Why you should turn to tobacco
Professional investor Bradley Mitchell believes in stocks that offer value for money, have a strong market position, a proven management team, and a good balance sheet and cash flow. Here, he explains why tobacco companies are a good buy, and picks three of his favourite stocks.
I've been following Tesco (LSE:TSCO) for over 20 years and I've seen it become one of the UK's most successful firms. It's the top food retailer by some distance, with a huge non-food operation and a very successful global operation. If I had to bet on a UK retailer developing a successful business in America, I'd bet on Tesco. Yet I invest in shares, not companies, and for the first time in nearly 20 years I believe the shares are a sell.
Let me explain. I don't believe Tesco is firing on its normal eight cylinders just now. Monthly trade data suggest that not only is "Mum off to Iceland", she's also popping down to Aldi. The recession has led to consumers trading down more dried pasta, less fresh food all of which has an impact on cash profit. We saw a similar picture in the early 1990s recession, when Tesco shares performed well against the rest of the market. But Tesco is very different compared to then. In some ways it is bigger, more diverse, and more efficient. But it is also exposed to more markets, which will prove less resilient than its UK food operation. Food retail is seen as defensive, but Tesco's UK operations have changed over the years. It is now one of the largest non-food retailers in Britain, so it may prove far more cyclical than expected. Also, the collapse in sterling will mean higher import costs for all retailers, both on food and clothing. These costs will be harder to pass on, given the very poor economic backdrop.
The stock market is also very concerned about the global economy, particularly emerging markets. Tesco has built up strong positions in Eastern Europe and across Asia. A considerable chunk of its profits now come from the likes of Poland, South Korea and Thailand, which face serious stresses due to the credit crunch and wider global slowdown. Some of their currencies have been even weaker than sterling, resulting in a profit translation hit. So Tesco faces a tough year. Management will realise this and is no doubt planning accordingly. But while the shares look good value on absolute terms, they now trade at a big premium to the market, leaving little room for disappointment. Apologies to Sir Terry and the team, but I'm minded to be out of Tesco for a while.
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So the big question is, even with our very cautious view on the economy, are there any quality stocks to hold? I think so, but you have to tread carefully. I'm looking for products or brands that are perceived to offer value for money, have a strong market position, a proven management team, and ideally have a balance sheet and cash flow that offer reassurance, rather than something to worry about.
Two defensives I've favoured for a long time are British American Tobacco (LSE:BATS) and Imperial Tobacco Group (LSE:IMT). Both provide high dividend yields, have healthy balance sheets, and generate a robust cash flow. The tobacco industry is well protected by the government, which depends on it to generate revenues, and hence prices are kept artificially high. I'm also finding growth in stocks that have already priced in bad news, such as Amec (LSE:AMEC). It's an oil services company that also has exciting exposure to the nuclear clean-up industry. More importantly in these markets, it has a huge amount of cash on its balance sheet as well as a pension fund surplus. If you strip out the cash from the valuation it is trading on a ludicrously low rating.
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