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Is the tobacco sector going up in smoke?

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Ketan Petal, manager of the Amity UK fund, explains why it’s time for income-seeking investors to look beyond tobacco stocks.

The tobacco sector, seen as a traditional income stalwart, has been the best performing sector since the launch of the FTSE 100 index 35 years ago.

For responsible and sustainable investors, the tobacco industry has always been excluded as part of screening processes because the activities of tobacco companies are deemed harmful to society.

It is a stance that has stood against the tide of most income investors, who have long seen the tobacco sector as a core part of portfolios. In addition, the defensive nature of the sector has long been lauded.

For responsible and sustainable investors, the challenge has always been to find a similar yield profile with defensive characteristics.

A tough year

2018 was a watershed moment for tobacco stocks in the UK: the sector was the worst performer over the calendar year on the back of regulatory concerns, a growing threat from electric cigarettes and the continuing legalisation of marijuana.

British American Tobacco (BAT) was down 47.2 per cent at the close of 2018, effectively wiping out any of its gains for the previous five years.

Imperial Tobacco, the other dominant UK player, fared slightly better but was still down 19.6 per cent over the period. Imperial has performed better than BAT and the FTSE All-Share over five years, but less so over a 10-year period.

It is becoming increasingly clear that the tobacco industry faces structural headwinds. In November of last year, the US’s Food and Drug Administration (FDA) proposed a ban on menthol cigarettes in the US, following Canada’s lead and the European Union’s ban which is set to come into force in 2020.

There are larger social changes afoot which will continue to impact the future of the industry. In the developed world, the number of smokers continues to decline as consumers become health-conscious and educated about the negative impact of smoking tobacco.

Even in areas where tobacco companies have found potential opportunities for diversification, such as e-cigarettes, there will be regulatory hurdles to overcome in the near to medium-term.

The tobacco lobby has long cited the tax paid by the industry to deflect critics, who highlight the negative impact of smoking on the already overburdened NHS. However, a recent study by the University of Bath’s School of Management concluded that the industry creates a shortfall in the tax paid versus the negative impact on the NHS.

The study also highlighted the low levels of tax paid by both of the UK’s big tobacco companies, with BAT paying “virtually no” corporation tax over the past seven years. Meanwhile, Imperial Tobacco paid an effective tax rate of 13 per cent over seven years – at a time when UK corporation tax has ranged from 20 per cent to 28 per cent.

These are not just short-term issues for investors. These are inherent structural problems in the tobacco sector, which could mean that the industry struggles to deliver similar returns over the next 35 years.

Healthcare: defensive and diverse

The healthcare sector stands in stark contrast to the tobacco industry, with the UK continuing to develop its global leadership position in research and development. The total spend in global healthcare is projected to reach $10trn by 2022, led by improvements in medical treatments, digital technology, and the emergence of personalised medicine.

Other structural tailwinds include a growing and aging population, which is developing chronic conditions such as diabetes, cardiovascular and auto-immune diseases. These typically require a lifetime of medical attention.

There is a positive correlation between rising GDP and total healthcare spend. The emergence of a large middle class in emerging economies, coupled with rapid urbanisation, has increased the ability of patients to pay for advanced medical care.

The pharmaceutical sector, which dominates healthcare, is attractively positioned, with companies offering rising dividend yields, robust balance sheets and good long-term growth prospects – all on undemanding valuations.

The two UK pharmaceutical giants, GlaxoSmithKline and AstraZeneca, have become global leaders in their respective therapeutic fields. Investors have been handsomely rewarded on a total return basis by AstraZeneca over five and 10 years.

However, the diversification of the healthcare sector is often understated, with investors only focusing on pharmaceuticals. There are several sub-sectors, including medical technology, diagnostics, life sciences and animal health – which are available to investors, offering both defensive and diversified business models.

Long-term investors in Smith & Nephew, a leading medical technology company focused on joint implants and trauma products, have enjoyed total returns of over 300 per cent, nearly three times more than BAT and Imperial Tobacco over the last decade.

Inflection point

The expectation that the tobacco sector will be able to deliver significant returns for shareholders going forward must be reassessed, given the emergence of healthcare as a viable and long-term replacement within income portfolios.

The irony will not be lost on responsible and sustainable investors that the very success of tobacco is leading to the creation of patients with chronic conditions, creating greater demand for healthcare services.

Long-term investors will have to make a decision on whether to continue to back a structurally-challenged industry. Alternatively, they can shift to healthcare – a sector that offers a high and growing dividend yield, supported by unlevered balance sheets and compelling long-term market dynamics.

Ketan Petal manages the Amity UK fund