Investors are often warned against the dangers of blindly chasing stocks with a high yield, as this figure can be artificially inflated by a fall in the share price and may be a sign the dividend is about to be cut.
And with many analysts saying the tobacco sector is in long term decline – global cigarette sales fell by 9.2 per cent from 2012 to 2017 – a trailing dividend yield of close to 8 per cent on British American Tobacco raises question marks about the sustainability of this figure.
However, David Smith, manager of the Henderson High Income Trust, said this does not tally with the fundamentals – and may signal a buying opportunity.
“The dividend yield on the likes of British American Tobacco is now close to 8 per cent,” he said. “When you look at the cashflows in the business, there is no reason why they can’t continue to pay that dividend, there is no reason why they can’t continue to grow that dividend.
Source: Bernstein, as at 31 December 2018
“On that sort of yield, the market is telling you that is unsustainable, it’s going to be cut. When I do my analysis, I can’t see it. I can’t see how it could be cut. The cashflow comfortably covers the dividend.”
Smith admitted that challenges in the regulatory and competitive environment have created uncertainty, which the market hates above all else.
However, he said it is this uncertainty that creates opportunities for stockpickers, with valuations among the tobacco giants now at their lowest since 2002 to 2003, when there was a serious regulatory threat to the sector.
The manager (pictured) said this appears to be part of an ongoing trend in the market where emotion is triumphing over fundamentals.
“Now when you do see stocks go out of favour, I mean they really do go,” he continued. “And that creates incredibly good opportunities for us as income fund managers
.
“The dividend yields are close to those sorts of lows in the heights of the dotcom bubble where no one wanted to own any 'old economy' shares.
“That was an incredibly good buying opportunity and I think again today where we stand it’s a very good buying opportunity.”
One of the reasons suggested for the unpopularity of tobacco is the increased focus on environmental, social & governance (ESG) issues, leading investors to shun the sector. However, Smith is not so sure.
The manager said that a focus on corporate governance has always been a major part of the process for Janus Henderson’s income team, with numerous studies showing companies that place an emphasis on upholding high standards in this area tend to outperform those that don’t.
In terms of the environmental and social issues, the manager said that while this is more of a challenge for the typical “old economy” income stalwarts, such as tobacco and oil & gas, what is most important is they are moving in the right direction.
“What we look for in these companies is they are doing the right things, so the likes of Royal Dutch Shell are investing heavily in renewable energy,” he added.
“They can see that very, very long term there probably won’t be a need in the economy for oil so they will have to readjust their business.
“For tobacco they are investing in lower-risk products. So vaping, the likes of heat-not-burn and so on because they recognise that actually again maybe the outlook over the very long term for the cigarette is declining. They are aware of that and they need to invest in other things as well to keep their business going.”
However, it is the rise of vaping that possibly poses the biggest threat to tobacco. While British American Tobacco has a 40 per cent market share of the UK vaping market, there are worries that the low barriers to entry with e-cigarettes are threatening the wide margins and cashflows traditionally enjoyed by the sector.
As a result, Smith thinks the long-term prospects for tobacco rest with heat-not-burn technology instead – although it remains to be seen how successful this will be.
“They are currently in a period of high investment and the profitability isn’t coming through,” he said.
“In terms of heat-not-burn, arguably when you get to a more mature level then there is no reason why it couldn’t have the same margins. Effectively you are still having your stick of tobacco, you’ve still got the same barriers to entry.
“If you look at the different products as a traditional smoker, if you can get the same nicotine hit, the same feel, the same taste, but a lower risk, heat-not-burn maybe does that better than vaping. And I think heat-not-burn is maybe the longer-term solution to cigarette smoking.”
He said another consideration is whether vaping takes a bigger than expected proportion of the overall market share.
“But I think as long as they are doing the right thing in terms of addressing that – I mean if they had their head in the sand and were just not doing anything, then you would question why you still owned it. But I think they are doing the right things,” Smith finished.
Data from FE Analytics shows the Henderson High Income Trust has made 29.93 per cent since Smith took charge at the start of 2014, compared with gains of 36.38 per cent from its FSE All Share benchmark and 34.16 per cent from its IT UK Equity & Bond Income sector.
Performance of trust vs sector and index over manager tenure
Source: FE Analytics
The trust is yielding 5.62 per cent and has ongoing charges of 0.75 per cent.
It is trading at a discount to net asset value (NAV) of 4.67 per cent compared with 2.97 and 0.71 per cent from its one- and three-year averages. It is 25 per cent geared.