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The Guardian (UK): Your money in their hands: “BP is a reasonably good quality business, but I don't think Shell is at all.”: Saturday September 24, 2005


It's not fashionable or 'ethical'. So why become the UK's No 1 in tobacco shares? Patrick Collinson reports


Tobacco companies face multi-billion pound lawsuits, bans on smoking in pubs and restaurants and the prospect of permanently falling sales. A mad share to invest in, then?


Wrong. Imperial Tobacco (Lambert & Butler, Golden Virginia) has seen its shares soar from 500p five years ago to 1544p this week, a new high. Gallaher (Silk Cut, John Player, Benson & Hedges) is up from 400p to a record high of 877p, while British American Tobacco (Rothmans, Lucky Strike, Dunhill) has tripled from 400p to 1192p since mid-2000.


The extraordinary outperformance of tobacco shares is one reason why the UK's second largest unit trust, Invesco Perpetual High Income, has performed so strongly in recent years.


Neil Woodford, who has run the fund since 1988, has one-fifth of the £4bn fund invested in tobacco shares. He's the biggest single investor in tobacco shares in the UK, pouring £880m into the sector. That's equal to around 3,520,000,000 ciggies, even at Britain's steep prices.


The non-smoking Woodford makes no bones about his continued enthusiasm for the controversial shares, shunned by ethical investors. Stock prices are likely to rise further, he says, partly because he expects a round of takeovers. "It's more than likely that Gallaher will be acquired by Phillip Morris or Japan Tobacco. Imperial will eventually get together with Altadis." Altadis makes Gauloises and Gitanes.


But the long-term outlook for tobacco companies is driven by growing sales of premium cigarette brands across Asia and Eastern Europe. As an investor, he likes the fact that tobacco companies generate huge cashflows and pay out big dividends.


He likes BAT most. "It is a simple equation. It yields just a shade less than 5%, at a time when the company is buying back 2% of its equity every year and growing its dividend by 9-10% a year. On a dividend discount model, that puts BAT in the mid-teens, which is terrific for a company that is in a low-risk and predictable business."


Second to BAT in the fund's holdings is Reynolds, makers of the familiar Camel brand.


He believes that litigation risk, which has for so long depressed tobacco stock prices, is less of a worry than at any time in recent history. "We are through the worst part of US litigation risk. There are two more important decisions to come, but the industry is in a massively better-off position than four years ago."


But he says he's not addicted to tobacco, and if valuations changed, he'd happily sell out. He's done the same with oil, a sector the market is currently in love with.


"It's been a risk to be short on oil, and I don't own any oil stocks. But I've managed to be out of oil, and still the fund has performed better than the market. Having made my mark, I'm not going to compound things by choosing a commodity stock at the wrong price.


"BP is a reasonably good quality business, but I don't think Shell is at all. My view of the oil price is that $70 was a spike and that it will re-trace."


Utilities make up close to 30% of the fund, a bigger share than tobacco, but one that is less eyebrow-raising. National Grid, BT, Centrica and Northumbrian Water are all in his top 10. Northumbrian has performed brilliantly, doubling since Woodford bought in. "When I look at water, I look at cash flows and dividends. Northumbrian has a quantified dividend policy and I expect to obtain 11%-12% a year on a dividend discount model."


He's the second largest holder of Northumbrian stock after the Ontario Teacher's Pension Fund.


"Water companies are allowed to earn a return based on the size of the business. As their invested capital grows, because of the requirements for improved quality of supply and infrastructure rebuilding, so your return as an equity investor continues to grow."


But elsewhere in the stockmarket he's convinced that investors are over-optimistic on profit forecasts, especially in stocks exposed to the consumer. "I'm very confident that the fund can continue to deliver 10% dividend growth going forward, although I don't see that happening for the market overall. The world economy is facing some big challenges."


Neither does he see himself constrained by size, despite the fund being the second biggest in the market.


"My style is not troubled by being a large fund. I own half a percent of the UK stockmarket. I'm still a very small drop in a big pond." 


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