Tobacco has been one of the best sectors in the world to be invested in over the last few decades.
In both the US and the UK, tobacco has been a great investment compared to the index over the past 20 years or so.
Even in more recent years, the outperformance has continued, with the likes of Altria and Reynolds in the US more than doubling since 2013.
The industry has fought off widespread disapproval, regulation upon regulation and tax upon tax to keep churning out profits for shareholders.
But now it might be facing its Waterloo – genuine competition.
Tobacco stocks have been staggeringly successful
Tobacco stocks have always been fascinating investments. They’ve done spectacularly well over the last decade or more, despite constant attacks by global governments and regulators, and huge compensation payouts.
Of course, the crafty secret behind the tobacco stocks’ success is this: regulation actually helps.
Let’s say you’re a great big, dominant company in a mature industry. Your product really isn’t that different to the product of your biggest rival. But you have loyal customers; they are addicted to your product and they have no reason to switch brands.
What’s your number one wish? For nothing to change. And governments have done little but help with that side of things for a long time. They’ve helped cigarette companies to build the ultimate ‘moat’.
Ban cigarette advertising. That’s great. It means there’s absolutely no room for new competitors to come in, even if someone did have the clout to even consider trying to muscle in.
That means you get to slash the advertising budget too – you can stop wasting money trying to differentiate between products that are fundamentally the same. As long as your rivals can’t advertise either, you’re safe.
Meanwhile, you can keep putting prices up, because your customers are used to ever-increasing tax bills and their demand for ciggies is “inelastic”, as an economist might put it.
So on the one hand you get to milk your declining but still massive developed-markets business for all its worth. And on the other, emerging markets are still getting to grips with tobacco control, which means you still have potential growth in other global markets.
Just to be absolutely clear – I personally avoid tobacco stocks. I must own some – I hold a lot of tracker funds in my pension, so they’ll have exposure to them – but I wouldn’t own any as individual holdings in my share portfolio. (I find lots of ethical investment to be chock-full of woolly-headed thinking about both money and ethics, but the moral case for avoiding tobacco stocks is pretty cut and dried.)
But put bluntly, tobacco is a fantastic business. No wonder it’s done so well.
The big risk for cigarette makers – the rise of e-cigarettes
However, tobacco share prices took a big hit on Friday afternoon. Imperial Tobacco and BAT both fell sharply on Friday night and have continued to slip this morning. What’s going on?
It’s all to do with a rather aggressive-sounding attitude change from the US. Scott Gottlieb, the head of the US Food and Drug Administration (FDA – the relevant regulator), has said that the FDA will force cigarette makers to cut the amount of nicotine in their products, to make them less addictive.
However, what’s more significant – argues Andre Picard in The Globe and Mail – is that the FDA has decided to delay regulation of e-cigarettes. Instead, it wants manufacturers of e-cigarettes to be regulated as “smoking cessation” products.
In other words, the US regulator is actively trying to push nicotine consumers (because that’s ultimately what a hardened cigarette smoker is) from getting their buzz from burning tobacco, and instead getting it from the new kids on the block – the e-cigarette makers (“vaping”).
“We must recognise the potential for innovation to lead to less harmful products”, said Gottlieb. “The biggest problem is the delivery mechanism – how the nicotine gets delivered.”
So what does this mean if you invest in tobacco? According to analysts in the FT, Phillip Morris International (which has spoken of a “smoke-free future”, and of how “one day we want to stop selling cigarettes”) and BAT are best placed to compete in the vaping market.
Philip Morris, for example, has launched a successful e-cigarette product in Japan, which has more than offset a 25% drop in the number of normal cigarettes it sold there last year.
However, I’m not sure how keen I’d be on any tobacco stock right now. The “big picture” case for investing in tobacco has for years been predicated on the idea that the market is unassailable.
That key benefit – a static market – is now at real risk of being eroded away. In effect, e-cigarettes represent a new form of substitute product that people are actually keen to buy – a new mousetrap, if you like. That’s knocked a hole in the moat for ambitious young challengers to take advantage of.
The big incumbents still have an advantage, that’s absolutely true. And the tight regulation around the industry means that they’ve also been given a bit of time to adapt to the idea of disruption – unlike supermarkets or publishers, or all those other businesses that have been turned upside down by new technology.
However, I’m not convinced that the disruption is yet priced in. Imagine having to go back to investing money in R&D, consider things like advertising all over again, and having to launch and scrap new products on a regular basis. That’s a lot of work for an industry that’s presumably grown used to hunkering down in its bunker and watching the cash-flow roll in.
In short, you might not worry about the ethics of investing in tobacco – but I reckon there’s now a good financial reason to be avoiding cigarette stocks too.