Merchants Trust Buys Back Into Tobacco

After 14 months having zero exposure to tobacco – “which for an income fund was quite something" – Gergel’s Merchants Trust (MRCH) bought Imperial Brands (IMB) in September 2018 having fallen over a third to £26, from a peak of £41 two years earlier.

Four months later, British American Tobacco (BATS), which had more than halved to £24 since May 2017, was reintroduced to the portfolio after an 18-month hiatus. Early signs have been positive, with BATS up 25% since purchase.

The bear case for tobacco stocks is obvious. It’s a market in structural decline as fewer people in advanced economies now smoke; regulation, particularly in the US, is tightening; and next-generation products, like e-cigarettes and heat-not-burn, are flooding the market.

Of course, the big players in traditional cigarettes are moving into these new areas, but competition will be much higher and the new products are unlikely to be as “phenomenally profitable” as the old ones.

Then there’s the ESG angle, Gergel adds: “We’ve been worried for a while that investors will be a bit more nervous about investing in tobacco, so we put more of a discount than maybe other people did a year or two ago.

Those concerns haven’t disappeared, but valuations are now more attractive. Gergel runs Morningstar.co.uk through the investment case for both firms.

Imperial Brands

It was a long time between Imperial being cut from the portfolio and then added back in again. In hindsight, Gergel says he was a bit too early in selling initially, although “it was the right thing to do”. Evidently, he was a bit early getting back in, too.

He purchased the stock on a “quite extraordinary valuation” – a lowly price/earnings ratio of just 10 times, a double-digit free cash flow yield and a 7% dividend yield that was growing at 10% a year.

The share price fell further still to a five-year low by December, but the stock is up 11% year-to-date.

Gergel says Imperial is, fundamentally, a decent business. It generates a lot of cash, is growing its earnings through efficiencies and raising prices and has a dividend that may not be sustainable in the long-term but in the short-term can continue to grow for a while yet.

The manager also thinks it has “an underappreciated portfolio of new products”. Despite that, “the market was very focused on Philip Morris International and BATS with their new products and was very dismissive of Imperial”.

“Even though we’re cautious about how profitable the new products can be, it is still an avenue of growth,” Gergel adds. “And because [Imperial is] quite small in some of their markets like the US but they’ve got a decent portfolio, they can take more share and potentially do quite well.”

It’s also a recovery story. One of the big reasons Imperial was rapidly losing market share was because it was cleaning up its very long tail of brands. “If you take a brand out of the market it’s quite hard to get the consumers to go to your other brand because you’re not allowed to advertise.”

As a result, Imperial’s decision to trim its brands meant it lost market share. But that process is now at an end and the firm’s market share is recovering.

The final, but less reliable, case for Imperial encompasses the firm’s strategic value. “If there’s any further consolidation in tobacco Imperial is the one company that could be taken over,” he continues.

British American Tobacco

The case for adding Imperial to Merchants before BATS was primarily due to the former’s higher level of debt, which came about due to its 2016 acquisition of US-based rival Reynolds American.

That throws up another risk, in that it has more exposure to the US market where regulators continue their crackdown against tobacco. However, there’s a long process to go through before their proposed legislation gets implemented.

BATS is also better positioned in emerging markets, explains Gergel. It worked against them last year, but is a good place to be. Although the trend in emerging markets is similar to their developed peers – demand is declining – there is a premiumisation going on.

As consumers in the likes of China and India become wealthier, their tastes are changing. “They are trading up to Western brands for better products than the local stuff,” says Gergel.

All in all, while Gergel doesn’t see share prices getting anywhere near where they were a few years ago, when they were valued similarly to other consumer staples – “that was just wrong” – there is still potentially decent upside to the shares.

It’s also a defensive sector and, with the economic cycle reaching its latter stages, fund portfolios are becoming more economically resilient. As a result, the shares could be in demand for a while still.

Cheap UK Stocks

As a whole, 2018 was a busy year for Merchants, as UK plc continued to get sold off and valuations begun to look cheaper. The trust took profits from top performers like Shell, BP and GlaxoSmithKline in order to rotate into other stocks that looked better value.

Wealth manager St James’s Place (STJ) was added earlier in the year. Gergel says it’s a very high growth company, in terms of its number of advisers, assets under managers and the dividend, which is now at a yield of 5%.

“We don’t think the market quite understands the embedded value of the assets it’s got on the platform and the growth that’s going to come through.”

Another sector he’s cautious on is real estate. “I wouldn’t want to buy a shopping centre or office building today, but the companies trade at discounts of 40-50% to those asset values, which is really unusual,” says Gergel. Land Securities (LAND) and Hammerson (HMSO) were bought in April.

Media company ITV (ITV), too, was added in September as a small position. Clearly the core television proposition has structural headwinds with more people watching the likes of Netflix and on-demand programmes.

However, recent results showed ITV’s audience was growing year on year, as was its revenue from the television business. “I don’t think it’s one of those things like physical newspapers where potentially you see a wholesale shift of advertising away from TV,” predicts Gergel.

“If you want to get to an audience of five million people in the UK tonight, it’s Coronation Street, or Emmerdale.”

It’s easy to forget, too, that a third of the business is content. ITV makes many programmes through its content business, both for itself and for other channels like the BBC and Netflix. That business is growing, as well.

Finally, engineer Keller (KLR) was added in the summer shortly before a profits warning related to its Malaysian business saw shares fall a third overnight and more than halve to year-end.

After better results recently, year to date the stock is back up 30% but still trading on around six times earnings. “I think it’s a really interesting company, really cheap with a good structural position, albeit it’s cyclical,” he says.

“They suffer from being quoted in the UK and they’re seen as being a domestic mid-cap, but only 3% of their sales are in the UK.”

Keller is the world leader in geo-technical engineering. Its products are used in the preparation of the ground for big infrastructure projects and office buildings. These days, with underground systems, rivers and other things to navigate around, this is becoming increasingly complex but more important with urbanisation continuing.

Keller’s world-leading position, particularly in the US, therefore puts it in a good position.