Is British American Tobacco more than just an income investment?

If you’re not worried about the ethical implications of investing in tobacco companies, then being a shareholder of British American Tobacco over the last decade would have been a very profitable experience.

The shares have risen from around 700p in 2002 to more than 3,000p today.  Along the way, it’s paid out another 700p in dividends, which gives a total gain of approximately 3,000p on an initial 700p investment.  That’s more than 400% in 10 years compared to the FTSE 100’s total gain of nearer 50%.

But just because a stock has had a great past, it doesn’t automatically follow that it has a great future.  The company could run into problems, or we could just be overpaying at today’s prices, so let’s dig in and see how British American Tobacco shapes up for the next ten years.

Start with safety in mind

As a defensive value investor, I like to start off by looking at how robust the company is in order to get an idea of how well it can cope with the harsh capitalist environment in which most companies exist.

Diversity – Whether it be products, suppliers, customers or locations, diverse operations can help a company to survive problems in any one area.  The most obvious sign of diversity for British American Tobacco is that it is incredibly international, selling tobacco products to over 180 countries with revenues spread fairly evenly between all the continents of the world.  If one region becomes less friendly towards tobacco, the company has other regions to sell into.

Consistency – Estimating the intrinsic value of a company is not an easy thing to do, but it’s child’s play compared to predicting the future.  However, both of these tasks can be made somewhat easier if the company you’re looking at has a consistent history.  By consistent I mean consistent results in terms of sales, profits and dividends, as well as a consistent operating history, i.e. they’ve done the same thing for a long period of time.

British American Tobacco ticks both of these boxes.  They have been in the tobacco business for more than 100 years, and more recently, they’ve turned out consistent results and returns to shareholders.  Both earnings and dividends per share have increased in every one of the last ten years, from 66p and 35p a decade ago to 194p and 126p today.

Success – Another trait of defensive value investors is that they tend to invest only in very successful, market-leading companies.  Once again, British American Tobacco ticks this box as it’s the second largest (by market share) listed tobacco group, with a market cap of more than £62 billion.  Of course, the consistent profitability I’ve already mentioned is another sign of a successful company.

A survivable present and future – It’s no good buying a company with a great track record if it’s about to go bust or if its main product or service is likely to become obsolete within a few years (as happened recently to Game Group).  In this case, there are no obvious immediate threats to the company’s existence, but there is at least some level of uncertainty about the future.

Although it’s unlikely that mankind is going to kick the cigarette habit any time soon, it is, at least in the West, obvious that cigarettes are becoming marginalised and pushed out from mainstream society.  Just think back to the days when guests (or even hosts) on talk shows could sit there puffing on a cigarette live on TV.  So there is an issue, but I don’t think it’s likely to impact the big tobacco firms in the near future.

Prudent finances – Debt can kill even the healthiest company if it’s used to excess, so prudent levels of borrowing are another indicator of a good defensive stock.  Once again, British American Tobacco sails through with interest payments covered more than ten times over by earnings, and although total debts of £10 billion sounds like a lot, it’s less than three times the adjusted earnings which are over £3 billion.  Both of those are relatively conservative debt ratios.

So, it looks like British American Tobacco may be the sort of company that a cautious or defensive value investor could invest in at the right price.

Look for returns from all sources

Returns in the long run typically come from three places: dividends, earnings growth and increases in the price-to-earnings ratio.  It is the combination of returns from these three sources which produces the total return that the investor sees over time.

Look for a low price relative to long-term earnings

I’ll start with the PE ratio, which is one of the main drivers of returns from the stock market.  Earnings can bounce around all over the place from year to year, rendering the usual PE ratio almost meaningless, so I prefer to use the average earnings of the last ten years rather than simply the earnings of the last 12 months.  This is especially appropriate for the sort of large, stable companies that defensive value investors are mostly interested in.

For British American Tobacco, the price is currently around 3,160p, and the adjusted earnings have averaged about 116p in the last ten years, so the price is over 27 times the long-term average earnings, while I prefer companies to be below 20 times.

Ben Graham suggested various limits at different times, but one that may be useful was the suggestion to be wary of paying more than 25 times the 7-year earnings average.  Using 7-year average earnings, the company is currently priced at over 23 times that amount, so by both Graham’s measure and mine, the company looks to be expensive.

To give you some context, the FTSE 100 is currently priced around 14 times its 10-year average earnings, and the median of FTSE 350 companies is about 17.

So relative to past earnings, the shares do not look immediately attractive unless, of course, there is a reason to believe that the company has an outstanding future, far better than that for the average company in the FTSE 100.

Look for long-term growth

Typically I would expect a stock which is expensive relative to past earnings to either be a ‘hot favourite’ of the market or a stock with a high past growth rate which is expected to continue into the future.

In this case, it looks like British American Tobacco has indeed managed to produce an above-market growth rate over a long period of time.  In 2002 the adjusted earnings were 66p while the dividend was 35p.  In 2011 they were 194p and 126p, respectively. That’s a pretty healthy growth rate of around 10% a year and one that has also been remarkably consistent, with earnings and dividends per share growing in every single one of those years.

Most companies would love to have a track record like that, and it shows the real power of tobacco economics.

That 10% growth rate compares well to the FTSE 100 as a whole, which has generated earnings growth nearer 5% over the same period.

Look for a high and sustainable dividend yield

The dividend for this stock has a very solid history, and tobacco stocks are well-known and liked by many investors who are primarily looking for income.  The stock has yielded around 4% historically, and that’s about where it is today.  Also important for income investors is the consistent above-inflation growth rates that the dividend has seen over the years.

The dividend is not well covered relative to most other companies, with earnings only 1.5 times the dividend.  However, that’s not such a problem as it may at first appear, as tobacco companies don’t generally have to retain much of their earnings to generate new growth.  It’s not like a pharmaceutical company that has to pump millions into R&D to develop new products.

Two out of three isn’t bad at all

Of the three sources of total stock market returns, British American Tobacco has the market beat in two of them.  Both its growth rate and its dividend yield are higher than the market can manage, and that may potentially point to better returns going forward.

The only downside from the valuation point of view is the high price relative to past earnings, but to some extent, that’s to be expected of a company which can generate very high rates of return on retained earnings, and that is also quite likely to continue to perform well relative to the market.

BAT’s Stock Rating

Members of UK Value Investor will know that each month it produces a ranking for about 200 FTSE 350 stocks which is used as an indicator of a potentially interesting defensive value stock.  This rank is a combination of the stock’s relative performance for dividends, earnings growth and PE valuation (10 years of course).

The rank for British American Tobacco in the April issue was 589, while the FTSE 100 at 5,800 points had a rank of 590, so there is but the thinnest of cigarette papers between them.

In reality, it may be that BATS is overly hurt by its high price relative to past earnings, which may be justified to some extent by the high growth rate and the low level of earnings required to sustain that growth, as well as the dividend.

To make the defensive value rating system a little clearer, I will be changing it to a 5-star rating system which most people are familiar with from sites like Amazon (although the underlying ranking process remains the same).

Currently, the FTSE 100 just about makes it into the 4-star category, which suggests that it may be an attractive investment at current levels (which is something I agree with).  BATS currently also has a 4-star rating.