Read more on ethical and sustainable investing in Morningstar's Ethical Investing Week 2013.
This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here Aruna Karunathilake, manager of Fidelity UK Select, shares his views on e-cigarettes and their impact on the tobacco industry.
British American Tobacco (BATS) has been in the top 10 of my fund for all of my investment career. I was attracted to the high visibility of cashflows and strong competitive position, which historically resulted in a high score on my company scorecard both for fundamentals and franchise quality. However, the tobacco industry is now entering a period of real uncertainty due to the emergence of e-cigarettes, which has resulted in me selling out of BAT completely.
I am not expecting smokers to immediately quit tobacco en masse over night in favour of electronic alternatives. However, e-cigarettes offer significant advantages over tobacco (eg relative health benefits & lower cost), and could well cause an average smoker to substitute a couple of cigarettes per day with e-cigarettes. In some cases, it could lead to outright cessation of smoking over time. In an industry with little organic growth, any loss of market share or reduction of demand, however marginal, is a real threat to cashflow.
Governments and legislators are likely to look favourably on electronic cigarettes in comparison to tobacco. Currently there is little in the way of regulation in the US and UK, where penetration has been highest. It is likely that as demand grows, regulations around e-cigarettes will become tighter, but it is almost certain that regulation will not be as costly as that imposed on tobacco. Given the public health benefits, there is an incentive for governments to encourage smokers towards e-cigarettes. E-cigarettes also enjoy the privilege of being able to advertise and market the products openly, something tobacco has been unable to do for many years. US e-cigarette company Lorillard claims that 20% of American smokers are completely replacing their traditional tobacco consumption with e-cigarettes and a further 36% of smokers have reduced their traditional tobacco consumption using e-cigarettes.
Tobacco has always provided an incredibly defensive earnings stream, and it will take time for investors to wake up to the fact that this is now being challenged, but as they do, I think tobacco companies will become viewed as lower quality franchises due to the emergence of a credible alternative product for the first time. The market is still some way from discounting this in share prices. BAT currently trades on around 15 times next year’s earnings; close to its peak. This is not the rating of a company entering a period of structural challenge. UK supermarket’s have de-rated significantly over the past 3 years as the market has woken up to the structural challenge posed by the internet. I think there is a significant risk that in time, the market will decided that tobacco stocks also deserve lower ratings.
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