British American Tobacco’s positioning in Discovery portfolios

What has happened?

On Friday, 28 July 2017, the Food & Drug Administration (FDA) in the US announced the following:

• It is considering limiting the amount of nicotine used in traditional cigarettes sold in the US, to non-addictive levels.
• It will be reviewing and consulting on the impact of flavouring in tobacco products.
• It is extending the deadline to submit applications for approval of other types of tobacco products (including extending the deadline for next-generation products, such as heat-not-burn and e-cigarettes, from 2018 to 2022). 

Although there will still be a period of consultation, and timing of any additional regulation remains uncertain, there has already been a significant market reaction to this news in trading. Tobacco shares across the world have been volatile, but those with US exposure have been affected the most, given concerns over US volumes as a result of this announcement. Over the two days following the announcement, British American Tobacco’s (BAT) share price fell considering that roughly 40% of its profit comes from the US through its tie-up with Reynolds. At close on Tuesday (08 August 2017), BAT was down only 5.2%, after the share fell 8.9% in the first two days since the announcement.

Source: Investec Asset Management
Considering that BAT is one of the largest domestic equity holdings in the Discovery Balanced range of funds, the share’s sharp correction had a negative impact on performance in the last two days of July. However, despite this impact, the funds are well diversified, and ended the month within the top quartile of their respective peer groups. The sharp recovery of the share price since the start of August has been a positive contributor to returns.

Looking forward

The medium- to long-term impact of the FDA’s announcement is difficult to determine. The following points should, however, be noted:

• This is the start of a process that is likely to take many years to conclude (at least only in 2022).
• The FDA has jurisdiction over the US only, and must rule on the basis of science/clinical evidence and an appreciation of unintended consequences.
• Reducing nicotine content in cigarettes may have the unintended consequence of simply resulting in more cigarettes being smoked.
• Encouraging innovation and extending the application deadline for next-generation products (including allowing manufacturers to continue to market these products in the interim) is most likely a positive for companies such as BAT and Philip Morris International (PMI) that are the market leaders in reduced-risk products, and where the economics and growth prospects are strong.

It is important to note that the announcement does not impact the short-term operational performance, and the longer-term assessment of earnings expectations remains unclear (and not necessarily a negative!).

Positioning

We have not made any material changes to our BAT position in the Discovery Balanced range of funds over the past two weeks. BAT trades on reasonable valuation levels, the earnings profile (especially in hard currency terms over the medium term) remains supportive and, importantly, the share plays an important diversification and defensive role when constructing the portfolios. While we remain constructive on the outlook for global growth (an environment that would typically be supportive for South Africa), the local environment remains uncertain due to domestic factors. We maintain a significant exposure to domestic, listed counters that will continue to benefit from the improving global environment (Bid Corp, Mondi, Naspers, Richemont and specific resources stocks) where earnings are receiving positive revisions. In addition, we have exposure to specific SA Inc. counters (retailers and banks) that should benefit from an improving inflation/interest rate environment. As a defensive, rand-hedge counter, BAT plays an important role in the portfolio to protect assets in times of uncertainty, especially when considering the domestic political/economic environment.

Nothing contained herein should be construed as financial advice and is meant for information purposes only.