Smoking returns - tobacco stock outperformance

Midas tobacco stocks
In line with our recent ‘Devil Stock’ theme which looked at the succcess of investment funds' interested in sin stocks generally, we take a look at the outperformance of tobacco stocks. Charts 1 and 2 highlight the out-performance of the tobacco industry. Furthermore, Chart 1 highlights the disparity in returns with Swedish Match AB significantly outperforming both the MSCI World Index and its tobacco peers. The industry out-performance is primarily driven by the cash generative, defensive nature of the sector with limited commodity inflation exposure as tobacco leaves are purchased up to one year in advance (in general) and are grown globally, thereby limiting supply shocks. In addition, the industry offers attractive yields (average 4.3 percent) with Reynolds American standing out with a reported yield of 9.8 percent.

Drivers and risks
Moving forward, Developing Markets (DM) remain key to driving organic growth as they make up some 80 percent of global consumption, with China being by far the largest smoking nation globally, see chart 3. However, the Chinese tobacco industry is presently controlled by a state monopoly.

Presently, developing nations make up less than half of the profits of the tobacco industry. As these nations' disposable incomes increase so too should their portions of corporate profits. Furthermore, with organic growth remaining benign (ex. DM) acquisition led growth via M&A remains a potential catalyst given the sector's low debt levels and robust cash flow generation.    

The industry is not risk free and key risks include: 1) regulatory risk including increased taxes eroding corporate pricing power; 2) increased market competition in developed nations; 3) FX risk as corporates chase growth overseas; 4) legislation given the highly debatable health effects of smoking; and 5) increasing unemployment in developed nations with smokers trading premium labels for their lower priced alternatives. Furthermore, the lower beta nature of the stocks is a double edged sword as it is attractive in uncertain times however, these stocks are less leveraged to a general market recovery.

BUTT.. Always a 'butt'..
Chart 3 highlights that from a valuation perspective those larger companies with ‘sustainable’ EPS growth are trading at a premium to their average five year twelve month forward Price to Earnings Ratio.

However, investors would be wise to remember that sometimes, just sometimes, outperformance warrants a premium.