Anniversaries provide good opportunities to reflect and re-assess. We have had a few notable milestones recently, with the 10th anniversary of the Great Financial Crisis, the 20th birthday of the Euro and it has been 35 years since the launch of the FTSE 100 index. The latter has been in greater focus, as investors continue to search for reliable sources of income at a time when a low interest rate environment continues to dominate. The tobacco sector, which has been a traditional income stalwart, was highlighted as the best performing sector since the launch of the index, which captures the 100 largest listed companies in the UK by market capitalisation.
For responsible and sustainable investors, the tobacco industry has always been excluded as part of screening processes, which seek to exclude companies from their universe of investible stocks on the basis that their activities are deemed harmful to society. This stance has traditionally stood against the tide of most income investors, who have long seen the tobacco sector as a core part of their portfolios. In addition, the defensive nature of the sector has long been lauded. For responsible and sustainable investors, the challenge has always been to find a similar yield profile with defensive characteristics.
TOBACCO: GOING UP IN SMOKE?
2018 was a watershed moment for the tobacco sector in the UK, with the sector being the worst performer over the calendar year on the back of regulatory concerns, a growing threat from electric cigarettes and the continuing legalisation of marijuana. British American Tobacco (BAT) was down -47.2% at the close of 2018, effectively wiping out any of its gains for the previous five years. Imperial Tobacco, the other dominant UK player, has fared slightly better, but was still down -19.6% over the period. Imperial has performed better than BAT and the FTSE All-Share over 5 years, but less so over a 10 year period.
It is increasingly clear that the tobacco industry is facing structural headwinds. In November last year, the Food and Drug Administration (FDA) moved to propose a ban on menthol cigarettes in the US, following Canada’s implementation of a ban, and the EU’s ban which is set to go into effect in 2020. There are larger social changes afoot which will continue to impact the future of the industry. In the developed world, the number of smokers continues to decline as consumers become increasingly health conscious and educated about the negative impact of smoking tobacco. Even in areas where tobacco companies have found potential opportunities for diversification, such as e-cigarettes, there will be regulatory hurdles to overcome in the near to medium term.
2018 was a watershed moment for the tobacco sector in the UK, with the sector being the worst performer over the calendar year on the back of regulatory concerns, a growing threat from electric cigarettes and the continuing legalisation of marijuana.
The tobacco lobby has long cited the tax paid by the industry into the coffers of the UK Treasury to deflect critics who highlight the negative impact of smoking on the already overburdened NHS. A recent study by the University of Bath’s School of Management concluded that the industry creates a shortfall in the tax paid versus the negative impact on the NHS. The study also highlighted the low levels of tax paid by both the UK companies, with BAT paying “virtually no” corporation tax over the past 7 years, including no tax payments for the period 2011-14 in the UK. Imperial Tobacco managed to pay an effective tax rate of just 13% over 7 years at time when UK corporation tax has varied between 20% and 28%. This will come under increasing scrutiny with both consumers and policy makers asking for greater transparency on the tax planning practices of global companies across several sectors.
These are not just short-term issues for investors. These are inherently structural problems with the future of tobacco, which will mean that the industry will struggle to deliver similar returns over the next 35 years, although supporters of the sector will point to growth in emerging markets, where health education and policy is behind the curve.
HEALTHCARE: DEFENSIVE AND DIVERSE
The healthcare sector stands in stark contrast to the tobacco industry, with the UK continuing to develop its global leadership position in research and development. The total spend in global healthcare is projected to reach $10 trillion by 2022, led by improvements in medical treatments, digital technology, and the emergence of personalised medicine. Other structural tailwinds include a growing and aging population which is developing chronic conditions such as diabetes, cardiovascular and auto-immune diseases which require a lifetime of medical attention. In addition, improvements in diagnostics will lead to a greater cohort of patients being captured much earlier, leading to a greater spend on all parts of the investment value chain in healthcare.
There is a positive correlation between rising GDP and total health care spend. The emergence of a large middle class in emerging economies coupled with rapid urbanisation has increased the ability of patients to pay for advanced medical care. The pharmaceutical sector, which dominates healthcare, is attractively positioned, with companies offering rising dividend yields, robust balance sheets and good long-term growth prospects, all on undemanding valuations. In addition, the wider healthcare sector offers investors a broad and deep investment opportunity set.
The attractiveness of UK companies was highlighted by the recent buy-out of Shire by Japan’s Takeda, marking one of the very few overseas M&A forays by a Japanese company. The two UK pharmaceutical giants, GlaxoSmithKline and AstraZeneca, formed via a series of mergers, have become the global leaders in their respective therapeutic fields. Investors have been handsomely rewarded on a total return basis by AstraZeneca over 5 and 10 years. The diversification of the healthcare sector is often understated, with investors only focusing on the pharmaceutical industry. There are several sub-sectors - including medical technology, diagnostics, life sciences and animal health - which are available to investors, offering both defensive and diversified business models. Long-term investors in Smith & Nephew, a leading medical technology company focused on joint implants and trauma products, have enjoyed total returns of over 300%, nearly 3 times more than BAT and Imperial Tobacco over the last decade.
SEARCH OF YIELD: INFLECTION POINT
Expectations that the tobacco sector will be able to deliver significant returns for shareholders going forward needs to be re-assessed given the emergence of healthcare as a viable and long-term replacement candidate for income portfolios. The irony will not be lost on responsible and sustainable investors that the very success of tobacco is leading to the creation of patients with chronic conditions which are leading to a greater demand for healthcare services. Long-term investors will have to make a decision on whether to continue to back a structurally challenged industry or make the shift to healthcare, a sector that offers a high and growing dividend yield supported by unlevered balance sheets and compelling long-term market dynamics.