The largest tobacco companies have traditionally been favoured by equity income fund managers as they are known for their healthy dividends.
According to Capita Asset Services, while there are only two tobacco stocks in the FTSE 350 – Imperial and British American Tobacco – these accounted for £1 in every £19 of income paid to investors last year.
Since developed markets have actively started legislating for tobacco marketing that clearly highlights the health risks, alongside bans on smoking in public places, tobacco companies have shifted their focus to emerging markets instead, particularly Indonesia, Russia, the Philippines and China.
But now those markets look set to follow suit and bring in anti-tobacco legislation as well. The Chinese National Health and Family Planning Commission, for example, is seeking to introduce a law by the end of the year which bans smoking in indoor public venues.
So could tobacco companies be becoming the new yield trap?
Liontrust fund manager Stephen Bailey, who co-manages the £358m Liontrust Macro Equity Income fund, says: “If we see a similar scale of attitude shift to that which took place in developed markets over the last generation, will this mean the sector can finally be consigned to the ex-growth bucket?
“Tobacco stocks in particular look to be a yield trap; as their emerging market businesses inevitably follow developed markets into decline, dividend payouts will increasingly represent a declining annuity as business goes into run-off.”
Hargreaves Lansdown senior investment manager Adrian Lowcock says tobacco companies have delivered good dividends and highlights that investing in UK tobacco would have given investors a 414 per cent return over 10 years compared with 131 per cent from the FTSE All Share.
Lowcock says: “The recent sell-off is most likely down to concerns about emerging market growth.
“While they are currently not cheap I would not underestimate the tobacco companies’ abilities to deliver earnings growth even in difficult markets. Tobacco companies are used to doing this. “
Threadneedle Investments fund manager Stephen Thornber has chosen to increase his exposure to tobacco companies, despite an awareness of the challenges they face.
Thornber, who manages the £886m Threadneedle Global Equity Income fund, says: “We have a generally positive view of these companies and have built up our exposure as the sector struggles.
“We are about 2 per cent overweight in the fund to the food, beverage and tobacco sub-sector. I have probably added about a quarter of this over the past six to nine months.”
Thornber, who has always held tobacco stocks in his fund, is still a big fan of how these companies are run in terms of cash control.
He says: “They are able to recoup losses through price increases. Their cost control and efficiency gains are good and they really grind down on them.”
Psigma Income co-fund manager Eric Moore agrees these companies are well run and has 5 per cent of his portfolio in tobacco stocks. Moore is particularly attracted to British American Tobacco, which has returned a dividend of 15 per cent a year over the past five years.
Moore says: “The reason it has done very well is because it has been focusing on cost savings. For defensive income seeking investors, these are still viable options.
“If you look at Imperial, its yield is 5.8 per cent. It has committed to growing it by 10 per cent in the medium term.”
Moore is less concerned about regulatory pressures and more concerned about the recent rise in the number of people switching away from traditional cigarettes in favour of e-cigarettes.
Moore says: “There have been very few periods of technological change in tobacco. Something I do worry about is e-cigarettes. But it is a very small sector, and they are made by very small companies.”
Capita Asset Services shareholder solutions chief executive Justin Cooper says: “Some fear the rise in e-cigarettes may stub out the future dividend might of tobacco stocks, but these firms are well placed to dominate that market as well in due course, and ethically minded investors may not feel so squeamish about benefiting from a less obviously unhealthy product.”
Henderson Global Investors fund manager Matthew Beesley has not owned any tobacco stocks for a long time, and believes the emerging market focus could be a big risk.
Beesley, who manages the £157m Henderson World Select fund, says: “The top line for emerging markets is coming under pressure, because demand has really been emerging market led and revenue growth is likely to come under pressure.
“We have seen evidence of consumption growth in emerging markets slowing down. We saw this last year with Unilever and Nestle and this will impact tobacco companies as well.
“How much more scope is there for their margins to improve? The scope for them to become meaningfully more efficient is limited.”
Moore is mindful that one day tobacco companies may falter due to mounting social pressure, and fears that pricing control can only do so much.
Moore says: “In the very long run, volumes will continue to fall. The question is, how much will the last smoker pay for their last smoke?”