Are in­vestors de­pend­ing too much on to­bacco?

As the US author­i­ties take aim (again), James Con­ning­ton ex­am­ines in­vestors’ grow­ing re­liance on to­bacco’s div­i­dends

The Sunday Telegraph - Money & Business - - Front page -

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.

In­sti­tu­tional in­vestors

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”.

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