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What you can learn from Neil Woodford’s biggest investing mistake

Given his long and storied career you’d expect Neil Woodford’s greatest investing mistake to be rather dramatic. Perhaps missing out on the small-cap that leapt from the AIM to FTSE 100 returning 1000% along the way, or holding on too long to a failing company that was perpetually on the verge of turning things around but ended up in receivership.

However, fitting his more down to earth investing persona, Woodford had a slightly more boring response when this question was put to him earlier this year and replied: “Probably, if I were to put my hand up, the biggest single mistake I’ve made in my career is not having enough tobacco exposure.”

High returns

This is a big statement from Woodford considering two of the five largest holdings in his flagship Equity Income Fund are tobacco stocks. But, if we look at the 80%-plus return these two shares, British American Tobacco (LSE: BATS) and Imperial Brands (LSE: IMB), have provided over the past five years, it’s understandable if he felt he could have invested even more money in them.

Of course, we’re more concerned about the next five, 10 and 20 years, not the past five, so what does the future look like for these giants?

Unless cigarettes magically lose their addictiveness overnight, all signs point to a solid future for both BATS and Imperial in my eyes.

The main reason is that addictive nature. People buy cigarettes in good and bad economic times alike and largely remain loyal to their favoured brands. This means tobacco companies enjoy incredible pricing power. We can see this in action in the latest half-year results for BATS, where adjusted operating margins were 37.4%, and Imperial, where they were 46.4%.

Incredible margins such as these mean both companies are as close to cash generating machines as you’re likely to find in the FTSE 100 these days. And although each is reinvesting significant sums on acquisitions, there’s still plenty of cash left over to return to shareholders. Dividends at BATS now top 3.2% while Imperial shares offer a yield slightly above 3.6%.

Rising consumption

And, despite major public health campaigns against smoking across the developed world, global tobacco consumption continues to rise as increasingly wealthy consumers in developing nations clamour for more cigarettes. The World Health Organisation estimates that 80% of the world’s 1bn smokers live in developing nations and both BATS and Imperial are targeting these countries as critical markets for the years to come.

The bad news for investors on the outside looking in is this combination of stable revenue from the rich world, growth markets in the developing world and high dividends hasn’t escaped other investors’ notice. Shares of BATS are now quite highly valued at 19.6 times forward earnings while Imperial trades at 16.6 times 2016 earnings.

But analysts are forecasting double-digit earnings growth for both companies over the next two years. And with their history of rising dividends, the long-term potential among the growing middle classes from Brazil to China and a product that sells in recessions and boom times alike, I have to agree with Neil Woodford that BATS and Imperial should continue to reward investors for years to come.

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Ian Pierce has no position in any shares mentioned. 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.