Are tobacco companies still a good play for investors?

The tobacco industry is facing disruption, but this has benefits for investors, argues Alex Tedder.

Disruption, whether as a result of new tech, stricter regulations, or changing consumer habits is affecting all sectors of the global economy. 

For many years, tobacco stocks were the ultimate safe haven, providing shareholders and fund managers with a steady, and largely predictable, flow of earnings.

Although smoking rates have been declining for years as governments around the world raised taxation rates, the traditional tobacco firms remained profitable as they continued to hike their prices.

There’s plenty of ‘cheap’ UK shares for bottom-fishing investors

Disruption benefits: growth and innovation

Alternative nicotine delivery systems, such as e-cigarettes and heated tobacco products, are the first technological leap in the industry for generations.

Such products are gaining in popularity as consumers seek healthier alternatives to traditional cigarettes, taking market share and profits away from the traditional tobacco companies in countries such as the US, Japan, South Korea, and Germany.

Although e-cigarettes account for just 7% of the US nicotine market, this could rise to 50% within the next five years.

This disruption is being led by companies such as Juul, which makes vaping and e-cigarette products. Established a little over four years ago, Juul has gone from a start-up with three employees to US tobacco giant Altria buying a 35% stake in the company last year for nearly $13 billion.

Juul was not the first to introduce a vaping product, but it was the first to develop an attractive and easy-to-use product at a reasonable price. The company has also benefited by being the first to introduce multiple flavours, and by aggressively promoting itself on social media.

However, Juul’s success could be challenged by increased regulation. The City of San Francisco recently banned the sale of all vaping products until there is further clarity on the health implications.

This step, which leaves traditional cigarettes as the only legal method for consuming nicotine in the city, could hamper the company’s growth if it is copied by other cities or countries.

Fighting back

Some long-established tobacco firms such as Philip Morris International (PMI), which owns the Marlboro brand, are adapting well to the disruption.

The firm has invested $6 billion since 2008 to develop its own heated tobacco system. This has gained good traction in markets such as Japan. And in a bold, some may say strange, move for a tobacco company, PMI has stated that it can envisage a time when it may stop making tobacco products - presumably once all its customers have switched to its e-products.

Some of the other established tobacco companies have been less successful in their attempts to adapt. Imperial Tobacco has been trying to gain a foothold in the market with an e-cigarette concept, but has so far failed to gain any significant traction.

Around 7.4 million adults in the UK reported that they smoked cigarettes in 2017, according to the most recent data issued by the Office for National Statistics (ONS) in 2018. This equates to around 15.1% of the population.

However, while the number of people smoking cigarettes has been in steady decline for years, as the health risks of tobacco have become more widely known, the use of e-cigarettes is moving in the opposite direction.

In 2017, 5.5% of people in Britain reported that they use an e-cigarette, which equates to approximately 2.8 million people. In 2014, when data on e-cigarette use was first collected, the figure was 3.7% of the population.

Why care about disruption?

Disruption is transforming consumer habits. The interesting feature from an investment perspective is the growth that arises from disruption. When disruption occurs, you tend to get innovations and developments that can be quite powerful.

The successful companies in the future will undoubtedly be those that adapt to change caused by disruption.

As an investor in disruption, I look beyond the headlines and analyse trends to identify what the world will look like in the future. I seek to identify those companies that are likely to benefit from disruption rather than become a victim of it.

Going forward, investors looking to create a portfolio of stocks may wish to allocate some of it to the theme of disruption, rather than focusing on a particular country, industry or index.

Alex Tedder is head and chief investment officer of global and US equities at Schroders.

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