Up in smoke: Is it time to stub out your exposure to tobacco stocks?
“Blow in her face and she’ll follow you anywhere.” That was how one advert tried to sell cigarettes back in the 1960s.
More than half a century later, the glamorous, seductive veneer of the cigarette industry has gone up in smoke.
Gone is the attractive packaging, which has been replaced by ugly images of tarred lungs, rotten teeth, and even the odd coffin.
And investors are increasingly recognising that the tobacco sector’s days are numbered. Over the past three years, allocation to tobacco across the UK large-cap equity category average has fallen from seven per cent to four per cent, while the UK equity income category has fallen from 6.3 per cent to 3.6 per cent, according to Morningstar.
Meanwhile, earlier this month, the UK’s largest pension scheme, Nest, announced that it will sell all of its shares in tobacco companies, divesting its £40m holdings over the next two years.
“Tobacco companies are facing legal challenges across the world from governments taking action against an industry causing serious harm to their citizens,” says Nest’s chief investment officer, Mark Fawcett.
It’s not just Britain that has got tough on tobacco either, as 194 countries (including the UK) signed up to the World Health Organisation Framework Convention on Tobacco in 2005, in which members have committed to reducing the demand for tobacco. As a result, strict governmental controls on marketing, advertising and selling of tobacco products have been put in place, such as banning the sale of tobacco products to under-21s in certain US states.
“In our opinion, tobacco is a struggling industry which is being regulated out of existence,” Fawcett adds.
And of course, this harsher regulatory environment has made it a lot harder for tobacco companies to attract new customers, while they’re also battling declining volumes in traditional cigarettes due to the growing popularity of e-cigarettes.
Nicotine high
Despite clear questions over the sustainability of the tobacco sector, Nest is the first auto-enrolment scheme in the UK to announce its intention to divest.
And indeed, almost every asset manager in the UK has at least one fund that is exposed to this sector.
So while the health risks are clear, tobacco companies are still big business. Indeed, the UK’s two tobacco companies, British American Tobacco and Imperial Tobacco, still feature highly in the FTSE 100 index.
Keith Bowman, equity analyst at Interactive Investor, says that both of these companies are still attractive to investors because of the dividend payments on offer. “Both continue to offer yields comfortably above the average of the FTSE 100 index,” he says.
And while the demise of the tobacco industry has been predicted for some time, Bowman reckons that it shouldn’t be stubbed out just yet. “Investors may be underestimating the timing and impact which increased regulation could have. For now, expectations appear to point to around the middle of the next decade for any ban to take full effect, giving the industry time to build sales of alternatives.”
As with everything investment-related, timing is critical – and for the most part, it’s the timing of US regulations that investors need to be aware of.
For example, the US is mulling a potential ban on menthol cigarettes, which are often seen as a gateway into smoking. Likewise, a possible move to impose maximum nicotine levels on cigarettes by the US regulator also raises investor uncertainty.
However, consensus expectations suggest that these proposed rules are unlikely to come into force within the next 10 years, therefore giving the industry time to adjust.
For now, Bowman points out that valuations on the two big FTSE 100 companies are at 10-year average discounts. “Consensus opinion gives both UK companies the benefit of the doubt, coming in at a buy.”
Slow-burner
While you might be able to buy tobacco stocks at a bargain price and make a short-term gain, holding these them over a long period of time is unlikely to be a good idea.
Bear in mind that British American Tobacco and Imperial Tobacco share prices have declined 20 per cent and 29 per cent respectively over the past five years. This is perhaps unsurprising given that smoking has hit an all-time low, with 25 per cent fewer UK adults smoking over that period.
The Share Centre compared the share price performance of stocks deemed unhealthy (including British American Tobacco, Diageo, Domino’s Pizza, Coca-Cola, McDonald’s and Nestle) to companies more steered towards wellness and sport (like Adidas, Fresh Del Monte Produce, Lululemon, Nike, Under Armour, and Weight Watchers).
It found that if you had invested £1,000 in the healthy companies, your pot would have grown by £1,245 after five years, while if you had invested in the unhealthy companies, you would have gained £710 over the same period (British American Tobacco performed the worst of the six companies).
Ultimately, while the picture might not look too bad in the short-term, there is no denying that the smoking industry is burning away slowly. In fact, the World Health Organisation forecasts that prevalence of tobacco smoking will fall to 18.9 per cent by 2025, from 22.1 per cent in 2010.
This inevitably has a knock-in impact on the performance of tobacco stocks.
And unless tobacco companies are making a conscious effort to diversify into alternatives, long-term investors should be cautious, particularly if they are investing for their pensions.
With health and wellness currently valued at £3.3 trillion, making it the fastest growing sector in the world, perhaps asset managers should look to swap their smoking habit for the better-performing and more sustainable wellness sector.