Are investors depending too much on tobacco?
As the US authorities take aim (again), James Connington examines investors’ growing reliance on tobacco’s dividends
In the income-starved era since the financial crisis, tobacco stocks have doubled their share of total FTSE 100 dividend payments. In 2007, tobacco firms accounted for 3.5pc of the total income distributed to the shareholders of Britain’s biggest companies. The figure peaked at 6.6pc in 2010 and today is 6pc.
And yet – as Friday’s sharp fall in tobacco share prices made clear – this is a sector with unique vulnerabilities to regulation and law. The threats, though, are not new.
In recent years tobacco firms have first grown – and then maintained – their revenues and distributions, and their soaring share prices across the period are a testament to investors’ gratitude. Even if you do not directly own shares in Britain’s two biggest tobacco firms – British American Tobacco and Imperial Brands – you are quite likely to have exposure via pensions, Isas or other funds.
Currently, 47 out of the 84 funds in the UK Equity Income sector (encompassing the most popular funds) own either or both BAT and Imperial Brands as a top 10 holding. Darius Mcdermott, of broker Chelsea Financial Services, said: “This is for good reason. The big threat of litigation has mostly passed, and cigarette companies are still managing to grow profits, have cut costs and have no hefty advertising budgets. As a result, cash flow is passed back to investors through dividends and share buy-backs. That type of stable income is hard to come by.”
Over seven years, BAT and Imperial Brands have returned – through share price appreciation and dividends combined – 210pc and 152pc, respectively, compared with 80pc for the FTSE 100. A concentration on any one sector poses risks, but tobacco, mired in controversy and facing a number of challenges, is a special case.
Smoking is declining – so can revenues be sustained?
Tobacco firms may be profitable but, in the developed world at least, smoking rates are declining sharply. In 2000, one in four Britons over 16 smoked. Now, that is down to 16pc. In the US, the adult smoking rate declined in an almost identical pattern. So tobacco companies’ hopes are on new markets. Last year, 54pc of BAT’S revenues came from Eastern Europe, the Middle East, Africa and Asia-pacific.
Over time, smoking rates typically drop as societies develop. For instance, in India, the world’s second biggest cigarette consumer, adult male cigarette use declined from 36pc in 2000 to 20pc in 2015, according to World Health Organisation (WHO) data. Adult female use fell from 7.3pc to 1.9pc.
Worldwide, the adult female rate declined from 11pc in 2000 to 6pc in 2015 – for men, the fall was from 44pc to 35pc. But those global declining smoking rates do not mean that total sales are falling. Population growth, especially in countries with young populations, could support continued growth in cigarette sales, the industry hopes. Even so, most commentators believe in “peak tobacco” – the point at which total consumption starts to decline. In China, the world’s largest consumer of cigarettes with 300 million smokers, it was reported by the WHO last year that total sales had fallen for the first time in decades.
E-cigarettes – can they replace tobacco?
Another area of potential revenue growth is in e-cigarettes, where traditional tobacco companies are heavily investing in the hope of replacing traditional revenues.
E-cigarette use is growing. In Britain, use rose by 24pc between 2015 and 2016, according to Office for National Statistics figures. A study published in the British Medical
Journal last week found evidence linking e-cigarette use to people successfully stopping smoking. This effectively reaches a new market of “quitters”. As e-cigarettes are comparatively cheap, there are hopes of higher sales volumes. There are also much lower barriers to entry in the e-cigarette market, however, meaning tobacco firms won’t enjoy the pricing power they are used to.
Regulation risk: firms have dealt with it, so far
Given the returns, it would be easy to assume smoking bans and massive
duty increases haven’t hurt the industry. But regulation is a constant threat. As governments’ hostility towards the sector grows, cigarette makers will become more reliant on consumers’ desire to smoke.
On Friday, the US regulator announced that it was considering requiring cigarette makers to reduce nicotine to non-addictive levels. In response, tobacco stocks fell sharply. Some countries have banned branding and advertising. This gives existing firms a level of protection, but they lose the ability to launch new products or to convert customers. On the taxation front, on a £9 pack of 20 cigarettes in the UK, tax accounts for 65pc of the cost. The WHO recommends 70pc taxation on each cigarette.
Although there is as yet little clear link to share prices, the decision by huge institutional investors to drop tobacco holdings for ethical reasons is not positive.
Fund groups and pension managers are under increasing pressure to divest. Last month, Aviva announced it was selling £1bn worth of shares and bonds that it currently holds in tobacco companies. Last year, Axa announced it was divesting its £1.4bn of tobacco holdings.
Giant national pension funds have
been selling, too. Norway’s sovereign wealth fund dropped all its holdings several years ago.
Pricey consumer stocks at risk of rate rise
As a whole, expensive consumer stocks – of which tobacco is an example – are a risky place to be if interest rates start heading up.
Their stable characteristics become less desirable when cyclical businesses such as banks begin to perform again, and when rates on cash improve. Out of the FTSE 100 giants, BAT is by the far the more expensive, currently trading at a price-to-earnings ratio of around 21. That is significantly higher than the wider market. Imperial’s pe ratio is a less heady 14.
Veteran income investor Neil Woodford recently sold his £10bn Equity Income fund’s entire stake in BAT, but kept Imperial, which he said remained “undervalued”.