Whatever your ethical stance on ‘sin stocks’, research has indicated they tend to outperform the market. When combined with strong branding, people tend to consume cigarettes, alcohol and even chocolate in a predictable fashion, resulting in consistent cash-flows. This is why Warren Buffett’s investment in See’s Candy has done so well over the years.
Another boon shared by many sin stocks is that their brands tend to foster loyal customers. Cigarette smokers are incredibly unlikely to switch brands, despite the bans on marketing in many countries, with only a 10% churn per year.
Combine these predictable habits with competitive advantages of scale, including buying power and hard-to-replicate distribution networks, and sin stocks like British American Tobacco (LSE: BATS) tend to achieve very nice returns on capital, one of Buffett’s favoured metrics.
The company’s acquisition of Reynold’s American back in July makes financial sense because the sheer size of the newly formed behemoth makes it the largest tobacco company in the world, increasing the company’s already impressive economies of scale.
Despite falling cigarette volumes, brokers are predicting a 13% increase in earnings this year, followed by a more muted 8% next. Of course, we shouldn’t rely on forecasts, but the company has proven its ability to increase earnings despite falling volumes.
The company pays a 3.5% yield that I believe will remain well-covered by cash flow. Investors considering an investment in British American must be aware of the US FDA’s plans to reduce nicotine in cigarettes to non-addictive levels.
That won’t be easy. Robert West, professor of health psychology at University College London, said: “The idea of gradually reducing the addictive ingredient of cigarettes, nicotine, looks attractive on the surface. But unless nicotine is pretty much eliminated quickly and comprehensively in all available tobacco products – which seems unlikely – it runs a serious risk of making things worse as smokers smoke cigarettes harder in order to get the nicotine they need, leading to more exposure to the harmful tar.”
Therefore, I believe the FDA is more likely to encourage companies like British American to increase investment in alternative products like vaping technology, something the company is already invested in.
Growth and Income
Micro Focus (LSE: MCRO) is about to integrate HPE Software in a deal that will turn it into a real behemoth of technology. But what does the company – and the soon-to-be-acquired HPE – do? The gist of it is they help “customers to link their investments in established technology with the latest innovation” by bridging the gap between old and new programming languages. This allows customers to make cost savings by getting more use out of outdated systems than would otherwise be possible.
Recently, improved cash flow has been used to clear some of the company’s net debt ahead of the deal. This will, of course, place a greater burden on the balance sheet. Given management’s track record of improving margins at acquired businesses however, the deal looks good to me.
Buffett is a big fan of companies that have high switching costs. Micro Focus’s solutions are embedded deeply in mission critical technologies and switching service providers could prove complicated and cause costly disruptions.
The company’s shares have risen 200% in the last five years, but still only trade on a P/E of 20 and offer a 3% yield.
Zach Coffell has no position in any shares mentioned. The Motley Fool UK has recommended Micro Focus. 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.