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Tobacco stocks could damage your wealth

Tobacco stocks are all the rage with fund managers, who see them as solid, income-generating defensive stocks. But it's an industry in terminal decline, says Merryn Somerset Webb.

What are the 20 best stocks listed in the UK? It's the kind of thing you want to know before this year's deadline for choosing your individual savings account (Isa) holdings, isn't it? It's good news, then, that Socit Gnrale's Andrew Lapthorne has made a stab at figuring out the answer, by compiling a list of the most consistent shares over the past 20 years.

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These he counts as the stocks that you could have bought in any month since 1993 and been certain to make a positive absolute return, had you held them for five years. To find them, he took all the stocks with a long enough trading history 329 qualified and ranked them every month on a five-year total return basis. All those with any negative returns were removed.

A mere 20 remained. Of these, the top ten were: Domino's Pizza, Centamin Egypt, BHP Billiton, Genus, Imperial Tobacco, Synergy Health, Dechra Pharmaceuticals, SABMiller, BG Group and Ultra Electronics Holdings.

That these companies have done so well in the past 20 years is no guarantee they will do anything useful at all in the next five, admits Lapthorne. But the fact that "they have delivered consistent share price performance over such a long period must indicate some form of competitive advantage".

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That makes sense and a good few of the companies will surely make their holders nice returns.

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Domino's is an excellent example of a well-managed company that has tapped into rising consumer demand for convenience food as is Greggs, which comes in at number 19 on the list.

Genus is a market leader and good pharmaceutical companies should be finding themselves in a demographic sweet spot.

But one bothers me. It is Imperial Tobacco.

Tobacco companies have had an extraordinary amount of bad publicity over the past 50-odd years. They've been in and out of court; they've paid out enormous settlements; the countries in which they operate have spent billions trying to prevent citizens from buying their products; and they've been severely limited in terms of how they can market, advertise and manage their brands.

Yet their shares have continued to be top performers. Look at how their businesses operate and you can glimpse the reason why. Big tobacco companies have very strong brands. There is never any new competition. After all, who's going to put up the money to enter such a vilified and low-growth sector when they aren't even allowed to promote their products?

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There is little price competition (it isn't necessary in a market driven by addiction). And, of course, the big companies have pretty cosy relationships with governments which need to find a balance between being anti-smoking and keeping up tax revenues.

Tobacco companies are also all the rage at the moment because in aggregate they have all the defensive/quality/income characteristics that fund managers and individuals are mad for at a time when inflation-beating yields are all but impossible to get elsewhere. Imperial yields 4.19%.

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But look beyond today's dividends and you have to wonder if the next 20 years will offer the consistency of the past 20. Growth is the key issue. All the big tobacco companies rely on growth in emerging markets to compensate them for falling consumption in Western markets. They might not get it.

China is the largest consumer of tobacco it has 350 million smokers! but there is already huge momentum behind an anti-smoking movement.17 cities have joined the Tobacco Free Cities project sponsored by the Gates Foundation and, in May 2011, China banned smoking in public places. It also has a cadre of "tobacco control officers" working to introduce such novelties as tobacco-free weddings (Chinese weddings come with an odd-sounding custom whereby the bride does the rounds of the tables and lights cigarettes for the male guests).

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Given the known health nightmares that come with smoking, it just isn't reasonable to think that emerging market governments will continue to allow their populations to take up smoking with the unchecked enthusiasm of the past. Our governments let us do it, but that was long before the relevant health information was in the public domain. Why would the Chinese, Russians, Brazilians et al make the same mistake when it is very clearly in the public domain?

Surely they will put the same restrictions on branding; introduce the same anti-smoking legislation; and allow the same litigation, too. Let's not forget that more than 170 countries have signed up to the World Health Organisation's Framework Convention on Tobacco Control (FCTC).

Look at it like this, and it is entirely possible that the much-discussed emerging markets growth that is supposed to make tobacco a long-term hold for defensive investors simply doesn't exist. Note that global tobacco consumption is declining, and sales at Imperial itself are expected to fall by about 4% in the six months to the end of March.

I'd be happy to tuck quite a few of Lapthorne's stocks away forfive toten years. But Imperial? No. The nation's fund managers might think of tobacco as a long-term income-generating industry. I think of it as one in terminal decline. And a nasty one at that.

This article was first published in the Financial Times.

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