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Questor: British American Tobacco’s yield is 8pc and is more likely to rise than fall

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·4 min read
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 British American Tobacco - Jason Alden/Newscast/PA
British American Tobacco - Jason Alden/Newscast/PA

One of legendary hedge fund manager Paul Tudor Jones’s 10 golden rules of investment is “run your winners and cut your losers”, so it is with some trepidation that this column returns to British American Tobacco.

The FTSE 100 stalwart has been a poor pick since our first look in 2017: a paper capital loss of more than 45pc, or almost £24 a share, is only partly offset by 726.6p a share in dividends. Despite the stock’s unpopularity, the powerful cash flow generated by the core tobacco business and the attractive valuation on the basis of both earnings and yield make us reluctant to cut and run.

Investors who run rigorous environmental, social and governance (ESG) screens before they select a share will not even consider BAT and there are other good reasons for giving up on the stock, especially as the regulatory pressure on tobacco remains intense.

The Tobacco Tax Equity Act proposed by the Democrats in America is just the latest example. The initiative, which would raise federal levies on tobacco products, came straight after suggestions that President Joe Biden’s party would also consider legislation to lower the nicotine content in cigarettes, in addition to re-examining a possible ban on menthol-flavoured products.

Yet those investors who target income above all else will be reluctant to sell. Bills to raise taxes on tobacco are introduced just about every year in America and they generally falter. The Democrats themselves seem divided on the issue and Republican support looks unlikely.

Even if it is forthcoming, implementation of any law may be years away. In addition, history suggests that the big tobacco firms are quite capable of raising prices to offset any tax hit that comes their way.

None of this is to play down the risks. But the combination of a forecast price-to-earnings ratio of less than 10 and a yield of around 8pc takes a lot of the dangers into account. Moreover, free cash flow covered the £4.7bn dividend by nearly 1.4 times last year and last week’s trading statement, issued alongside the annual meeting, read positively enough.

The chief executive, Jack Bowles, stuck to his 2021 guidance for mid-single-digit growth in earnings per share (on a constant currency basis), strong cash flow, lower debt and a 65pc dividend payout ratio. That in turn implies some growth in the cash distribution.

Long-term worries could undeniably limit the potential for capital appreciation but income seekers may yet get their dividends and that can help to put some sort of floor under the shares, which are so far holding firm in the face of the proposed new laws in America.

BAT remains a core option for income investors.

Questor says: hold

Ticker: BATS

Share price at close: £26.82

Update: Smith & Nephew

Last week this column took profits on Greggs, the snack seller, in the view that gathering optimism about Britain’s vaccination programme made the stock an “obvious” play on any economic recovery, and anything that was indeed obvious would not necessarily be profitable from an investment point of view.

The hunt is still on for less obvious recovery candidates, but we may have already unearthed one in the form of Smith & Nephew, the orthopaedics specialist tipped here in early March.

Last week’s trading update offered plenty of support to our thesis that an end to lockdowns and increased consumer confidence could lead to a rise in the number of elective and non-elective surgical operations, boosting Smith & Nephew’s high-margin after sales of consumables such as dressings in the process.

The chief executive, Roland Diggelmann, reported underlying sales growth in the first quarter across all three business units – orthopaedics, sports medicine and wound management – and even felt sufficiently confident to reinstate sales and profit margin guidance for 2021 as a whole, targeting 10pc-13pc underlying progress in the former and 18pc-19pc for the latter.

Both metrics suggest a strong profit recovery could be under way. This is a quality stock that is still on offer at a reasonable price. Keep buying.

Questor says: buy

Ticker: SN.

Share price at close: £15.71

Russ Mould is investment director at AJ Bell, the stockbroker

Read the latest Questor column on every Sunday, Tuesday, Wednesday, Thursday and Friday from 5am.

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