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Fund manager view: Why tobacco stocks may now need a health warning

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Axa’s planned removal of its exposure to tobacco stocks could put pressure on the share prices of the largest firms says IBOSS’s Chris Metcalfe.

It was recently announced by the Axa Group that it plans to remove all its exposure to tobacco companies, valued at approximately €1.8bn and furthermore the insurer will not be making any new investments into the tobacco sector.

Axa have taken this bold step based on what appears on the surface at least to be purely ethical grounds, after all as a health insurer their main focus is on companies whose raison d’etre is to prevent disease, not to cause it and the cries of hypocrisy were bound to get louder. It has already faced the inevitable accusations of too little too late, but the process had to start somewhere and sometime so why not here and now.

The value of the goodwill generated from this step will always be hard to quantify but in the short term at least the decision will cost the company money, so the conscience might be (slightly) clearer but the bottom line will be reduced and this won’t please everybody within either the shareholder or wider investor groups.

When your own profits are being in effect sacrificed for other people’s ethics then people can get upset. The abolition of the slave trade was vigorously fought by many who believed they would lose out financially and arguably it was only because of a change in the British economic needs that there was a final capitulation.

As their statement said: “As a major investor and a leading health insurer, the AXA Group wants to be part of the solution, and our hope is that others in our industry will do the same.” We will have to wait and see if their hopes are realised but we think this could be the first domino to fall and would have investment implications, not least for the yield-hungry equity income sectors.

Tobacco makes up a significant portion of some of the largest and best known UK equity income funds and while the Axa move is not significant in itself, if others do adopt similar policies in the coming years this could put pressure on the share prices of the large tobacco firms.

More importantly from an income perspective these stocks are in many income funds for their dividends and as we have seen with the oil stocks, dividends are only sustainable at their historic levels for a finite amount of time if the revenue is under persistent pressure. The share prices of the tobacco stocks, with their classical defensive characteristics, have been bid up to record levels along with many consumer staples for differing reasons but with a similar outcome.

At some point however stocks will reflect the fundamentals, and what starts off as a relatively small announcement by a single player can lead to a change of perception at a wider level. Everything has to start somewhere and initial evidence is almost inevitably debatable in the first instance.

In a wider context equity income funds have already had to come to terms with the loss or at least dramatic reduction of the big dividend paying banks. Yes, some are now paying dividends again but on a much smaller scale and anybody who thinks that the golden days of bank dividends are going to return is likely to be perpetually disappointed.

We have long been wary of the search for yield in both bonds and equities, as it seems to us that the risks have been incrementally increasing for many years within funds and from many different angles, each with its own compelling story of why it should persist. Historically, the longer we have had extremely low (or even negative) interest rates the more the siren-like narrative builds around so called defensive areas of the world’s stock markets.

Tobacco will stay attractive to managers and investors alike regardless of the health issues, aside from the still small percentage of ethical funds who screen out tobacco but as yield-hungry money chases the few high yielding stocks, the risks rise proportionally as they await a catalyst.

Axa is not going to change anything overnight with its tobacco announcement, but in our opinion the risks attached to tobacco stocks should now maybe come with a small health warning. As late as the 1960s some doctors were advising patients with nervous disorders to have a cigarette to calm them down; that seems pretty ridiculous now.

Chris Metcalfe is managing director and investment director of IBOSS Ltd.