Top UK equity income managers have been cutting their weighting in tobacco stocks as concerns over earnings momentum and new rules on plain packaging put pressure on share prices.
Tobacco firms, which are among the top performing of all UK-listed companies over the last decade, have become income staples for many investors.
While other income stocks have suffered catastrophes in recent years – banks were badly hit by the credit crisis, while BP lost more than 50% of its value after the Gulf of Mexico disaster – tobaccos have continued to perform strongly for income funds.
As a result, the equity income sector’s leading lights continue to hold the stocks in abundance, with British American Tobacco (BAT) appearing among the top 10 of 44% of funds in the UK Equity Income sector, according to data from FE.
Managers’ positions in tobacco stocks have paid off as British American Tobacco produced a total return of 661.44% over the last 10 years, while Imperial Tobacco returned 230.54%, according to Morningstar.
Tobacco features heavily in the largest of all the income funds, making up 15.5% in Invesco Perpetual’s £9bn Income fund, and 16% in the £12bn High Income fund, both run by Neil Woodford.
However, managers are now starting to turn against the sector on fears over the impact of new regulation.
PSigma’s Bill Mott, as well as Liontrust’s Stephen Bailey and RLAM’s Martin Cholwill, have significantly cut their tobacco holdings in recent weeks.
Australia, a key market for cigarette manufacturers, is bringing in plain packaging rules in December, meaning brand names will be removed from packets, and other countries are poised to follow suit.
The move means brand loyalty – and therefore reliable income streams – could come under pressure, and managers have reacted by scaling back exposure to the sector.
Bailey and co-manager Jan Luthman of Liontrust have halved their exposure to tobacco in the last six months as they feel there has been a hardening of attitudes towards smoking worldwide.
Bailey said this is happening even in places where smoking is culturally acceptable, such as Russia and Indonesia.
“We can see further bans being imposed on a global basis in future, and we have seen the issues such as plain packaging which have arisen in Australia.
“There are very few small to medium tobacco companies available worldwide as most of them have already been acquired, meaning the earnings momentum such acquisitions has created is perhaps coming to an end,” he said.
“We would argue there are quite a few headwinds facing the tobacco companies and, quite frankly, there are better places to be exposed to.”
At the end of August there was just over 8% in tobacco in the pair’s Macro Equity Income fund, but this has been cut to 5% and both BAT and Imperial have fallen out of the pair’s top ten.
Mott, who runs the £393m Income fund, has cut back his holding in BAT to 3.5%, down from 4.4% at the start of the year and is now underweight against the index “for the first time in recent memory”.
“The latest assault is the introduction of plain packaging in Australia, and other countries are likely to follow Australia’s lead,” he said.
“While regulation in the industry is not new, and companies have been masters at pushing prices up to cover volume declines, this gets harder as prices go ever higher.
“Even though smoking is addictive, customers cannot be totally price insensitive. At today’s prices in the UK of over £8 a pack, even the well-heeled must baulk at the price.”
Cholwill is also pulling back and said BAT in particular no longer represents good value for income funds as its yield is declining.
Following a strong run up in price, he said BAT’s yield is only at a slight premium to the broader stock market, and with yet more regulation on the cards, he is cutting back his exposure.
“Historically it has always been on a decent yield premium and actually with the shares having performed well, the yield has slipped,”Cholwill said.
BAT’s dividend grew around 9% last year but consensus growth forecasts for this year have fallen to just over 6%. Meanwhile, Imperial’s dividend grew by 11.5% last year, but this too is predicted to come down in 2012.
“Tobacco companies are usually bought for their defensive merits and resilient qualities in difficult economic times. If they are suffering downgrades, that to me is a bit of a flag, as are a number of changes in overseas markets,” Cholwill added.
The stocks still offer a defensive yield however, and some managers – particularly those who were running underweight positions – have been tempted back by the perceived safety they offer.
Adrian Frost, manager of the £4.5bn Artemis Income fund, considerably reduced his holding in BAT throughout the summer, but has recently been buying back in.
“We repurchased some of the BAT position after a period of lacklustre performance. Yield continues to look attractive, relative to other assets,” he said.
Threadneedle’s Richard Colwell, who manages the £1.48bn UK Equity Income fund with Leigh Harrison, also took some profits from BAT earlier in the year, but the duo is not concerned about plain packaging.
“Our central assumption is that plain packaging will spread to more markets, in particular New Zealand, the UK and France.
However, we do not believe this poses a threat to the future earnings of tobacco companies,” Colwell said. “Imperial trades on a P/E of 11x and BAT on 14x; both offer high single digit earnings growth and high, sustainable dividend yields.”
Key Points
Plain packaging
Australia is going to implement its plain packaging law as of 1 December 2012, making it the first country in the world to require tobacco products to be sold in this way.
The new packaging removes brand colours and logos and will be covered in graphic images warning of the consequences of smoking.
Many other countries such as New Zealand, India, the UK and even some states in the US have been contemplating taking similar measures in a bid to reduce the number of smokers.
Russian Prime Minister Dmitri Medvedev has also voiced support for a proposed ban on public smoking by 2015 in Russia, where close to a third of the population smokes