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Every Friday chief editor Peter van Kleef discusses thought-provoking topics with Robeco experts. This time: the remarkable outperformance of ‘sin shares’.
Since 1900 American tobacco shares have achieved annual returns of 14.6%. This is exactly 5% per annum more than the average returns on American shares, calculated the London Business School this month.
If you'd invested a dollar in American tobacco shares 115 years ago, you'd be USD 6.3 million better off now. If you'd have invested the same dollar in the wider American market on that same day, you'd have to make do with USD 38,255 today.
This 5% outperformance by the tobacco industry over such a long period is impressive – and it's not hidden behind a smokescreen either. Mark Glazener, fund manager of Robeco NV, summarizes the success in four words: “A good business case. How many products are there that elicit such a sudden moment of panic in users: ‘Have I got any at home, or on me?’ Not many.”
Twenty percent of the Western population smokes – a market share that is shrinking only very slightly – and the demographic development in emerging markets is providing tailwind. The degree of penetration is reasonably stable, but the population is growing and therefore the number of users continues to rise.
And then you have the pricing power, which according to Glazener is of unprecedented importance. “Rounded off, the tax on a packet of cigarettes is four euros and is raised occasionally by the government. And tobacco manufacturers have the opportunity to increase their margins each time the excise duties are raised. Basically, volumes are falling slightly worldwide – but this is more than made up for by the margins. In addition, the production costs rarely increase and tobacco manufacturers are not allowed to advertise – saving them millions each year. Unilever invests 11% of its budget in advertising.”
Another advantage is that there has been no major consolidation in the tobacco industry. Barring a few specific American players, there are but three big global names: British and American Tobacco, Philip Morris and Japan Tobacco. The competition from e-cigarettes doesn't pose much of a threat either. “The nicotine hit from e-cigarettes is much less intense. You don't get the same level of satisfaction from taking a drag.”
Glazener believes that the momentum in the tobacco industry can be maintained at least until 2020, thanks to the increasing prices that are compensating for the slight decline in volumes. But the prices of cigarettes cannot continue to rise without challenge, in particular because the majority of users are from low income groups. “During the crisis, the turnover in Italy and Spain plummeted because smokers switched to imitation brands, bought via the illegal circuit.”
Tobacco shares are examples of 'sin stocks' – shares in controversial sectors and activities, like the weapons industry and alcohol and gambling companies. As a result, these shares are avoided by a growing group of investors that is guided by principles concerning ESG (Environment, Social, Governance). But not by Glazener, who applies the best in class principle for his fund. “Excluding certain sectors limits your possibilities and opportunities as a fund manager and we only do that when it is required by law, like with cluster bomb makers. At the end of the day, you are judged by your returns in the financial sector.”
Shares that are excluded by groups of investors tend to be traded at a discount. Due to the taint on the sector or industry, as a rule they are valued lower than the market average. This doesn't apply to tobacco shares – these certainly aren’t cheap.
The merits of investing in shares in tobacco firms outweigh the disadvantages of the tobacco industry. “As long as these shares continue to perform above average, investors will continue to buy them.” Shares in tobacco will keep doing surprisingly well for now, even against the sentiment of the modern world. “The industry has survived billions in claims, the ban on smoking in public places, shocking messages on cigarette packs and even a ban in Australia on printing brand names on packets. But these shares have proven exceptionally immune to every type of headwind.”
‘We are looking into whether tobacco shares can be replaced in the portfolio – preferably by an alternative with the same risk-return profile’
The 5% extra return is obviously just too tempting to resist. Even the pension fund for GPs was investing in tobacco shares until a year ago. It has excluded this industry now, as has PGGM's Zorg & Welzijn (Health & Welfare) pension fund. A complete end to investing in tobacco shares is not in sight either.
But that time may come, thinks Glazener. “If further government restrictions cause the sector to lose its appeal, for instance.” Until then, investors remain caught in the devil's dilemma of return versus ESG considerations. Glazener too, despite the fact that the management team of Robeco NV is looking into whether tobacco shares can be replaced in the portfolio – preferably by an alternative with the same risk-return profile.