I have an admission to make – this past summer, I quit a popular investment habit.
As friends and colleagues will know, the headline of this post is an odd admission for a non-smoker, so I should explain. It is my belief that the tobacco industry is on the cusp of a profound change as it transitions to a world of less harmful next-generation products, which could damage the profits and returns of the incumbent companies. While I think this is good news for smokers and a must-do strategy for the tobacco companies, it could be unwise to be a shareholder during this transition and I have sold out completely of tobacco companies in the portfolios that I manage.
Tobacco companies have been a controversial, but rewarding set of companies to own for the last two decades. But as we all know, past performance is not a guide to future returns.
At a time when anti-smoking policies have been introduced around the world with a resulting decline in smoking populations, the tobacco companies have delivered a strong combination of revenue growth, margin improvement and shareholder-friendly capital allocation. They have managed to grow their revenues, using the cover of substantial tobacco tax hikes to raise their own net prices to more than offset the demand declines.
Over the last few years the market has started to change and we are seeing customers switching to next generation or tobacco replacement products, such as e-vapour or tobacco heating products, which are widely understood to be less harmful. The tobacco companies are rightly responding and meeting customer demand for these products and one major tobacco company has even gone as a far as to talk about a ‘smoke free’ future. Indeed, if they didn’t respond there would likely be concerns that the companies would be left serving a declining traditional cigarette market.
However, in my opinion, an exciting new range of products and much-needed switch to a less harmful business model is not necessarily good news for shareholders in the tobacco companies. In a market that is developing fast, higher levels of social acceptability, less regulatory restrictions and an ability to build market share through brand-building marketing will mean that barriers to entry are lower, encouraging new entrants into the industry. This could further exacerbate competition and rivalry in the early land grab stage of the market development, where customers appear to be experimenting with multiple products and brands.
I would be reluctant to assume that the incumbent tobacco companies will always be the winners in this new market as new entrants and start-ups may well be better at developing innovative product and new marketing messages.
In the US, new entrant JUUL has taken around 60% share of the e-vapour market in little more than 18 months. Its innovative product that uses nicotine salts in a pod-based, well designed device appears to have accelerated the switch from cigarettes in a way that the Vuse product from British American Tobacco and similar products from Imperial Brands, Altria and Japan Tobacco did not. According to Citigroup research, the introduction of JUUL into the market has driven e-vapour products from 1.3% to 5.0% share of the combined cigarette and next generation products in just two years.
The US Food and Drug Administration recently revealed plans to combat underage use of e-cigarette and nicotine that would age restrict the sales of flavoured electronic nicotine delivery system products. JUUL went further than this new policy, removing all non-tobacco flavours from vaping shops and age-restricted specialty stores.
I suspect that JUUL will just be the first of many new entrants that will take on the incumbents around the world, challenging the sustainability of tobacco company returns and cashflow generation into the future. In my view, this is normally a warning sign and for these investment reasons, I have given up tobacco.
Trade tariffs are a major concern for investors. The impact so far has been muted, but the risk of escalation looms. 25% tariffs on all Chinese goods are a credible threat from US President Trump but global auto-tariffs would be a much bigger risk to the US economy, encouraging others to launch a combined response. Find out more in my vlog below.