Jamie Clark

No smoke without fire?

Jamie Clark

It has been a torrid year for Big Tobacco, buffeted by multiple headwinds. Share prices have plunged accordingly. Does this sector de-rating offer an opportunity to buy into a cash cow with an addicted customer base? Or is it a case of ‘no smoke without fire’ – the early signs of an industry in structural decline?


2008 – 2017: A defensive haven


Tobacco Rerate Macro

Source: Bloomberg, Liontrust


In the post-Global Financial Crisis years, tobacco stocks re-rated as their defensive qualities proved increasingly attractive against a backdrop of anaemic economic growth.


Tobacco companies are high margin, cash-generative and boast generous dividend pay-out policies. There is a persistence to their earnings and dividends which confers ‘quality’ status and encourages easy comparison with fixed-income securities.


Following the crisis, bond-proxy equities, like tobacco, rallied with bond markets as central banks stimulated economies by cutting rates and undertaking quantitative easing, or bond purchase programmes.


It’s precisely because of the similarities with bonds that tobacco stocks are often the first names on the pad for an equity income manager. But avert your eyes from the spreadsheet for a just a moment and you’ll note that there is very good reason for investor concern.


2012: Macro-Theme emergence


It’s no revelation to point out that there is a causal relationship between tobacco use and incidence of cancer, lung disease and cardiovascular disease. What’s less well understood, perhaps, is the extent of the damage caused by habitual tobacco usage. The statistics are legion, but to alight upon several of the more shocking: roughly half of all tobacco users will die of tobacco-related causes; tobacco accounts for 12% of all adult deaths; and $422bn per annum is spent worldwide in treating tobacco-related disease (source: WHO ‘Tobacco Threatens Us All’, 2017) .


Little wonder then that NGOs and politicians have been quick to seize the anti-smoking mantle. Probably the most influential expression of this agenda is the World Health Organisation’s ‘Framework Convention on Tobacco Control’ (2003), an anti-smoking manifesto written with the express intention of cajoling governments to reduce tobacco demand and availability.


We paid little heed to the Framework at the time of its publication because, like many others, we were seduced by the financial attractions of tobacco stocks. But new Macro-Themes are often long gestation.


By 2011/12, it was apparent that governments across the world were taking a much more prescriptive approach to the regulation of smoking.


China introduced public smoking bans in May 2011, a Russian equivalent was being debated by mid-2012 (effective 2013) and Australia had legislated for plain packaging by Christmas of that year.


This pointed to a clear direction of travel with obvious consequences for tobacco demand. We sold out of tobacco stocks in Q4 2012 – initiating a non-hold Avoiding Tobacco theme - and haven’t held them since.

Tobacco Rally Macro


Source: Bloomberg, Liontrust


Put plainly, this hurt performance. From the end of 2012 to its mid-2017 peak, the FTSE 350 Tobacco Index appreciated by more than 70%, outperforming the market by over 20% and re-rating more than four prospective p/e multiple points to 17.3x forward earnings (source: Bloomberg).


With the clarity of hindsight, we underestimated the allure of businesses with mid-single digit compound earnings growth as the global economy stuttered in the aftermath of the Global Financial Crisis.


2017: Macro-Theme maturity


While tobacco’s strong performance from 2012 to 2017 was painful in the context of our funds’ zero weighting to the sector, events of the last 18 months have vindicated our conviction in the Macro-Theme.


 Tobacco Fall Macro


July 2017: The US Food & Drug Administration (FDA) gave warning that it could cut nicotine in cigarettes to “non-addictive levels” – a threat to the idea of Tobacco’s ‘addiction earnings’ and bond-like characteristics.


January 2017: The FDA concluded that there was little evidence for the claim that Next Generation Products (NGPs) – vaping and ‘heat not burn’ devices – were any safer than cigarettes. This was a blow to the idea that growth in newer, seemingly safer products, could offset tighter regulation on cigarettes.


April 2018: Disappointing Q1 earnings from Philip Morris, the tobacco company most invested in NGPs, gave notice that its “reduced risk products” were proving much less popular than expected. This was a big dent in the argument that tobacco users would switch to NGPs and justify the billions spent in R&D.


2018: Avoid the value trap


Following the sector de-rating, are the tobacco businesses now cheap enough to compensate for the risk of stricter anti-smoking measures?


In short, we think not.


Next Generation Products are likely to be lower volume and lower margin than cigarettes, and until questions over health effects are answered, investors are likely to apply a discount to NGP earnings.


