Karunathilake (pictured) has completely sold out of British American Tobacco (BAT), which had been a top-10 holding in his fund for his entire investment career. Tobacco stocks make up a significant part of many UK equity income funds, making the manager’s warning particularly alarming.
There are 185 IMA funds that hold BAT in their top-10, including 41 UK Equity Income funds, and a large amount also hold other tobacco stocks.
"British American Tobacco has been a top-10 holding for my fund throughout my investment career," he said.
"I was attracted to the high visibility of cashflows and strong competitive position, which historically resulted in a high score on my company scorecard both for fundamentals and franchise quality."
"However, the tobacco industry is now entering a period of real uncertainty due to the emergence of e-cigarettes, which has resulted in me selling out of BAT completely."
"I am not expecting smokers to quit tobacco en masse overnight in favour of electronic alternatives, however, e-cigarettes offer significant advantages over tobacco (such as relative health benefits and lower cost) and could well cause an average smoker to substitute a couple of cigarettes per day for e-cigarettes."
"In some cases, it could lead to outright cessation of smoking over time. In an industry with little organic growth, any loss of market share or reduction of demand, however marginal, is a real threat to cash-flow."
Karunathilake says that a shift in consumption is likely to be encouraged by governments looking to reduce the number of people smoking and cut healthcare bills.
"Governments and legislators are likely to look favourably on electronic cigarettes in comparison to tobacco," he said.
"Currently there is little in the way of regulation in the US and UK, where penetration has been highest."
"It is likely that as demand grows, regulations around e-cigarettes will become tighter, but it is almost certain that regulation will not be as costly as that imposed on tobacco."
"Given the public health benefits, there is an incentive for governments to encourage smokers towards e-cigarettes."
"E-cigarettes also enjoy the privilege of being able to advertise and market the products openly, something tobacco has been unable to do for many years."
Tobacco has already been threatened by plain-packaging regulations in a number of Western markets, leading some highly regarded managers such as Royal London’s Martin Cholwill to reduce his weighting to the sector.
The manager adds that trends in the US give a good idea of what is likely to happen in the UK soon.
"US e-cigarette company Lorillard claims that 20 per cent of American smokers are completely replacing their traditional tobacco consumption with e-cigarettes and a further 36 per cent of smokers have reduced their traditional tobacco consumption using e-cigarettes," he said.
"Tobacco has always provided an incredibly defensive earnings stream, and it will take time for investors to wake up to the fact that this is now being challenged, but as they do, I think tobacco companies will become viewed as lower-quality franchises due to the emergence of a credible alternative product for the first time."
"The market is still some way from discounting this in share prices: BAT currently trades on around 15x next year’s earnings, which is close to its peak."
"This is not the rating of a company entering a period of structural difficulty. UK supermarkets have de-rated significantly over the past three years as the market has woken up to the challenge posed by the internet."
"I think there is a significant risk that in time, the market will decide that tobacco stocks also warrant a re-rating."
British American Tobacco is held by 185 IMA funds in total, including 41 IMA UK Equity Income funds and 76 IMA UK All Companies funds. There are seven IMA Global funds that hold the company in their top-10 and three IMA Global Equity Income funds.
The £672m Morgan Stanley Brands fund has the highest weighting to the stock, at 9.54 per cent, according to data from FE Analytics.
BlackRock UK Focus has 8.6 per cent and BlackRock UK Dynamic has 7.7 per cent.
Funds with the highest weighting to BAT
| Fund | Weighting to BAT (%) |
|---|---|
| Morgan Stanley - Global Brands | 9.54 |
| BlackRock - UK Focus |
8.6 |
| BlackRock - UK Dynamic | 7.7 |
| SJP - UK High Income | 7.1 |
| BlackRock - UK | 6.9 |
| BlackRock - UK Income |
6.3 |
| M&G - Extra Income | 5.47 |
| BlackRock - UK Equity | 5.4 |
| Aviva Inv - UK Opportunities | 5.4 |
| Invesco Perp - High Income | 5.28 |
Source: FE Analytics
Of the UK Equity Income funds, SJP High Income has the highest weighting at 7.1 per cent. The fund is run by FE Alpha Manager Neil Woodford, who also has 5.28 per cent in the stock in his Invesco Perpetual High Income fund.
In a sign that the threat is being taken seriously by the tobacco industry, Imperial Tobacco this week announced it had bought the electronic cigarette unit of Dragonite International, which claims to have invented the product.
The hope would be that the industry can switch horses to avoid the threat to its revenues. BAT has also taken steps in that direction, having started to sell its Vype e-cigarette brand in this country over the summer.
Both BAT and Imperial announced falls in revenues this year. Imperial is a top-10 holding on 53 IMA funds, including 19 UK Equity Income portfolios.
Karunathilake’s £279m Fidelity UK Select fund has beaten its sector and FTSE All Share benchmark over the past five years, returning 52.56 per cent as the average IMA UK All Companies fund has made 47.81 per cent.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
However, it has slipped behind the sector average over three years, making 37.43 per cent to its peers’ 41.03 per cent.
The fund has ongoing charges of 1.72 per cent and requires a minimum initial investment of £1,000.
