Tobacco companies have largely been shunned as fund managers adopt more ethical approaches to investing, but they may appear attractive once more as recession looms.
These types of businesses are fairly resilient to recessionary pressures as their strong cash flows and high dividend payments tend to remain robust through volatility.
Performance of UK tobacco stocks vs wider market in 2022
Source: FE Analytics
Martin Walker, manager of the £1bn Invesco UK Opportunities fund, initially saw the appeal of these high income paying companies where share prices have been depressed by a lack of market sentiment.
However, after reviewing the tobacco industry closely, he found that the long-term success of these companies was too at risk from environmental, social and governance (ESG) factors.
Walker said: “I think that they look reasonably valued but I want businesses I invest in to have sustainable cash flows. In a world where tobacco volumes have been falling for decades and regulation is getting stricter, that worries me a little in terms of the sustainability of profit growth.”
Ethical considerations do not impact Walker’s investment approach – if a business presents an attractive opportunity, ethical elements will not sway him from investing, but Walker can see these issues having a material impact on tobacco companies’ performance.
“This is not about moral judgement. I've got my own moralistic views on tobacco, but it's not for me to impose those on my clients,” he said.
“They're just not attractive enough.”
Some ethically blurred holdings can be justified through engaging with those companies to improve their practises, but Walker could not find a way of making tobacco ESG friendly, stating: “I can’t see how you could ever polish them up.”
Contrastingly, James Harries, manager of the Trojan Global Income fund and Securities Trust of Scotland, is confident that the industry will be able to keep up with the shifting social landscape by moving away from tobacco and extending its heat-not-smoke ranges.
Smoking has declined over time as the damage to health associated with cigarettes becomes more prevalent, but vaping has become a popular alternative.
It’s a less harmful way to consume nicotine, so rather than tightening regulation as lawmakers so often have with cigarettes, the government is supportive of their wider use.
This means lighter taxation on smoke-free products and Harries predicts that well-established companies such as British American Tobacco and Philip Morris, which account for a sizable 12.6% of asset allocations in the Securities Trust of Scotland, are well placed to lead the charge.
Share price of British American Tobacco and Philip Morris over 2022
Source: Google Finance
He said: “Our perception is you've got a really high quality industry trading at a really cheap valuation which has unassailable pricing power in a world of greater inflation. Plus, they have a great business model which is morphing into one that's more sustainable and long term.
“To us, it's an incredibly attractive income opportunity and we can't understand why everybody didn't see the same thing six or nine months ago when we scaled the position.”
Harries set up an ESG alternative to Trojan Global Income in November last year called Trojan Ethical Global Income after a number of clients said that they liked the investment style but did not want to hold controversial sectors such as tobacco and alcohol.
This involved stripping out two of Trojan Global Income’s largest holdings in British American Tobacco and Philip Morris, which jointly make up a 11.5% stake in the portfolio.
When setting up the new fund, Harries decided that “nothing is as high quality, as inexpensive and as income bearing as those [tobacco] companies,” so instead allocated towards high quality assets that yielded less, such as Chr. Hanson, Universal Music and Colgate.
“There is a trade-off - by expressing an ethical view, you are accepting a low yield,” he added.
Dividend payments have taken a cut as a result, with Trojan Ethical Income yielding less than the original portfolio’s 2.7%.
Harries said: “I think that in terms of total return, both funds may well end up at the same place, but our ethical fund will be slightly more skewed towards capital growth than it is towards income.”
Matt Bennison inherited holdings in British American Tobacco and Imperial Brands when he took over the Schroder UK Alpha Income fund in March 2020, but sold out of them last year over concerns about their societal impact.
He said: “For unconstrained funds, owning tobacco is still acceptable from an investment perspective, but it's becoming increasingly uncomfortable to hold as more traditional funds adopt ESG integration into their process. Given the negative social implications of the industry, it is becoming harder to justify ownership even in conventional funds.”
He wouldn’t rule out investing again if these companies vastly expanded their heat-not-smoke operations, but as things stand revenue from combustible products still makes up the “vast majority of income streams,” meaning the negatives outweigh the positives.
Bennison used Schroders SustainEx tool to rank companies based on how much ESG risks could affect their longevity and “tobacco was comfortably the most negative scoring industry”.
Removing the high income from tobacco assets could of course have a negative impact on the fund’s overall yield, but Bennison supplemented this by allocating to other sectors that weren’t necessarily ESG friendly, but were less at risk from ethical factors.
“When we do sell out of a sector like tobacco, that can give us a little bit of headroom elsewhere in the portfolio to take a bit more social value risk,” he explained.
“This is a prime example of a very volatile period where the tobacco sector can be particularly useful to help you defend income, but as we've seen from the boom in the mining sector, there’s been a return in dividends. Those sectors in themselves look pretty attractively valued, but we don't feel a burning need for the tobacco sector in the portfolio right now.”