Imperial Tobacco is the epitome of a defensive company. It generates a steady flow of cash from millions of loyal customers who spend small amounts of their income on the company’s products every day, regardless of the state of the economic.
The result for shareholders has been steady and progressive but also relatively rapid dividend growth over long periods of time. When Imperial Tobacco was added to the UKVI model portfolio back in early 2013 I hoped that we would see more of the same and, in the end, that’s exactly what happened.
However, after a recent run up in price it is now one of the lowest ranked stocks in the portfolio, so I have decided to sell and lock in those capital gains.
As investments go it was relatively quiet, as the chart above shows. There was no drama and the company simply did what it said it would do, which was to raise the dividend by at least 10% a year. Eventually, as is often the case, the share price responded accordingly.
If the share price drops again I would not be in the least bit surprised to see this company back in the portfolio for a second time.
The decision to buy
As usual the main reason Imperial Tobacco made it into the model portfolio was its high rank on the UKVI stock screen. Back in March 2013 the company was in position 16 out of 162 companies, with the following features:
- Growth Rate of 13% (10 year average growth of revenues, earnings and dividends)
- Growth Quality score of 93% (consistency of revenue, earnings and dividend growth over 10 years)
- Dividend yield of 4.4% and
- PE10 ratio of 18.9 (share price to 10 year average earnings)
Adding the Growth Rate to the dividend yield as an estimate of possible future annual returns gave a figure of 17.4%, which of course would be more than satisfactory if it could be achieved. In the end, despite being a very high target, that’ wasn’t far off what the investment actually returned.
Buying Imperial Tobacco was also a relatively easy decision to make, given its obvious track record of success.
In early 2013 when I bought the shares (for my personal portfolio as well as the model portfolio), Imperial had been progressing well, the dividend was growing as regular as clockwork and there didn’t appear to be any significant problems ahead.
Given that rosy picture you might wonder why the shares were trading so cheaply. After all, a market-beating dividend yield was available from a company that had the intention to grow its dividend at 10% a year, and a track record which showed it could do it.
There had been some weaker results from Russia and Europe in the wake of the financial crisis, but those appeared to be relatively minor issues, so without an obvious cause for the low valuation I put it down to the discount that tobacco companies often trade at, relative to the rest of the market.
That’s partly because many investors don’t like to invest in tobacco companies, but also because some fear the hidden risks of government regulation and health-related litigation, particularly in the US.
Either way the shares appeared to be cheap, the company appeared to be capable of hitting its growth target, and so Imperial Tobacco did make it into the model portfolio.
The decision to hold
Whenever I add a company to the portfolio my assumption is that it will be held for around 5 years. That’s because the portfolio holds 30 companies and replaces 6 of them each year, so on average it will take 5 years to replace the whole portfolio.
But of course that’s an average and exactly how long each company is owned will depend on how it and the market evolve over time.
In this case, Imperial Tobacco did exactly as it said it would do. When the 2013 annual results were announced in November 2013 the dividend increased by 10% to 116.4p, as intended. Then again in November 2014 when the next set of annual results came out, the dividend went up another 10% to 128.1p.
If only all companies were that reliable and all investments that simple.
On the other hand, for the first year the share price went nowhere. In fact it did worse than go nowhere; it spent almost a year below the purchase price, indicating a paper loss of up to 10%.
Yet again this was another good example of why investors should think in terms of years and decades rather than weeks and months, because even if we do pick good companies there is no way to know how the market will behave.
Eventually though things began to change in early 2014. The shares moved to a new high, their 1 year record looked good, and that’s often enough to attract the attention of the in-and-out brigade, i.e. those “investors” who pile into whatever’s going up and jump out of whatever’s going down.
For the rest of 2014 the shares did well and more recently they’ve really started to shoot up. The result of course is worsening valuations and lower yields, all of which can be a good reason to look for the exit.
The decision to sell
At the start of December, Imperial Tobacco’s share price was 2,960p, giving the shares a 4.3% dividend yield and a PE10 ratio of 20.2. Both of these are only very slightly weaker compared to their values of 4.4% and 18.9 respectively, from early 2013.
