BNP Paribas' Trevor Allen investigates whether responsible investment can include shares in tobacco companies
SDG3, good health and well-being, is something from which none of us can hide. To invest and promote the success of SDG3, it is essential that we identify companies that market harmful products. It is somewhat an obvious choice to bring up tobacco here, but the reasons we are addicted to tobacco go well beyond nicotine.
The rise of responsible investing has seen an increase in the divestment from tobacco. These commitments to divest from tobacco, while admirable, have not helped investors to break their addiction to tobacco. Tobacco companies keep people addicted in three primary ways:
- Directly through the nicotine in their product
- Through high dividend yields
- With their inclusion in the most common indices
People in the developed world take for granted that we understand the harmful effects of tobacco, and that it is a personal decision to use tobacco. We forget that there are many people living in countries where regulation and health education around tobacco are non-existent. Below I have summarised some alarming stats around tobacco. It is important to remember that by investing in tobacco, you are promoting the tobacco companies to continue this behaviour.
The following stats are from Tobacco Free Portfolios:
- Tobacco is responsible for seven million deaths annually.
- In Australia the average smoker has the first cigarette at 15.9 years of age.
- Studies from the US Department of Health show that the levels of nicotine in cigarettes have increased from 1997 to 2005.
- The US Department of Labour lists 16 countries that enlist child labour to grow and harvest tobacco leaves.
In addition to these well-documented issues there are significant environmental impacts from the industry, not least in terms of its water and pesticide use.
Devil in the dividend
Tobacco companies like Altria are citing slumping sales in the US, and are actively looking to increase their market share in the vaping market. While tobacco companies seek innovative ways to increase their consumer base, investors are attracted through high dividend yields and aggressive dividend growth.
Dividends are one method for companies to return profits to investors, and while dividends are not guaranteed for common equity, they have become expected part of the value of the major tobacco companies. The cumulative value of dividends allows companies like Altria to have higher returns over long periods of time.
Chart 1 below shows the power of dividends for buy and hold investors. The orange line shows the value of Altria with dividends, while the white line shows the value of Altria without dividends.
This mostly attracts income investors, but high dividend yields with low betas can help reduce investor risk in portfolios focused on growth with high betas. It also creates a crisis for responsible investors who advocate higher returns through long-term buy and hold strategies. Steady cash flows and predictable business models for growth make the big tobacco stocks safe havens in recessions and all-purpose stocks to reduce overall risk in portfolios.
The table below shows the long-term returns of some of the largest tobacco companies from North America, Europe, and Asia. These returns, driven by dividend yields, are significantly higher than their standard benchmark indices, with betas that are closely correlated to the primary regional indices, with Altria and Japan Tobacco actually having betas that are less than 1.0, which means these stocks are actually less volatile than the market.
Ghost in the machine
The large tobacco companies also show up in the most commonly traded indices across the globe. While the largest tobacco companies had average trading volume over the last twenty years of around five million to 10 million shares per day, the indices have trading volumes in the billions. This volume means that many more investors are exposed to tobacco, mostly unknowingly through these bellwether market indicators.
In addition, asset manager performance is often benchmarked against some of the above indices. This means if the asset manager chooses to forgo investment in tobacco, they have a significant amount of yield to find and a significant amount of risk to reduce in their portfolios, because the above indices all hold tobacco companies. While the weighting of any of the tobacco companies above is relatively small in the index, it still makes the skill of stock picking that much more important.
Lastly, these indices form the basis for many other indices and exchange traded funds (ETFs). Some of the derivative indices will remove tobacco from their investment universe, but these tobacco free indices are still not as widely accepted as the above indices, when measured by daily trading volume.
Prescription for addiction
Tobacco companies all share similar traits: loyal consumers, steady cash flows, and a share of the profits. If we want to kick the tobacco habit in investing we need to ultimately remove tobacco companies from the most commonly traded indices. This is unlikely to happen if tobacco companies continue to provide stable investing with high dividend yields.
The way for investors to kick the habit is to starve tobacco companies through divestment. When you invest in a company, you are capitalising them in the hopes they will continue to grow their business. You are actively encouraging tobacco companies to convert more of your fellow humans to be tobacco users. Divestment will lead tobacco companies to be removed from common indices and will force tobacco companies to use their dividend proceeds to fund internal capital expenditure (CAPEX) programs or raise more debt. Divestment will also reduce externalities, such as cancer, shown to be correlated to tobacco use, and that will reduce the cost on health care.
Given the controversy surrounding tobacco, and guidance from groups like the UN and the WHO, via the Framework Convention on Tobacco Control (FCTC), specifically citing the impacts of smoking on children, it is hard to see that if this product were launched today, it would be warmly welcomed. Perhaps now it is time that we stop welcoming it into our investment portfolios.
Trevor Allen is sustainability research analyst at BNP Paribas
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