Neil Woodford may be a star fund manager – but he’s wrong about tobacco stocks

Star fund manager Neil Woodford recently revealed that of his top ten holdings, three are tobacco stocks. But that doesn't mean you should follow his lead. Ed Bowsher explains why.

140714-tobacco

Imperial Tobacco: about to crack America

Tobacco giant Imperial Tobacco (LSE: IMT) is set to break America.

Currently it has a tiny 3% market share in the US. But following two major deals, that figure could rise to 11%.

Shares in Imperial soared to a record high on Friday as a result.

However, I'm not tempted to buy Imperial or any other tobacco share.Yes, they've done very well over the last 15 years. But I don't see that performance being repeated in the future. Here's why.

A massive US tobacco deal provides a huge opportunity for Imperial Tobacco

Reynolds American

(NYSE: RAI)

Lorillard

(NYSE: LO)

So to keep the competition regulators happy, some cigarette brands will probably be sold to Imperial. That will make Imperial a serious player in North America for the first time.

Long-term shareholders will be pleased by the news. Since January 2000, they've seen the company's share price rise by 500%. And once you add in dividends, they've enjoyed a total return of more than 700%. Other tobacco shares have delivered similarly strong performances.

(By the way, calculating those figures was no fun for me. Back in 2000, I was one of the idiots who was still buying tech stocks. I would have done far better with tobacco.)

Tobacco's gains might surprise you. After all, hasn't the cigarette market been in decline since the 1970s? Why have tobacco shareholders done so well?

There are two reasons. Firstly, while tobacco is in decline in the developed world, there has been some growth in emerging markets.

But more importantly, markets were too down' on tobacco in 2000. In hindsight, tobacco was a classic example of a market overshooting' or in this case, undershooting.' Just as markets often rise too high when times are good, so tobacco shares fell too low in the late 1990s. The sad truth is that investors often move in packs, and once a clear trend starts, many investors can't resist following.

Investors were probably right to think that prospects for tobacco in the very long term weren't great. But by 2000, the market was pricing in a much gloomier scenario. Many investors seemed to have forgotten that tobacco is an addictive product an addictive product that would carry on selling for many years to come.

What's more, because share prices had fallen so low, most tobacco shares in the late 1990s and early 2000s were offering sizeable dividend yields, which led to great returns for anyone who bought and held from that point.

The best known tobacco bull of the last 20 years is probably Neil Woodford, the star fund manager who recently launched his own investment business. His long-term record is very good, and much of his success is due to his tobacco investments.

And he hasn't changed his stance. Last week he revealed the ten largest holdings in his new High Income fund. Sure enough, there are three tobacco stocks on the list. British American Tobacco (LSE: BATS) comprises 6.2% of the new fund, Imperial 5.31%, and Reynolds American 3.55%.

Tobacco stocks aren't the bargains they once were

You see, tobacco is no longer an unfashionable sector, and that means that valuations are no longer cheap. Imperial is trading on a historic price/earnings ratio (p/e)of 16, and the dividend yieldis 4%. That doesn't look too bad at first glance, but remember that tobacco is a declining industry. Philip Morris (NYSE: PM), which sells tobacco around the world, reported a 4.4% year-on-year fall in cigarette shipments in the first quarter of this year.

What's more, Imperial Tobacco is carrying quite a lot of debt. Its net gearingis 236%. Granted, Imperial has fairly predictable cashflows, so it can cope with that level of debt, but it doesn't help the valuation case.

It's a similar story with British American Tobacco. It's on a p/e of 17, and its dividend yield is 4%. Not horrendous, but not great for a declining industry. And don't be under any illusions this most definitely is an industry in decline.

The health message will inevitably sink in, even in emerging markets soon. And don't place too much faith in e-cigarettes either. Sure, electronic cigarettes will become more popular. But they're only going to appeal to existing smokers who are trying to wean themselves off tobacco. E-cigarettes may slow the decline of the big tobacco companies, but that's all they can do. They're not a brand new growth market.

Of course, I could be wrong on this. And if you'd prefer to follow Woodford's strategy rather than mine, I'd understand. But I really don't see a compelling buy case here.

That said, where I do agree with Woodford is pharmaceuticals. Woodford has three drugs companies in his new fund's top ten, and that seems like a smart move. The difference between tobacco and pharmaceuticals is that the pharma sector has real growth potential. That's why I'm happy to hold shares in GlaxoSmithKline (LSE: GSK), and I may well buy more pharma shares in future.

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