Earlier this month, the UK’s largest pension scheme announced it will no longer invest in tobacco and will sell off its £40m holding in the sector. The government’s £6 billion Nest pension scheme said the industry’s business model “looks increasingly unsustainable”.
It follows in the footsteps of Axa, Aviva, and the Dutch, Swedish and Norwegian government pension schemes, all of which have been busy permanently divesting their tobacco holdings.
The reason so many have turned their backs on tobacco is partly reputational risk, says Damien Lardoux, head of impact investing at financial planners EQ Investors: “They are happy not to be exposed to a sector that is killing people.” But, the sector more generally is “really challenged, and it is struggling to grow revenues,” he adds.
Earlier this month British American Tobacco (BATS) reported it had lost cigarette market share for the first time in years, and had seen disappointing sales growth in its alternative cigarette products.
Some of the headwinds Big Tobacco is facing include regulatory and political pressures, falling smoker numbers, and a rising trend towards ethical and ESG investing. Attempts to diversify into other areas such as smokeless products and e-cigarettes have proven less than straightforward. San Francisco authorities have just announced a ban on vaping in public until it can explore the health effects of these products, and other cities could follow suit.
But, in the face of all these risks, tobacco stocks still feature prominently in a number of leading UK and global equity income funds. Why aren’t fund managers more concerned about the future of tobacco?
Chasing Yield
The main attraction of the sector is, of course, its yield. So far, the pressures on tobacco firms’ bottom line have not translated into falling dividend payouts.
Dean Cheeseman runs multi-manager portfolios for Janus Henderson. When selecting funds for his portfolios he quizzes the managers closely on the reasons for any tobacco exposure. “The standard response is that if it isn’t a sustainable, environmental or ethical fund, so tobacco is in scope. It is a cash generative business, which has a policy of returning a high proportion of the cash generation to shareholders.”
While it is very easy to make a negative case and there are stocks that have structural issues, he says, if the manager has assessed the risk, calculated what the downside might be and has attributed an excess return to compensate them for the additional risk, then he is happy for them to invest.
But they must also show that they are on top of regulatory and local changes. Cheeseman points to a ban on menthol cigarettes being considered in the US and slated in the EU for 2020, as one example. This would put a big dent in tobacco firms’ earnings: around a quarter of BAT’s global profits, for example, come from menthol cigarettes.
He notes that BAT yields 7% and Imperial Brands (IMB) 10.2%. Imperial has this month announced a new flexible dividend policy: from 2020 it will no longer commit to a 10% rise in payouts every year.
The two stocks account for 0.27% of the total 4.5% yield of the FTSE All Share on a weighted basis. This means that, as a proportion of the total income generated from the UK market, they make up 6.1%, which Cheeseman considers “material without being massively significant”.
So, what could replace tobacco stocks in income-generating portfolios? There are other options for high yielding sectors, Cheeseman point out. “It’s the consumer-oriented stocks in the main. Utilities mostly yield more than 5% - Centrica has a 13.7% yield although I would challenge its robustness, given that we know there are issues at the company. Within telcos, BT is yielding 7.7%, so there are pockets.”
BP (BP), HSBC (HSBA) and Shell (RDSA) make up large proportion of dividends from the overall index, so they are quite hard for equity income fund managers to ignore. But Cheeseman points out that some small-cap focused equity income managers already avoid tobacco: “Gresham House UK Multi Cap Income, for example, will have zero in tobacco as there are no small tobacco companies,” he said.
Courting Sustainable Investors
One of the biggest challenges facing the tobacco sector is its image problem. With a healthier younger generation turning its back on smoking and wanting to invest its money in a way that has a positive social impact, the sector risks being totally blackballed.
As global interest in environmental, social and governance (ESG)-based investing grows, tobacco firms have been trying to improve their credentials in these areas - “they are trying to buy themselves a better reputation,” says Lardoux. This includes making charitable donations, improving female and minority representation on their boards, treating tobacco growers better, and investing in perceived “healthier” smokeless products. But there are only a handful of small-cap stocks offering exposure to these, so to access the theme in a more liquid way, you’d still have to hold Big Tobacco. Plus, vaping is still quite new, the health claims are untested, and smokeless products still account for a small proportion of the tobacco companies’ revenues.
For many investors with an ethical or green bias, the positives from tobacco companies will not cancel out the many negatives including a deadly end-product, the amount of water and pesticides needed to grow the crop, and the industry’s links to corruption and child labour in emerging markets, says Lardoux.
Yet, despite all this, the best of a bad bunch can find themselves featured in ESG indices because ESG ratings are done at the sector level, he explains, which might come as a surprise to some investors. BAT, for example, is part of the Dow Jones Sustainability Indices but, for EQ as impact investors, “there’s no way we would invest in any of those tobacco companies, and any sustainable funds investing in tobacco I would really question.”
Cheeseman uses ESG criteria as a risk tool and says that on many metrics, tobacco will score badly. However, those companies transitioning away from traditional tobacco to “heat not burn” products look more appealing, he says. “If you buy the highest scoring ESG stocks, you don’t necessarily outperform, but if you can identify companies that are on an improving ESG trend - for example, Philip Morris saying it will generate 30% of sales by volume from smoke-free products by 2025 - there is increasing academic evidence to support the idea that these companies do outperform.”
