A growing number of equity income fund managers are either selling down or exiting tobacco stocks as the defensive stalwarts continue to fall out of favour.
The sector outperformed strongly throughout the uncertainty of the first half of 2012, but has been left behind since the market has moved back into risk-on mode.
British American Tobacco’s (BAT) share price rose by 8.05% over the first eight months of last year compared to a 0.2% rise in the FSTE 100, but from there it has fallen by 1.58% compared to a 9.69% gain in the blue chip index.
Imperial Tobacco’s fall from grace has been even more pronounced. Peaking at 6.57% higher on 10 July last year when the FTSE 100 was down by 0.63%, it has since fallen by -7.9%, while the FTSE 100 has surged 10.61%.
Thomas Moore, manager of the Standard Life Investments (SLI) UK Equity Income Unconstrained fund, says despite this turnaround in their performance, tobacco stocks remain overvalued and over-owned by other income fund managers.
Research by SLI found that some 71% of funds in the Investment Management Association’s UK equity income sector have exposure to BAT which he deems a worryingly consensual trade.
‘BAT has been suffering consistent downward revisions to its earnings forecasts and this reflects the discussions analysts are having with the company’s management around pricing issues and volume data,’ he says. ‘It has fundamental issues of weakening demand and adverse regulation. We are also seeing downward revisions to its dividend due to this decline in fundamentals.’
A number of countries are currently in the process of tightening up their regulations on smoking with both Russia and China set to restrict the practice in public places and Australia having increased taxes in a move that has pushed prices through the psychological Aus$20 a packet barrier.
Moore’s fund, which is up 43.5% over three years compared to a sector average gain of 33.7%, has zero exposure to the sector.
Although he is confident about their pricing power and remains overweight the sector, he has reduced this position from 7.2% last year to 6.6% this year versus a 4.9% index weighting and he expects to reduce his exposure further. ‘We have reduced this because we are concerned that cigarette pricing is already very high in many markets, that the social and legal trends against the industry are increasingly negative and that the valuations are not as attractive as they once were,’ he says.
Moore believes these valuations could come under further pressure, however with BAT’s dividend growth in particular in a downward spiral. He points out that after upping its shareholder payout by 19% in 2009, this fell to 14% in 2010 and 10% in 2011. ‘It is gradually shifting from being a dividend growth stock to a stodgy flat dividend stock,’ he adds.
That said, there many still plenty of investors that continue to back the sector as a cash generative source of well-funded dividends. Invesco Perpetual’s Neil Woodford is the most high profile tobacco champion through his Income and High Income funds, while BlackRock UK Income co-manager Nick McLeod-Clarke says that he has been topping up his weighting in BAT on price weakness.
However, Ewen Cameron Watt, chief investment strategist at the BlackRock Investment Institute, another long-term tobacco holder, admits he sees his call to sell out of the sector as one of his biggest pain trades of 2013.
‘Our biggest contrarian ideas [include] selling “safe” tobacco stocks, buying US companies with cash piles abroad and European and US financials,’ he says.
Whenever the long-term tobacco lovers are starting to move on, the potential opportunity cost of standing firm should surely be reassessed.