Long-term backers of the tobacco sector are cutting their weightings amid the threat of competition from e-cigarettes, in a shift that could fundamentally change UK portfolios.
Tobacco companies have long been core holdings for UK equity fund managers, with income specialists in particular favouring their status as consumer staples with consistent, secure dividends.
However, backers from Aviva Investors and Allianz Global Investors have warned that e-cigarettes, which offer a safer alternative to cigarettes, are their “biggest concern” when it comes to the sector’s future.
Chris Murphy, manager of Aviva Investors’ £986.3m UK Equity Income fund, has divested half of his holdings in tobacco companies in the past few years. He now holds just over 4 per cent, compared to nearly 10 per cent previously.
“E-cigarettes are my biggest concern,” he said. “They are creating unresolved tensions that aren’t being priced in and eventually the stockmarket will catch up.” Cigarette sales have been on the slide of late, partly due to the rising threat of e-cigarettes, impacting managers’ views on stocks such as Imperial Tobacco and British American Tobacco (BAT).
Simon Gergel, chief investment officer for UK equities at Allianz Global Investors, said the threat of e-cigarettes is misunderstood by the market. They are a “disruptive technology”, he said, adding that he has been reducing his weighting in Imperial Tobacco.
“Some tobacco companies have looked into trying to take over e-cigarette companies but, even if they do, they will not be able to offer the same profit margins as they currently do,” he said. “E-cigarettes are a normal consumer product.”
Mr Gergel said the appeal of tobacco companies lies in their high dividend yields and pricing discipline. He added that the trend towards e-cigarettes is not creating a new investment opportunity. “There are no clear dominating companies,” he said.
However, the £2.7bn CF Woodford Equity Income fund has been continuing to invest in the tobacco industry, since the fund launched three months ago. Last month the fund’s manager Neil Woodford, a staunch backer of the tobacco sector, increased his exposure to Reynolds American after its proposed merger with Lorillard became known.
After selling his exposure to favoured pharmaceutical stock Novartis, the fund now holds 3.6 per cent in the tobacco firm. It also holds 5.8 per cent in BAT and 5.7 per cent in Imperial Tobacco.
Stephen Lamacraft, fund manager at Woodford Investment Management, said: “It is early days with e-cigarettes but it seems increasingly likely that they are turning into an opportunity, as opposed to a threat, for the main players.”
Managers in favour of tobacco companies argue they have unrivalled pricing power and there is little chance of new entrants coming to market.
Major players such as BAT are among those attempting to create their own nicotine substitutes.
Don’t give up on the tobacco giants yet
According to JPMorgan Asset Management’s Sarah Emly, embracing ‘vaping’ could be the key to making a profit.
“Tobacco companies have started participating in the e-cigarette market and that is a good sign for their future prospects,” Ms Emly (pictured) said.
British American Tobacco (BAT) set up a unit in 2011 to develop smokeless alternatives. In 2012 it bought UK-based CN Creative and now sells an e-cigarette called Vype in Britain.
Elsewhere, Reynolds American is rolling out an e-cigarette called Vuse across the US.
But e-cigarettes are a different beast from traditional cigarettes, prompting fears that even if tobacco companies enter the market, they will not be able to generate their current high returns.
Distribution channels will be different and, since e-cigarettes can be advertised across the world, they will incur an additional marketing cost for the companies.
Ms Emly, co-manager of JPMorgan’s UK Managed Equity fund, said this was something all e-cigarette companies will have to deal with. “I have conviction in these global tobacco manufacturers and their ability to generate growth from cigarettes,” she said.
The £284.9m fund, which holds 3.8 per cent in BAT and 3.4 per cent in Imperial Tobacco, has returned 12.8 per cent in the past year, compared to the FTSE 100’s 12.3 per cent.
