Tobacco stocks are generally considered as some of the best non-cyclical investments for income-seeking investors. This is because changes in economic conditions typically have very little impact on the demand for cigarettes, which results in tobacco companies generating very stable cash flows across the business cycle. Thus, this explains why tobacco stocks consistently pay very attractive dividends and tend to outperform most stocks in a bear market.
Historical Performance
Historically, tobacco stocks have been very successful investments too. In the past 10 years, British American Tobacco (LSE: BATS) has delivered shareholders a total return (that is, the rate of return with dividends being reinvested in the stock) of 176%. Imperial Tobacco Group (LSE: IMT), which has done somewhat less well, returned shareholders with a gain of 98%.
Looking forward, both companies are unlikely to repeat their performances in the future. Global cigarette volumes growth is slowing and regulation on the industry is increasing around the world. The rising popularity of e-cigarettes could certainly be game changer for the industry, and this uncertainty has already impacted on the valuations of the major tobacco stocks.
Nevertheless, both companies should still be able to grow their earnings steadily in the medium term. Earnings continue to expand because profit margins are widening from price increases, which is made possible by the brand value that these companies have built up.
And even as volumes shrink, further industry consolidation could enable firms to continue to grow profits. Compared to the food and personal care markets, tobacco brands operate in quite a fragmented market and consolidation would help to cut costs and bolster market share.
Valuations
| BATS | IMT | |
| Forward P/E | 17.0 | 15.1 |
| Prospective Dividend Yield | 4.4% | 4.4% |
| Adjusted Payout Ratio | 71% | 66% |
At a first glance, there seems to be little difference between the valuations of the two tobacco companies. The dividend yields, the most important metric for income investors, for both companies are essentially identical.
| BATS | IMT | |
|
3-year CAGR Underlying EPS Growth |
2.1% | 1.8% |
|
3-year CAGR Dividend Per Share Growth |
4.7% | 10.1% |
|
2-year Forecast Annualised EPS Growth |
8.6% | 6.5% |
Historically, British American Tobacco has a better track record of delivering growth in earnings, thanks to its emerging market focus. However, its forward-looking near-term outlook is not as attractive as Imperial Tobacco’s. City analysts expect Imperial Tobacco’s underlying EPS will grow by an annualised 8.6%, compared to British American Tobacco’s 6.5%. Dividend growth should also be faster on Imperial Tobacco’s side, as it has a lower payout ratio and is set to benefit from faster earnings growth.
This is because Imperial Tobacco has greater potential to cut costs, as it is in early stages of its cost optimisation programme. On the other hand, British American Tobacco faces major short term headwinds because of weakening emerging market currencies.
In the long term, this should not matter too much, as currencies tend to display mean reversion. What’s more, the outlook for cigarette volume growth in emerging markets is more promising.
Better buy?
In summary, both tobacco stocks are very tempting investments for investors looking for income and capital preservation. Both stocks have similar valuations and each have their own strengths and weaknesses. But, for me, Imperial Tobacco inches ahead slightly. Stock markets pay a lot of attention on short term financial performance and Imperial Tobacco benefits from faster near-term earnings growth.
