Sector Screener: two stocks for attractive long-term returns

Few stock market sectors divide opinion more than tobacco. Some investors will understandably not even consider buying shares in any tobacco company. And with the increasing popularity of environmental, social and governance (ESG) investing over recent years, a negative view of tobacco firms has arguably become more widespread.

Alongside this, the sector continues to face a highly uncertain future. Even though around 22% of the world’s population use tobacco products, consumers are becoming increasingly health conscious and reducing the number of cigarettes they smoke each day or quitting altogether. Indeed, the global number of tobacco users declined from 1.32 billion to 1.30 billion between 2015 and 2020. It is expected to drop to 1.27 billion by 2025. 

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Meanwhile, regulatory changes are further constraining prospects for tobacco firms. From outlawing smoking in public places to the prospect of banning it altogether, governments are increasingly taking a tougher stance due to its negative health effects. With regulations likely to become more, rather than less, onerous over the coming years, many investors will rightly argue that the industry faces a highly uncertain future.

Past performance is not a guide to future performance.

Good value for money

However, the extreme unpopularity of tobacco stocks means that the sector is now exceptionally cheap. Investors can expect to pay single-digit earnings multiples for British American Tobacco (LSE:BATS) and Imperial Brands (LSE:IMB), which are the only two UK-listed companies in the tobacco sector. Their low valuations mean that they offer wide margins of safety which adequately compensate investors for sector-related risks.

Furthermore, the tobacco sector offers a brighter future than many investors may initially determine. While regulatory risks and changes to consumer trends are undoubtedly present, tobacco companies have defensive characteristics that could prove extremely valuable in the current era of economic uncertainty. Their lack of dependence on the economy’s performance means they could realistically deliver attractive rates of profit growth even while the UK is facing the prospect of a recession.

Indeed, the addictive nature of tobacco products means that they are relatively price inelastic. Alongside a high degree of customer loyalty to specific brands, this provides tobacco firms with a significant amount of pricing power that enables them to raise the cost of cigarettes without having a commensurately negative impact on demand. It means that even as the proportion of cigarette smokers gradually falls, any loss in revenue prompted by lower volumes could be largely offset by price rises.

Growth opportunities

While the popularity of cigarettes is declining, the use of reduced-risk products such as heated tobacco and e-cigarettes is rising. In the UK, for example, 8.7% of adults use e-cigarettes on a daily or occasional basis. This is up from 7.7% in the prior year, with the apparently less harmful effects of next-generation products making them more appealing to consumers. And with tobacco firms investing heavily in such products that are generally less exposed to regulatory risk vis-à-vis cigarettes, their long-term growth potential may be highly attractive.

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In addition, the risk posed by regulatory change may not be as great as investors are currently pricing in. Tobacco provides governments across the world with highly reliable tax receipts that may prove difficult to replace. In the UK, for example, tobacco duty raises over £10 billion per year. To put that in perspective, inheritance tax raises £7 billion per year and air passenger duty contributes around £3 billion per annum. While governments may make smoking more expensive and more difficult for consumers, such as through various restrictions on where it can be undertaken, tobacco products are likely to continue to be sold due to the amount of reliable tax revenue they generate. 

Tobacco firms also offer highly attractive income investing prospects. In fact, both sector incumbents have been deemed worthwhile purchases by interactive investor’s The Income Investor column last spring and in December. Their relatively high yields and strong recent track records of dividend growth mean that the sector is likely to remain a highly popular choice among income-seeking investors during the current era of above-target inflation and weak economic growth.

Source SharePad. Data as at 10 January 2024. Past performance is not a guide to future performance.

British American Tobacco

Having fallen by 25% over the past year, British American Tobacco’s share price performance evidences the unpopularity of the wider sector. The stock now trades on a price/earnings (PE) ratio of just 6.3, which highlights the wide margin of safety on offer and scope for a significant upward rerating.

The company’s latest half-year results showed that it is well placed to capitalise on changing consumer trends. Its new categories revenue, which includes sales from e-cigarettes, heated tobacco and nicotine pouches, grew by 27% and now accounts for over 12% of total sales. And according to the company’s latest trading update, next-generation products are expected to have broken even for the first time in 2023 and to become profitable in the current year.

Under its recently appointed CEO, the firm is aiming to generate half its sales from sources other than cigarettes by 2035. In the meantime, and despite their recent impairment, its portfolio of cigarette brands that includes Lucky Strike, Camel and Dunhill provides stable profits that are set to rise at a mid-single digit annual pace over the medium term.

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A net gearing ratio of 53% and net interest cover of over six in the first half of the 2023 financial year, show that British American Tobacco has a sound financial position. Its dividend yield of 9.8%, when coupled with a modest dividend payout ratio of 62%, suggests it offers a highly appealing income investing outlook.

With exposure to a wide range of countries and a mix of defensive characteristics provided by its cigarette brands, alongside exposure to fast-growing next-generation products, the company offers attractive total return potential over the long run.

Imperial Brands

After a difficult period where it struggled to put in place an effective plan to transition to reduced-risk products, Imperial Brands is now making encouraging progress in this area. Although they accounted for just 3% of net revenue in the 2023 financial year, sales of next-generation products have nevertheless grown at an annualised rate of 19% over the past two years.

Perhaps more importantly, the firm now has exposure to e-cigarettes, heated tobacco and nicotine pouches across 20 European markets and the US. Together, they offer long-term growth potential as consumers continue to switch to less harmful products.

In its latest financial year, the firm’s cigarette brands made modest market share gains in their key territories. It was able to offset lower volumes of cigarettes sold by raising their prices, with this strategy set to provide a degree of stability as the business gradually transitions towards e-cigarettes, heated tobacco and other next-generation products.

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Although Imperial Brands has a relatively high net gearing ratio of 126%, its net interest costs were covered over 11 times by operating profits in its most recent financial year. This shows it has the financial capacity to further invest in new growth areas.

Having fallen by 9% over the past year, the company’s shares now trade on a PE ratio of 6.7. Alongside a dividend yield of 7.9%, this highlights how cheap they are in relation to other FTSE 100-listed stocks.

While both Imperial Brands and British American Tobacco face uncertain futures and could therefore remain relatively unpopular among investors over the short run, their high yields and low valuations mean they offer favourable risk/reward opportunities. Their growth potential in next-generation products, solid financial positions and defensive characteristics make them worthwhile purchases for long-term investors.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.