Can you think of a UK business that can double its profits while its sales halve?
Such a company would have to possess phenomenal pricing power and incredibly strong cash flows – making it an ideal holding in these times of rising inflation and stagnant growth.
But it’s impossible, isn’t it? An oil company might see its profits double in an energy crisis, but that would only be due to the never-ending queues at its pumps. A gold miner could cash in on a speculative bubble or a flight to safety, but both would involve more people actually buying the stuff.
No, making so much more from so much less just can’t be done.
I certainly would have thought that, had I not paid a visit to Artemis, the fund manager, this week. Amid a conversation about the risks to equity and fixed-income holdings, manager James Foster casually mentioned that – if you take a 15-year timeframe – one UK company has achieved such a feat: Imperial Tobacco.
Imperial’s UK sales have followed the wider trend. Data from health statisticians Sir Richard Doll and Sir Richard Peto show that annual UK tobacco sales began falling from an eye-watering £150bn in 1965 to just £80bn in 1995. In the past 35 years, the number of people coughing their way to an early grave has also halved – suggesting more people have been stubbing out Imperial’s Lambert & Butler Superkings before it’s too late. Those customers who remain expect to cut their expenditure very soon. According to the National Statistics publication “Smoking and Drinking among Adults 2009” (why am I working for the FT and not that?), a quarter intended to stop buying tobacco over the following 12 months. Another quarter said they were already ex-purchasers, while seven out of 10 wouldn’t let the products into their homes.
Can you think of any other consumer business that could boost its profits while being so unpopular? Apart from Microsoft? Or a Simon Cowell record label?
In the case of Imperial, Foster suggests it’s to do with “price opacity” – the thick fug obscuring the true cost of tobacco, created by the cigarette companies’ greatest ally: HM Government.
Over the past 15 years, taxation has effectively put up a smokescreen around tobacco pricing. If the Budget includes a big increase in tobacco duty, and the price of a packet of 20 leaps to £7, no-one notices that 30p of that increase has nothing to do with the chancellor – and is all profit margin. As Foster puts it: “The consumer associates increases with tax. But when the tax rises, so does the maker’s price and margin.”
At the same time, tobacco sector regulation has erected a barrier to entry as robust as the smokers’ shelter in your local pub car park. A ban on advertising has prevented the launch of any new tobacco brands in the UK, making the value and power of Silk Cut and other incumbents even greater. “Because regulation and legislation have put up almost insuperable barriers to entry, the franchises of existing tobacco brands are exceptionally valuable,” says Foster. “Secondly, because they fear litigation, tobacco companies pass as much of their revenues on to their shareholders and deliberately keep their balance sheets weak. But their cashflows are exceptionally strong. Finally, investors are either (over)scared of litigation, or object to tobacco on ethical grounds, or both. So tobacco companies have to pay a relatively high yield – and are relatively cheap.”
It’s not surprising, then, that Imperial’s shares meet all three of Morgan Stanley’s criteria for “preferred dividend strategies”. Nor is it surprising that tobacco shares have been a mainstay of UK equity income funds – the most successful manager in that sector, Neil Woodford of Invesco Perpetual, has held them for years, and calculates that total shareholder returns from the tobacco sector have been more than 9,000 per cent over the last 25 years.
What you may find surprising, however, is that these same qualities have made tobacco companies’ bonds a profitable, and high-yield, holding for the Artemis Strategic Bond fund. Just the thing for a worried fixed-income investor who doesn’t want to give up just yet.
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