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Why This Fidelity Fund Manager Has Sold British American Tobacco plc

Fund manager Fidelity is the world’s leading name in managed investments. When the manager of their UK Select Fund decided to dump British American Tobacco (LSE: BATS) (NYSE: BTI.US), I had to find out why.

Introducing Aruna Karunathilake

Mr Karunathilake’s fund is up nearly 25% in the last 12 months, handsomely beating the FTSE 100. Aruna does not neatly fit any particular investor classification such as growth or value. He is prepared to pay up for a company that possesses the right qualities, what he calls ‘good franchises’.

The e-cigarette threat to British American Tobacco

The rapid rise of electronic cigarettes has led Mr Karunathilake to question his holding in British American Tobacco. The fact that they will remain unregulated in the EU sealed the deal and he has now disposed of all of his fund’s holding.

“About a year ago I started to experience a growing realisation that e-cigarettes will be soon become a more mainstream product” he says. “I expect them to have a significant impact on tobacco sales. Data from US manufacturer Lorillard shows how in just two years, smoker trials of the product have nearly doubled. The cost per use of e-cigarettes is lower than traditional cigarettes. They are a credible alternative to tobacco and I expect their rise to result in lower revenues and a smaller profit pool for British American Tobacco”.

According to Lorillard data, regular e-cigarette usage has doubled among tobacco users. One fifth of smokers surveyed revealed that they are using e-cigs to replace combustible cigarette use entirely. The writing is on the wall.

The threat from a lack of regulation

Government regulation makes business expensive and deters new entrants. It favours large organisations that can comply with minimal impact on profitability. However, the EU left e-cigarette manufacturers to operate unregulated. To Mr Karunathilake, this is a major bear signal.

“The tobacco market was a fantastic structure for a small number of players. With e-cigarettes however, there will be much greater competition. This will result in lower margins. Participants will be weaker franchisers. They will become the kind of businesses that deserve a P/E discount, not the premium that British American Tobacco shares enjoy currently.”

Mr Karunathilake has reserved the right to buy back in should European e-cigarette regulation become more favourable. When added to declining volumes, increased controls worldwide and softening earnings forecasts, the march of e-cigarettes is just another reason to avoid the shares.

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> David has bet that the share price of British American Tobacco will fall. He has no financial exposure to any of the other companies mentioned in this article.