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Is Neil Woodford wrong about British American Tobacco plc and GlaxoSmithKline plc?

Known for his love of dividends and long investment horizons, Neil Woodford has built a reputation as one of London’s most savvy investment managers who does not chase short-term market trends but instead concentrates on the long-term earnings potential of companies.

With this being the case, his decisions to dump holdings in GlaxoSmithKline (LSE: GSK) and British American Tobacco (LSE: BATS) took some analysts by surprise. These two companies have a reputation for being some of London’s best dividend-paying stocks — a reputation that remains intact today.

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Running out of room for growth

British American Tobacco has expanded quickly over the past decade, and when it completes the acquisition of peer Reynolds American, the company will be the largest tobacco company in the world. Despite this transformative acquisition, Woodford believes the company’s opportunities are limited. The deal has caused debt to increase sharply, and rising interest costs, coupled with slowing sales growth may put pressure on the company’s dividend payout.

Criticising Woodford’s concerns about British American is difficult. By acquiring Reynolds, British American has absorbed the last easy growth opportunity available to it, now opportunities for growth through acquisitions are virtually non-existent. At the same time, tobacco sales are falling. Reduced risk products are picking up some of the slack, but the general trend is down.

That said, it is not going to disappear overnight. City analysts are expecting the company to report earnings growth of 13% this year and 9% for 2018. The shares currently support a dividend yield of 3.3%, and the payout has been rising at around 10% per annum. Still, the shares look relatively expensive, trading at a forward P/E of 19.3 and the dividend yield is only 3.3%. So if you’re looking for cheap income, British American might not be the right company for you.

Bright outlook

GlaxoSmithKline currently yields 5.3% and the shares trade at a forward P/E of 13.3. Based on this valuation, the company looks attractive as an alternative to British American, even though Woodford has turned his back on the business.

This decision was based on the new management’s reluctance to break up the business, a transaction he believes would unlock significant value for shareholders. Instead, Glaxo’s new CEO is looking to streamline the business by selling off non-core assets and refocusing its drug development pipeline.

This new course of action might not be what Woodford was looking for, but it does not mean that the investment case for Glaxo has completely changed. The company is still one of the world’s largest pharmaceutical companies, with an enormous consumer healthcare division. As the world’s population continues to expand, live longer and grow richer, demand for healthcare and health products will only increase. Glaxo is well positioned to benefit from this growth.

And after recent declines, investors can snap up shares in the firm at a rock bottom valuation. Indeed, as noted above, shares in Glaxo are currently trading at a forward P/E of 13.3, 26% below the global pharmaceutical sector median valuation of 18.

Overall, while British American looks as if it is running out of puff, Glaxo still appears to offer value for investors, even though Neil Woodford is skeptical about the firm’s outlook.

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Rupert Hargreaves owns shares of GlaxoSmithKline. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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