Among Neil Woodford’s top five holdings are Imperial Brands (LSE: IMB) and British American Tobacco (LSE: BATS). They’ve performed exceptionally well in recent years, rising by 78% and 73% respectively over the last half-decade. This compares to a 31% gain for the FTSE 100. However, are declining sales volumes of cigarettes likely to hurt their financial and share price performance over the medium term?

Across the tobacco industry, sales volumes of cigarettes are falling. This is due to a mix of factors. One of which is tighter regulation. For example, in the UK there’s a ban on the display of tobacco products in shops and smoking isn’t allowed in workplaces or in pubs and clubs. Similarly, regulations have tightened in other countries across the globe. In Australia, plain packaging has diluted the marketability of different brands, while in Russia restrictions on smoking in public places have also been put in place.

As such, it may appear to many investors as though smoking is in decline. Certainly, people across the world are becoming more health conscious and are increasingly shunning the ill effects of cigarettes. Therefore, tobacco could be viewed as a declining industry which shouldn’t be invested in for the long term.

Growth potential

However, the reality is that tobacco companies such as Imperial and British American Tobacco have huge growth potential. Much of this comes from increased pricing. Each year, cigarette prices rise at what is normally a much faster pace than inflation and this helps to adequately offset the decline in volumes sold. This strategy has a long way left to run, since demand for tobacco doesn’t change in line with prices rises as a result of its addictive nature.

Furthermore, people may be getting increasingly health conscious, but world population growth could mean that the absolute number of smokers in the world increases in the long run. For example, the UN estimates that the world’s population will increase from 7.3bn today to 9.7bn by 2050. This means that even if the proportion of smokers falls, the total number of smokers may stay the same or even rise.

Although cigarette volumes are falling at present, demand for e-cigarettes is on the rise as more smokers find them an effective way to give up or at least to avoid the worst health effects of smoking real cigarettes. Both Imperial Brands and British American Tobacco have exposure to this market through their Blu and Vype brands respectively. This provides them with a new growth space alongside tobacco. With the cost to manufacture e-cigarettes likely to fall on a per unit basis as their sales increase, they’re likely to become increasingly profitable for tobacco companies in the long run.

Imperial Brands and British American Tobacco yield 4% and 3.4% respectively. As such, they remain relatively high yield stocks with stable dividend outlooks. In addition, their earnings growth potential is high despite volume falls thanks to a growing population, price rises and e-cigarettes. Therefore, they’re not destined to fail and Neil Woodford’s decision to have them among his top holdings may prove to be the right one.

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Peter Stephens owns shares of British American Tobacco and Imperial Brands. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.