Smoking! Why I think Imperial Brands and British American Tobacco could soon fly

Tobacco and smoking products shares have taken a battering over recent years. Imperial Brands (LSE: IMB) at today’s share price around 1,958p is just over 50% down from its peak almost exactly three years ago, and British American Tobacco (LSE: BATS) is down around 46% over the same period.

Changing sentiment

It’s impossible to pinpoint the exact reasons for the change in investor sentiment, but I would observe that three years ago many were talking about what looked like a ‘bond-proxy’ trade. In other words, investors had been piling into the shares of companies with defensive, cash-generating businesses to collect the ‘sure-fire’ dividends in lieu of interest payments from bonds and bank accounts, which were at pitifully low levels – hence the term ‘bond-proxy’.

Interest rates had been low for a long time and therefore the so-called bond-proxy trade had been going on for a long time. The outcome was that the valuations of firms such as BATS and IMB were driven up to high-looking levels – think price-to-earnings (P/E) ratios in the mid-to-high teens in the case of tobacco shares.

Now, I’ve long argued that defensive shares tend to suffer from a valuation cycle over time, with the valuations rising and falling alternatively. The underlying businesses may not have to endure the famine-and-feast economics of out-and-out cyclical enterprises, but the effect of a valuation cycle can make share prices behave in a similar way to those of cyclical firms.

Low valuations now

And right now, valuations look low. The forward-looking P/E rating for BATS for the current year is just over nine and the dividend yield a little higher than 7%. IMB’s P/E rating is around seven and the yield more than 10%. I think the chances that these valuations could cycle back up is high.

I banged out an article in April asking, “Is Imperial Brands’ 8% dividend yield safe?”  The numbers looked good. IMB has a decent record of “robust and consistent” cash flow, borrowings look as if they’re under control, and the dividend has risen more than 60% over the past five years. There’s some decent cover for ongoing dividend payments from cash flow. I concluded that the firm has“plenty of opportunities that can lead to further growth and continuation of dividend payments to shareholders.”

And in an article at the end of May, I reported on BATS’ recent view that its business is in good shape despite investors’ concerns about possible regulation in the US and “competitor dynamics” in new product categories. Far from being a problem, BATS had said those concerns “in fact present significant opportunities for future growth.”

Building new markets

The market for traditional smoking products may be in long-term decline if you consider the combined global picture, but there’s a strong market for new-generation smoking substitutes. These days, every street corner seems to feature a cluster of people puffing fruity vapour, for example. Who would have foreseen such a take-up of that habit just 15 years ago?

Given how perky the underlying businesses look, my view is that valuations could have over-shot to the downside. That’s why I suspect shares in Imperial Brands and British American Tobacco could fly higher.