Why you should avoid tobacco stocks

Yesterday, China’s new smoking ban came into effect.

Of course, this isn’t the country’s first such ban. Four years ago, Beijing issued ‘guidelines’ banning smoking in hotels, restaurants and railway stations. But they were largely ignored in a country where around half of all men smoke – and where the head of the smoking regulator is also the CEO of the state tobacco firm.

But this time the government seems a lot more serious. Unlike the previous ban, this one will apply to all indoor spaces, including offices and factories. A large number of inspectors, with the power to fine individuals and businesses, will be deployed to make sure that it is enforced. There will also be measures against tobacco ads.

China isn’t the only emerging market cracking down on the habit. Russia passed a similar ban a year ago, building on a 2013 law. Brazil’s ban also came into effect last summer.

This may be good news for the lungs and hearts of the people in those countries, but it is bad news for global tobacco companies. Here’s why – and the one stock that you should buy instead.

Consumers in developed countries are quitting smoking

It’s no secret that cigarette sales are falling in developed countries. Decades of education about the negative effects of smoking, higher sales taxes, indoor smoking bans and restrictions on advertising are all having an effect. Fewer young people are taking up smoking – a big concern for an industry that depends on a constant stream of users to replace those who die or quit.

As a result, the percentage of smokers has declined rapidly. Surveys suggested that as late as the mid-1970s, four out of ten adults in the US smoked regularly. Now, it’s less than one in five. Similar falls took place during the same period in the UK.

Meanwhile, those who continue to smoke tend to buy fewer cigarettes than before. The combination of both trends has led to a dramatic plunge in the number of cigarettes sold – down by 42% in the UK in the last 15 years. In the US, volumes have dropped by a third during the same period.

Emerging market sales are flatlining

Until now, tobacco companies have been able to offset this by growing sales in other countries, especially in Asia. Indeed, roughly two-thirds of global sales come from Asia, especially China, Indonesia, India, Vietnam, Philippines, Japan and South Korea.

The Chinese market is dominated by the state-run China Tobacco, which contributes 7% of the Chinese government’s revenue. But other markets are far more open.

British-American Tobacco (BAT), the world’s second-largest tobacco firm by market capitalisation, now gets over a third of its revenue from Eastern Europe, the Middle East and Africa, and 27% from Asia.

However, even these markets are starting to shrink as governments start to tighten up regulations and raise taxes.  BAT has reported zero growth in Asia, and an overall 1.4% fall in sales in its latest annual results.

Tobacco stocks are expensive

Until now, investing in tobacco stocks has been very profitable. A study by academics at London Business School suggests that $1 invested in American tobacco companies in 1900 with reinvested dividends, would have produced $6.5m by last year.

Even since 2000, when tobacco firms were dealing with massive lawsuits, these stocks have surged. BAT has risen by nearly ten times in 15 years while Altria has gone up six-fold. Even Philip Morris International has gone up by two-thirds since it was spun out of Altria in 2008.

This performance has earned cigarette companies a reputation of being recession-proof. But it also means that they are extremely expensive: Imperial Tobacco and BAT trade at 16.3 times and 21.6 times forecast earnings respectively.

This is a huge price for firms in a declining industry. While they offer solid dividends, it’s difficult to see how these can be maintained in the long run, if sales keep falling and taxes keep rising.

E-cigarettes are the future

So, if the big tobacco companies are in decline, should you avoid the entire sector? Perhaps surprisingly, our answer is no.

Electronic cigarettes, which deliver a hit of nicotine without the smoke and other chemicals from tobacco, are experiencing a rapid growth in sales. In part this comes from evidence that they are much more effective in helping people quit smoking than other treatments, such as patches. They also benefit from looser restriction on ‘vaping’ in public places.

Sales of e-cigarettes are estimated at just under £100m a year in the UK, and as much as $1.7bn in the US. With sales expanding by 25% a year, some experts think that they may overtake sales of traditional cigarettes within a decade.

At the moment, there are a large number of e-cigarette firms. However, this is unlikely to last, with regulators concerned that a ‘wild west’ approach has led to a large number of dodgy products.

What’s more, in an effort to protect their position and make up for falling sales, the global tobacco giants are also looking to throw their marketing weight between some of the more established products.

All this should present a big opportunity for a firm that can produce a medical-quality product.

Why you should buy Consort Medical

Consort Medical (LSE: CSRT) is a manufacturer of medical devices. The firm has developed a nicotine inhaler, Voke, which is almost identical to an e-cigarette.

The core difference is that it has a licence from the Medicines and Healthcare Products Regulatory Agency (MHRA) in the UK. This not only certifies that it is safe, but allows doctors to prescribe it on the NHS as an anti-smoking device.

Voke is backed by Nicoventures, which is itself owned by BAT, and is being marketing as a safer alternative to smoking. If the product takes off, then Consort (which is in charge of making the device) could stand to make a lot of money.

Since we tipped Consort two years ago, the shares have surged by a third. Despite this, it trades at 16 times forecast earnings for 2017 – a more than reasonable price given its growth potential.

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