This report provides an insight into the future of tobacco firms and asks whether, beyond an ethical incentive, is there a financial incentive to divest from tobacco stocks?

The four largest tobacco companies generate over US$100 billion in net sales per year. The massive size of this industry has historically been accompanied by strong performance of tobacco stocks, providing high growth rates and dividend yields. The S&P 500 Tobacco Index outperformed the S&P 500 by more than 1000% between 1989 and 2017, highlighting the financial benefits of being invested in this industry.

This outperformance and growth have stalled in recent years. Between April 2017 and 2018, the S&P 500 Tobacco index was down 23.4%, compared to the S&P 500 which was up 11.1% over the same period. In order to understand what is driving these trends, the paper conducted a political, economic, social and technological (PEST) analysis on the industry.

The key changes to global policy identified by the paper were the legalisation of formerly illicit drugs, greater regulation in both developed and developing economies and reduced lobbying power over regulators. The changes to the economic landscape are largely determined by the ever-growing economies and populations of the developing world, and the increased demand for tobacco that will come as a result.

The pivotal social aspect that is expected to impact the tobacco industry is the act of boycotting over concerns that include the adverse health impacts of smoking. An increasing number of banks, insurance companies, healthcare providers and pension funds, have actively boycotted the tobacco industry in recent years by divesting current holdings, resisting future investment or limiting access to credit for tobacco firms. Finally, the paper highlights key technological advancements that will likely impact the tobacco industry and its future performance. The focus is largely on the development of e cigarettes and other ‘reduced harm products’. The use of E-cigarettes by US high school students grew by 900% from 2011 to 2015. This increased uptake is expected to continue despite research suggesting its adverse impacts on health.

Based on this PEST analysis, the paper models three potential scenarios. Scenario 1 models a relatively positive PEST environment for the tobacco industry over the next few decades with modestly increasing revenues, stable costs and low costs of capital. Scenario 2 suggests a less optimistic outcome for the industry with a lower increase in revenues and simultaneously an increase in operational costs. Scenario 3 suggests a very negative outcome for the industry with significant decreases in revenues and overall profitability. The paper provides share price valuations for each of the biggest tobacco companies given each of the scenarios. The report compares those valuations with current market prices. It finds the stock prices for those companies have decreased significantly since early 2018, suggesting the market expects a future scenario somewhere between scenarios 2 and 3.

The report concludes that there is plenty of downside risk associated with investment in the tobacco industry and that the continuation of the industry’s historically superior performance is highly unlikely.

1. This report models the future of the tobacco industry in order to inform investors about the potential downside risk associated with tobacco companies and the future prospects as a result of changes in the political, economic, social and technological environments in which they operate.
2. The World Health Organisation states that smoking prevalence decreased from 23% to 21% between 2007 and 2013 suggesting the considerable impact of stricter regulations on sales. Whilst regulations in developing economies are limited, tax rates on tobacco products are expected to increase in these regions as a result of international cooperation such as the Framework Convention on Tobacco Control.
3. International cooperation on the regulation of tobacco products is important because litigation risk to tobacco companies is currently low, the impact of successful litigation is limited to developed countries and the industry effectively lobbies regulators in developing countries.
4. The impact of the legalisation of marijuana on the tobacco industry remains unclear. However, the industry may benefit from a shift towards offering these products as an increased demand for tobacco is often associated with an increased uptake in marijuana.
5. The economic drivers of change in the tobacco industry come from emerging markets, where more than 80% of smokers live and education and health awareness levels are low. High GDP growth rates (twice as high as advanced economies) and growing populations have resulted in an ever-increasing market for tobacco products.
6. Most tobacco is grown in developing countries where farmers favour tobacco over other crops due to what they see as higher and more secure returns, policy makers in those countries encouraging this to maintain employment. There are concerns that this gives tobacco companies buying power that results in low leaf prices, unfair contracts and, thereby, reliance on child labour amidst major health hazards such as green tobacco sickness and exposure to toxic chemicals.
7. The amount of private and institutional investors boycotting the tobacco industry has led to an increase in the market capitalisation of investor-boycotted stocks from US $27 million between 1963 and 1972 to US $490 million during the years 2003-2012. AXA Group, BNP Paribas AM and Robeco are a few of the large institutional investors who have recently stated their move to boycott investment in tobacco.
8. Boycotts relate to the health effects of smoking but also manufacturing conditions, in particular, concerns about child labour which pose risk to the tobacco industry through harm to reputation and the cost of replacing that labour. Industry-sponsored programmes to eradicate child labour may not succeed if they do not address low leaf prices and unfair contracts for farmers.
9. Alternative smoking products and e-cigarettes are a crucial determinant of the future of the industry. While there has been a surge in their use by young people, other smokers use these products as an aid to smoking cessation and increasing research shows significant health hazards associated with their use.
10. The report contains tables and an appendix that set out the calculations for the valuation of tobacco stocks under three scenarios as to the future of the industry. The report also contains a list of references for the key drivers of change in the industry.