Over the next few weeks, I’ll be introducing a fellow blogger here on The Adventurous Investor, Frank Buhagiar. I’ve known Frank for many years and like me, he’s obsessed by investment trusts. Crucially, Frank spent 16 years as a private client stockbroker managing discretionary and advisory accounts and has also worked as an equity and fund analyst with a particular focus on investment companies. Frank’s focus today is on two stars in the equity income firmament……
For over a decade, equity income sector stalwarts Perpetual Income and Growth and Edinburgh IT have benefited from being heavily overweight in the tobacco sector. In a world in which investors have been scrambling for yield, the cash flows generated by feeding smokers’ addiction to nicotine offer stable income streams that have served both trusts well. For good measure, tobacco’s defensive qualities have also helped to shelter the NAV of both funds, which are run by highly respected fund manager Mark Barnett, from the worst effects of the financial crisis. After all, as the theory goes at least, smoking can help calm frayed nerves during a crisis.
But concentration in a particular sector can be a double-edged sword, as investors in both trusts could soon find out following recent developments that threaten to stub out the long-term outperformance of tobacco. And BATS, the largest holding by some margin in both trusts following the completion of its takeover of rival Reynolds, is at the heart of it all. As at 30 June 2017 (before they joined forces), the two tobacco heavyweights were the top two holdings in Perpetual and Edinburgh: Reynolds at 6.6% and BATS at 5.1% accounted for a combined 11.7% of Edinburgh; the equivalent weightings for Perpetual were 6.2% in Reynolds and 4.9% in BATS, giving a combined weighting of 11.1%. Add in a further 7.2% of funds invested in Altria and Imperial, and at the last count Edinburgh had 18.3% invested in the tobacco sector, a high conviction stance when compared to the sector’s 7% or so weighting in the FTSE 100 which, before the consummation of BATS takeover of Reynolds, was considerably lower.
Until recently, with BATS trading near its all-time highs and churning out regular dividends, the large position paid dividends (literally). Over the past week, however, BATS shares have tumbled 11 per cent after US regulators unveiled a new approach to tobacco control that could see manufacturers having to sell cigarettes with non-addictive levels of nicotine. Good for the smoker, not so good for those selling the cigarettes. This was swiftly followed by news that the UK’s Serious Fraud Office has launched a formal investigation over claims that BATS bribed officials in east Africa to undermine anti-smoking laws. Along with other emerging markets, Africa is a key growth area for tobacco companies as they look to offset the decline in smoking in developed markets. The news caused further weakness in BATS’ share price. While the SFO news is very much company specific (for now at least), a renewed effort by the US to tackle addiction to smoking affects the sector as a whole, including Altria and Imperial Brands, each of which accounted for 3.6% of Edinburgh’s funds as at 30 June 2017, while Imperial is 3.2% of Perpetual.
Whether the above proves to be merely a short-term blip in what has been a successful long-term investment, especially for Mark Barnett, or a return to a period of uncertainty similar to the one that dogged the sector in the 1990s, remains to be seen. But with the BATS holding now above Edinburgh’s individual holding cap of 10% of the market value of the fund and also nudging Perpetual’s upper limit of 12% of its gross assets, is Barnett about to finally kick the cigarette habit? If so, which sector will this high conviction fund manager turn to next?