So what else has changed to move Imperial Tobacco from a buy in early 2013 to a sell in late 2014? The biggest change has come from declining Growth Rate and Growth Quality scores.
Over the last two years, while dividends have been growing at 10% a year, Imperial Tobacco has seen its revenues and adjusted earnings per share shrink rather than grow. This is obviously a trend which needs to be reversed if dividend growth is to be sustained longer-term as the chart below shows.
This lack of top and bottom line growth means that the company’s Growth Rate has fallen from 13% to 11% and its Growth Quality score has dropped from 93% to 71%. This, combined with a higher PE10 ratio and lower dividend yield gives the company a much lower rank on the screen of 84 rather than the 16 it had before.
On a more qualitative basis, the declining earnings are a definite concern for future dividend growth. Another concern is the relatively high levels of debt, which currently stand at almost £10 billion of borrowed money, or 5.4 times the company’s current Earnings Power (5 year average adjusted profit after tax), which is above my preferred maximum level of debt.
For all those reasons I have now sold Imperial Tobacco and I’m looking forward to ploughing the proceeds back into another company next month.
I own tobacco stocks for 14 years. In 2000-2001 they were so depresed and every Court case in the US was heavily discounted.
At one moment I use to own 7 diferrent tobacco stocks which represented nearly 40% of my portfolio. Those days have passed. I still own 4 tobacco stocks with the highest allocation to Japan tobaco, but I still own a bit of IMT.
I have to recognize I am biased, i owned tobacco stocks for so long (the longest) that I felt in love with them. I have to recognize this. To be honest I am afraid of disruption in this industry, with the electronical stuff coming into the market.
I always liked BATS better although I own both of them. Tend to agree with Motley Fool analysis on this one:
John Kingham says
Hi Andrew, I hold British American as well. It’s hard to have a defensive slant and NOT invest in tobacco.
Interesting time to sell IMT as the likes of Neil Woodford and Terry Smith are adding. In particular Woodford stated in his report on November trading that they are further enthused by the value proposition that UK tobacco companies offer that they made a decision in the fund to sell Philip Morris and reinvest the proceeds in IMT and BATS.
Given that IMT and BATS own significant portions of the US market indirectly through their ownership 42% of Reynolds American (in the case of BATS) and IMT picked up several top US brands when Reynolds bought Lorillard. There are few entering this market now and the few will dominate and crank up the margins in coming years together with further consolidation. Between them they also have many of the leading electronic cigarette brands.
The game is just beginning and now is the time to buy BATS and IMT.
I confess to owning BATS; IMT and Reynolds as a significant portion of my portfolio.
John Kingham says
Hi LR, Woodford and Smith are probably the two active managers I’ll be comparing myself performance against most as they’re in roughly the same defensive/value space. However, I’m quite happy to sell if they’re buying; after all going against the crowd is an occupational hazard for value investors.
As for how IMT will perform in the years ahead, I think it probably will continue to do well, both the company and its shares. I’m not selling because I think it’s overvalued (it has a rank of 84 on my stock screen while the FTSE 100 is at 174), I’m selling because there are other things that look more interesting.
And I still hold BAT, so it’s not like I’m abandoning the tobacco story just yet.
I was just wondering how exactly you calculate a company’s ‘current Earnings Power’- is it simply the last 5 years worth of profits averaged? For the Imperial Tobacco example this would be: (2,118.0+2,153.0 + 1,081.0 + 1,261.0 + 1,520.0)/5=1,627mn (for pre-tax profits – I don’t have the after tax profits to hand).
“Another concern is the relatively high levels of debt, which currently stand at almost £10 billion of borrowed money, or 5.4 times the company’s current Earnings Power (5 year average adjusted profit after tax), which is above my preferred maximum level of debt.”
John Kingham says
Hi Tim, yes that’s right, although exactly what number you come up with depends on pre- or post-tax, adjusted or basic profits, etc. The numbers I have are slightly different to yours as they’re adjusted and post-tax, but they’re in the same ballpark.