Despite having gone from “hero to zero in a remarkably short space of time”, according to Allianz’s Matthew Tillett, British American Tobacco (BATS) is still a perennial favourite of the UK retail investor.
The stock was the 10th most-popular stock on Hargreaves Lansdown’s platform through 2018. That’s despite a huge 50% decline in the share price over the year.
As a high-dividend-paying stock, it’s unsurprising BATS is popular with retirees, or investors nearing retirement. It’s continued to be well bought by Hargreaves’ clients in January and, after the sharp fall in the stock price, fund managers are increasingly seeing value in the shares, too.
Clearly, it’s been a stalwart in many a UK income portfolio for years – a dividend survey from Link Asset Services shows BATS has been one of the 10 largest dividend payers annually since 2008. Today, the yield stands at 8%, which has obvious attractions.
Sell-side analysts love the stock, as well. Research from AJ Bell showed it was the FTSE 100 stock with the highest proportion of analyst ‘buy’ ratings, at 94%; just one of the 17 covering it told clients to ‘sell’. It didn’t work out for them last year, but they’ll be hoping that changes in the future.
The recent share price decline has been due to regulation. The US continues to crackdown on tobacco products, with menthol the latest area in their sights. British American has high exposure to the US market due to its 2016 purchase of Reynolds American.
But it’s not the first time the tobacco industry has come under fire and the likes of BATS and Imperial Brands (IMB) are still going strong. Indeed, today’s single-digit price/earnings multiple has tempted some long-term investors to top up their positions.
British American has been held in the OYSTER European Opportunities fund since 2014, but manager Mike Clements says he increased his holding during the final three months of last year.
Is British American Tobacco Still a Buy?
Clements, head of European equities at SYZ Asset Management, accepts in some parts of the world demand for tobacco products is declining. But that is being offset in most jurisdictions by price rises. And BATS’ underlying cash flows are pretty stable, anyway, meaning the dividend has “bond-like characteristics”.
“We could buy BAT at the cheapest it’s been in 30 years in the fourth quarter and it should give you your money back in eight, nine, 10 years,” he explains.
From peak in June 2017 to trough 18 months later, the total share price fall for BATS was 58%. Despite this, notes Tillett, there was little in the way of underlying earnings downgrades over that period.
“This is a useful reminder of how even seemingly rock-solid defensive businesses can be brutally punished by the stock market,” he says.
Sentiment has been hit by the crackdown from the US Food and Drugs Administration and Tillett says the ban on menthol cigarettes in particular could wipe up to a fifth of British American’s profits out.
“For British American’s equity, this potential negative has been compounded by the currently elevated level of debt that the company took on in order to finance the purchase of Reynolds.”
But any ban appears to be some way off, he adds. There are many processes and stages the FDA has to go through in order to implement it, many of which are likely to involve lengthy litigation.
“The reality is that menthol related revenues and profits are unlikely to disappear for several years yet,” Tillett continues. In the interim, BATS should continue to generate very strong cash flows. “This can be used to reduce debt, putting the company in a strong position to deal with the possible loss of US menthol profits in the future.”
Further, adds Clements, the firm has significant exposure to emerging markets, one area where it is still seeing volume growth coming through. With better demographic profiles in emerging economies, this should help offset declines in developed countries.
Both managers note BATS is well-diversified geographically, with excellent next-generation products like heat-not-burn and vaping.
Tillett says he added a small position to BATS in his Allianz UK Opportunities fund. “The stock market has taken an overly draconian view of matters, heavily discounting the menthol risk and creating an attractive risk-return profile for BAT shares.”
Morningstar analyst Phillip Gorham is also bullish on the stock and Morningstar has BATS on its Europe Value Stock List. It currently trades at a 40% discount to Gorham’s fair value estimate of 4,500p.
Clements, meanwhile, says he is keeping a close eye on rival Imperial Brands (IMB). For now, BATS is better on the next-generation side and has more attractive geographical exposure. However, “there’s not that much to choose between them and the differences aren’t as big as people try to make out”.
Should Investors Back UK Equities?
On the UK market in general, Clements says he’s underweight UK domestics, “but it’s certainly on our radar screen”. Recently, he’s been looking at areas like housebuilders, industrials and real estate companies, which are very exposed to the UK economy.
“We may get a chance to buy some of these if we get a difficult outcome to the Brexit negotiations,” he predicts.
Similarly, colleague Claire Shaw, manager of the OYSTER European Mid and Small Cap fund, says she’s drawn up a “wishlist” of UK cyclical stocks to analyse ahead of time.
“You get these opportunities once in a blue moon, so we want to be ready to pull the trigger if they do sell off,” says Shaw.
Shaw’s fund is also underweight UK cyclicals, but “some of these UK industrials are good companies with high returns on equity, high margins and protected business models with niche products that have stood the test of time over decades”.
“I’d love to own some of these companies and I’m coming around to the idea of dipping my toes in because of the valuations – they’re pricing in such a doomsday scenario that anything slightly better that that and these things are astonishingly cheap.”
But multi-asset portfolio manager Maurice Harari is one investor at SYZ who has recently bought a position in UK equities. In January, his OYSTER Multi-Asset Diversified fund went from a 0% exposure to 4.5% in UK stocks through FTSE 100 futures and a high dividend ETF.
"If we look at valuation, UK equities have been quite attractive for a while and the currency is undervalued against the US dollar. You can find lots of attractive companies in the UK space with dividend yields above 5%."