  1. Next Generation Products are not the answer to declining cigarette volumes.

    There’s no doubt that tighter regulation has cut demand for tobacco. We see it in the cigarette stick volume declines reported by the tobacco companies and data collated by the World Health Organisation showing that smoking prevalence is falling in most areas of the world.


        Tobacco Smoker Ages Macro   


    Source: “Who Global Report on Trends in Prevalence of Tobacco Smoking 2000 – 2015”


    Understandably, the tobacco industry has responded by pouring large sums of money into developing reputedly safer alternatives - NGPs. This isn’t just about the Vape shops that pepper our high streets, but includes other products like tobacco ‘heat not burn’, snuff and snus.

    US company Philip Morris is the poster child for the initiative. Curiously, it has adopted the anodyne corporate slogan smoke free future and spent upwards of US$4.5bn on developing IQOS, its ‘heat not burn’ offering.

    From launch, IQOS garnered five million users and achieved significant share in the NGP test markets of Japan (15.8%) and Korea (7.3%). NGPs accounted for 12.4% of Philip Morris’ 2017 sales and Philip Morris duly rerated to more than 20x forward earnings as markets anticipated growth to come.

    However, IQOS gives an instructive example of the hope invested in the success of NGPs and the difficulty of replacing a product as lucrative as cigarettes.

    April’s Q1 earnings delivered unwelcome news of appreciably slower NGP sales in Japan. Philip Morris blamed “conservative adult smokers with “slower patterns of adoption”.

    Now this seems to be the rub. Cigarettes are addictive for a number of very particular reasons – chemical content, delivery mechanism and ritual – and it seems fanciful to suggest that a new product, however well executed, can tempt habitual users to switch.

    The problem the tobacco industry has encountered in Japan will likely be encountered elsewhere. We have severe doubts that NGPs can compensate for falling cigarette demand.

  2. Next Generation Products are lower margin

    Cigarettes are an incredibly lucrative business. Whilst tobacco companies report group operating margins of c.40%, the margin on premium brands can exceed 60%.

    NGPs threaten margin dilution. From factories to retailing and marketing costs, enormous outlays are needed to make NGPs commercial.

    Again, Philip Morris offers insight on this score. IQOS devices are sold at a 25% discount to cost and 21% of its total commercial costs are attributed to the new distribution and sales channels required for NGPs.

    In short, it’s unlikely that NGP’s return on capital will ever match that of cigarettes.

  3. Next Generation Products’ health impact is not yet known

Tobacco company websites are full of scientific citations attesting to the safety of NGPs relative to cigarettes. At the same time, the likes of the World Health Organisation and The Lancet medical journal have drawn attention to the lack of evidence regarding the long-term health effects.


The point is that NGPs have only been commercially available for the last decade. Consequently, the data is too immature to yield any definitive idea of whether they are harmful or not. Time, more data and further study are the only recourse. In the interim, the tobacco industry will find it difficult to dispel the significant doubt attached to cigarette substitutes.


Another headwind to tobacco is a reversal of the ‘bond-proxy’ effect.


The current global economic upturn means that the well-worn strategy of investing in ‘quality’ defensive growth companies in a low rate environment could be coming to an end. Higher rates are on the way and extraordinary bond purchase programmes – or quantitative easing – are being phased out.


This suggests higher sovereign yields. Notwithstanding the Bank of England’s dovishness, the UK is party to this. An unemployment rate of 4.2% is the lowest reading in more than 40 years, the past 18 months have seen a steady pick-up in wage inflation, headline inflation is running at 2.4% and, by consequence, inflation adjusted interest rates are materially negative. Make no mistake, rates are set to rise.


This means the tables have turned on ‘quality’ companies.


Tobacco FTSE Macro

Source: Bloomberg


The relationship between the FTSE 350 Tobacco Index and the 10 year UK government bond yield is clear to see.


Despite their recent share price weakness, we think that tobacco companies represent a value trap which must be avoided.


While the Avoiding Tobacco Macro-Theme has matured in recent months, it hasn’t expired. We find cause to believe tobacco companies’ share prices will continue to languish and we maintain our zero sector weighting.

Key Risks & Disclaimer

Please remember that past performance is not a guide to future performance and the value of an investment and any income generated from them can fall as well as rise and is not guaranteed, therefore you may not get back the amount originally invested and potentially risk total loss of capital.

This blog should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust.

Friday, July 27, 2018, 2:31 PM