The increasing popularity of tobacco stocks among income investors has left the sector vulnerable to sharp downturns, according to Schroder’s Andrew Williams, who warned the market area has reached worryingly toppy valuations.
He said an example of this was the sector’s correction over the last month, which was caused by the US Food and Drug Administration (FDA) proposal to reduce the amount of nicotine in tobacco products.
From a cyclically-adjusted price/earnings (CAPE) ratio perspective, in fact, Williams said tobacco is still trading on a much wider premium to the broader market and is also towards the upper end of its historic valuation range.
“A month has now passed since tobacco businesses – and their share prices – were sent reeling by a US regulatory announcement,” the investment specialist, who works on Schroders’ Value Perspective team, said.
“So what was the news that, for example, wiped out all the gains British American Tobacco had made in the first half of this year? Was it perhaps about to become illegal to smoke in US homes? Or was a prohibition-style ban on selling cigarettes maybe on the cards?
“Well, if you remember, what actually caused tobacco companies and their investors such a fright was the revelation by the US Food and Drug Administration that it was planning to ‘begin a public dialogue’ on the subject of lowering nicotine levels in cigarettes to non-addictive levels.
“Not the end of the world, you might think – but markets are hardly renowned for their measured response to unexpected news.”
Performance of indices in 2017
Source: FE Analytics
Andrews said the reason the market’s reaction was so severe is because more and more investors have been willing to pay a premium for perceived safety and a regular stream of income.
As such, he explained that small events can ripple outwards when it comes to market behaviour and believes tobacco stocks are now particularly susceptible to sudden corrections.
“When a stock is ‘priced for perfection’, its investors can find themselves very exposed,” the investment specialist added.
The flock to so-called ‘bond proxies’ due to low yields from fixed income and low interest rates has been well-documented. Although this is of course up for debate – many investment professionals have cited tobacco stocks as being a prime example of these high-cost, low-growth income stalwarts.
Within the IA UK Equity Income sector, for instance, data from FE Analytics shows that 37 (or 42.5 per cent) of funds hold British American Tobacco within their list of top 10 largest holdings. Eight of these have allocated more than 5 per cent of their overall portfolio to the stock, with Lazard Multicap UK Income, F&C UK Equity Income and BlackRock UK Income holding a 6 per cent weighting or more.
In terms of Imperial Brands - the FTSE 100’s other large tobacco constituent - 30 (or 39.5 per cent) of funds in the sector hold the stock within their list of 10-largest individual weightings. Funds with the largest allocations include CF Woodford Equity Income (as covered in an FE Trustnet article published last week), Threadneedle UK Equity Income and Premier Optimum Income.
Overall, 52 (or 59.8 per cent) of funds in the sector hold at least one of these two stocks in their top 10 list. Some 14 of these funds hold both in their top 10, with the list including the likes of Troy’s Trojan Income, Fidelity Moneybuilder Dividend and Invesco Perpetual Income & Growth.
Given how widely-held these stocks are across the industry, does this mean many UK investors could be exposed to more sector-specific risk than they thought?
“A lot of equity income portfolios [are] becoming overloaded with food, beverage, tobacco and other assets characterised as ‘bond proxies’ on account of the elevated dividends they pay,” Andrews continued.
“Here on The Value Perspective, however, our unwavering focus on valuation means our own income portfolios are positioned very differently.
“A good illustration of this is our preference for banks – a sector where many investors still fear to tread.”
Research from The Value Perspective team – as seen below – depicts the widening valuation gap between UK banks and tobacco stocks based on their CAPE ratios over the last decade relative to the wider UK market.
Source: Schroders, Thomson Datastream
Despite this, the data also shows that the average yields of UK bank and tobacco stocks – at 3.6 and 4 per cent respectively – are similar.
“Back in 2011, a Value Perspective piece called ’Smoke and mirrors’ drew comparisons between the then out-of-favour pharmaceuticals sector and the deeply unloved tobacco industry of the 1990s,” Andrews explained.
“We argued investors were, in each instance, so concerned by the sectors’ respective negatives they had become blind to how they in fact boasted well-run businesses with attractive dynamics and sensible amounts of debt.
“In the six years since that piece was written, pharmaceuticals have done so well the comparison is no longer appropriate – though we would argue investors could benefit from thinking about banks in a similar light.”
The investment specialist argued that, over this time frame, tobacco stocks also thrived and have done so to the point where a “fairly mundane” regulatory announcement can deal a significant blow to share prices.
“The suspicion must be that any number of pieces of negative news – for example, something relating to the emerging markets, where the hopes for so much of the sector’s profits now rest – could have had a similar effect on tobacco share prices,” he warned.
“Indeed, they still could – and yet when investors focus on yield to the exclusion of considerations such as valuation or total return, they leave themselves no margin for error.”
Andrews believes ultra-low interest rates have blinkered investors from noticing valuation risk, which is why tobacco stocks have continued to rocket in price.
“The reality is many are buying these stocks not for their underlying quality but for the simple reason they are going up in price,” he said.
“In essence, they are not buying what they think they are buying – high-quality businesses with stable earnings – but very sensitive and increasingly expensive assets.”