Tobacco Stocks Significantly Undervalued say Analysts

British American Tobacco and Imperial Brands are the only two UK stocks to earn a five-star value rating from Morningstar equity analysts

Emma Wall 10 July, 2018 | 12:13AM

tobacco cigarette sin stock investment undervalued esg

Tobacco stocks are controversial. As environmental, social and governance factors come to the fore for investors, the ethics of profiting from these sin stocks are at best hazy, at worst immoral.

Ostrum Asset Management, an affiliate of Natixis Investment Managers, proudly pledged last week to exclude tobacco from all its open-end funds.

But tobacco companies continue to offer compelling opportunities for growth and income to shareholders.

“The economics of the major tobacco manufacturers are – or at least have been – unquestionably enticing,” says Ian Woolley, senior investment analyst at Hawksmoor Investment Management. “More than one billion consumers regularly buy their product regardless of the economic climate or price. Cigarettes are cheap to produce and transport, growers have little bargaining power, and bans on advertising inhibit new competitors from entering the market, so saving a packet on marketing.”

Several high-profile UK equity income fund managers hold a significant stake in tobacco companies, Silver-rated Franklin UK Equity Income has both British American Tobacco (BATS) and Imperial Brands (IMB) in its top 10 holdings, with fund manager Colin Morton saying in the past: “Tobacco companies have very low amounts of debt and offer investors inflation protection, as every year the Government whacks the duty up and the companies put prices up.”

He is not the only one to back these so-called sin stocks. Imperial and BATS appears in the top 10 holdings of Invesco Perpetual High Income, Woodford Equity Income and SLI UK Equity High Income – among many others.

“Concerns over falling cigarette volumes, the implementation of a nicotine standard in the US, and the economics of next generation products have recently led to sharp falls in tobacco share prices: their previous premium ratings relative to the wider market are now substantial discounts,” argues Woolley.

“While these are valid concerns, current share prices now discount very severe outcomes. Change is coming, though from growth in emerging markets to the potential of NGPs, an investment case cannot be stubbed out just yet.”

Morningstar analysts agree – British American Tobacco and Imperial Brands are the only two UK stocks to earn a five-star value rating in the current market. Philip Gorham says the industry is on the cusp of a seismic shift to next generation products such as e-cigarettes, but conventional tobacco will remain the driving force of the industry profit pool for at least the next decade.

“The advent of e-cigarettes has created the most significant change in the industry since the 1960s. Early forms of e-cigarettes have existed for a generation, but the consumer is arguably less brand loyal and more aware of health issues than ever before,” he says. “Big Tobacco manufacturers are placing their bets on the new categories most likely to win share of smokers.”

BATS has allocated most capital to the vaping category and has doubled-down on the combustible business with its acquisition of Reynolds American.

Imperial’s core business is similarly threatened, but its commitment to quality, reducing its total brand count by 32% by the end of fiscal 2017, has some miles yet.

As for the next stage? Gorham says: “Imperial's focus remains firmly on vaping, a category that we believe is commodified with fairly low barriers to entry. Competitors have invested more heavily in heated tobacco, a category that we suspect may have more success in attracting quitting smokers and could be more profitable. Nevertheless, we think given its distribution capabilities, particularly in Europe, Imperial could regain lost ground if it entered the heated tobacco category, and the company has announced plans to test market heated tobacco products in the near future.”

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Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
British American Tobacco PLC3,940.00 GBX2.02
Franklin UK Equity Income W Acc2.12 GBP0.95
Imperial Brands PLC2,933.00 GBX0.95
IP High Income Z Acc339.72 GBP-0.21
LF Woodford Equity Income C Sterling Acc121.50 GBP0.61
SLI UK Equity High Income Inst Acc297.90 GBP0.20
About Author Emma Wall

Emma Wall  is Senior International Editor for Morningstar