of the share price and earnings forecasts. BAT’S admission that its American brands were worth £25bn less than previously thought, as per a trading update late last year, has left us stewing ever since, as it has brought the multiple challenges to face the FTSE 100 constituent into clear relief. On one hand, we have the ongoing shrinkage in the legacy tobacco operation, thanks to regulatory pressure and the prospect of next-generation products cannibalising it. On the other, regulators are looking ever more closely at those new products, especially vapes, and it is surely only a matter of time before the rules are tightened here.

A report from the charity Action on Smoking & Health (Ash) makes sorry reading. It asserted that by spring 2023 one in five children had tried vaping, of whom a third had continued to vape.

This is not a moral judgment. It is not this column’s place to preach to readers who are grown up enough to make their own decisions. And while some investors take a strong stance on environmental, social and governance issues, many do not, in the view that investment is about (risk-adjusted) returns and nothing else.

Instead, our judgment is a financial one, with the key words here being risk adjusted. Ash’s findings are likely to rouse the regulator into action before too long. Even if BAT is pleased to report that next-generation products are going to make a profit two years ahead of plan, in 2024, that could itself stir a response.

Of course, it is still tempting to rely on the dividend, because the company will continue to throw out cash. In 2022, the last year for which we have a full set of figures, free cash flow (after working capital, capital investment, tax, lease payments, interest on debt and pension contributions) was nearly £7bn, enough to cover the £4.9bn cash dividend payment 1.3 times.

Growth may be modest at best as regulatory and political headwinds keep blowing, and interest bills will go up as debt matures and is refinanced, so it is by no means inconceivable that interest cover narrows. In addition, the forecast dividend yield, which exceeds 10pc, is bordering on too-good-to-betrue territory at more than twice the prevailing “risk-free” rate (10-year gilts yield 3.9pc at the time of writing).

The list of FTSE 100 companies that offered yields of 10pc or more on paper but ultimately cut the dividend instead includes Shell, Centrica, Vodafone and Marks & Spencer. BAT will doubtless do all it can to avoid joining that club, but it is flagging the need for greater investment in its business.

Our retreat from BAT also raises the question of what do to with Imperial Brands, where 565p a share in dividends enable us to show a positive total return of 20pc relative to our positive note of four years ago. It seems more focused on maximising value from its existing tobacco brands than transitioning to new products, continues to buy back shares and yields nearly 8pc even after 2020’s dividend cut. But the regulatory and political risk feels as substantial here as it does at BAT. Income seekers may continue to cling on here as well, but anyone looking for big capital gains is probably blowing smoke.

Time to stub out both names. Sell.

‘This is not a moral judgment – readers are old enough to make up their own minds. It is a financial one’