5 Overvalued Stocks Driven by Sterling Weakness

As British American Tobacco confirms it will buy rival Reynolds American, we look at BATs and four other overvalued stocks boosted by the weak pound

Karen Kwok 17 January, 2017 | 3:39PM
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British American Tobacco (BATS) today announced a $49.4 billion agreement to buy 57.8% of rival company Reynolds American (RAI). The merger will make BATS the world's largest listed tobacco company by net revenue and operating profit. Share prices of British Tobacco dropped 2.8% today after the announcement.

British American first announced plans to buy the remaining stake in Reynolds in October. The company is currently the world's second largest quoted tobacco group by market share, while Reynolds is the second largest tobacco company in the US.

Nicandro Durante, chief executive of British American said in a statement the combination with Reynolds “will create a stronger, global tobacco” business. Morningstar senior equity analyst Philip Gorham said despite the offer being slightly rich, it is a good deal for British American strategically.  

“Reynolds possesses solid competitive advantages, including very high brand loyalty to Newport, arguably the strongest brand in US tobacco, and a cost advantage over smaller domestic manufacturers,” said Gorham.

“Acquiring Reynolds would again give British American operational control of its interest in the U.S. market. The US is an attractive market, where the affordability of cigarettes leaves plenty of scope for multiyear price increases,” said Gorham.

The weakening of sterling after the Brexit vote in June has also boosted British American’s market valuation that has helped to make this deal more financially attractive, Gorham added.  

British American Tobacco is rated as an overvalued two-star stock by Morningstar analysts, meaning analysts believe the stock is trading above its share price fair value estimate. Apart from British American Tobacco, there are currently 10 other overvalued stocks in the UK market, according to Morningstar Select.

We picked four more stocks that our analysts believe would be affected by current currency fluctuations – either that their sales and earnings would be boosted or damaged by a weak pound.

4 More Stocks Impacted by Sterling

Associated British Foods (ABF) has turned in a strong start to the year, with its trading update for the sixteen weeks to January 7 showing a 22% jump in sales, said Morningstar equity analyst Adam Kindreich. All businesses appear to be performing at least in line with, or better than, analysts’ expectations. Share prices of the stock fell 16.8% in 2016.

Currencies can have a large impact on margins and earnings of the company, particularly from a transactional point of view, said Kindreich. To simplify, Associated British Foods buys raw materials from grain to wool, in US dollars, but generates nearly all its revenue in British pounds and euros. The recent weakening of the British pound will therefore positively boost sales in 2017, said Kindreich.

Another retailer Morrison Supermarkets (MRW) is the fourth-largest U.K. supermarket chain with 10.8% share and strong market positions in the north of England and Scotland. Higher inflation mainly brought about by the sterling pound's depreciation in recent months should boost same-store sales growth in the year to January 2018, and Morningstar analysts’ forecast is 2.8%, said Kindreich.

However, Kindreich warned that there is also a geographical risk in having all the stores in the UK with no international business to offset. This involves an indirect foreign exchange risk linked to merchandise purchased in foreign currency, so changes in the British pound's value could affect margins of the company.

Victrex (VCT) is a British specialty chemicals company whose business is based predominantly on manufacturing and creating solutions using polyetheretherketone, an ultra-high-performance lightweight plastic. Around 40% of sales are generated in Europe, with Asia and the Americas contributing 30% each, said Morningstar equity analyst Rob Hales. Sales and profits will rise in 2017 due to a currency tailwind from the depreciating British pound, said Hales.

Commodities and mining stocks have seen massive gains in 2016, including the share price of Anglo American (AAL). This company is the best performing UK stocks of 2016, gained 289% in the year.

As China rebalances away from infrastructure and construction-led growth, global miner Anglo American will find itself better positioned than most diversified peers, said David Wang, equity analyst at Morningstar. 

The company has greater exposure to consumption-oriented commodities like platinum and diamonds, which should enjoy better demand growth than investment-oriented commodities like iron ore and copper that prospered most in the past decade. There Wang believes that Anglo American is at a unique position among global miners with significant platinum and diamond exposure.

The company is the only one-star stock, meaning Morningstar analysts believe the stock is trading significantly above their fair estimate for the share price.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Karen Kwok

Karen Kwok  is a Reporter for Morningstar.co.uk