High dividend yields have made tobacco stocks a favourite for passive income investors. And their fundamentals can look pretty good.
A lot of investors have ethical reservations about investing in these companies. But how do things stack up from a returns perspective?
Fundamentals
There’s a lot to like about British American Tobacco (LSE:BATS) shares. At least, in terms of what income investors usually look for.
The stock currently comes with a 5.5% yield. And that dividend has grown at an average of over 4% a year in the last decade.
Source: Fiscal.ai
The dividend is also well-covered by the company’s free cash flow. So it’s not as though the business is taking on debt to finance this.
British American Tobacco’s profit margins are huge. And the stock trades at a very reasonable price-to-earnings (P/E) ratio of 12.55.
This, however, is why investors don’t just look at financial metrics to make decisions. Not every risk shows up in a firm’s financial statements.
Ethical investing
A lot of investors wonder whether they should stay away from tobacco stocks on moral grounds. And it’s a good question.
Tobacco products are harmful. But – as Warren Buffett once pointed out – moral questions don’t just apply to the firms that make these products.
Retailers like Tesco sell them while knowing about the potential harms. So are they morally equivalent to British American Tobacco?
I rarely disagree with Buffett. But I think there is a relevant difference between letting people buy cigarettes and actively marketing them.
I’m a philosopher by training, but I see this as an area where investors need to decide for themselves. And there’s plenty more to think about.
Tobacco stocks
The big elephant in the room with tobacco stocks is the decline in the core product. The number of cigarette smokers is going down.
So far, that hasn’t been a problem. British American Tobacco has been able to offset volume declines with price increases.
That, however, won’t go on indefinitely. It won’t get to the point where one remaining smoker replaces all of the current revenues.
The company is trying to replace the declining consumer base by launching new products. Whether it can do it fast enough remains to be seen.
British American Tobacco’s dividend growth over the last 10 years has been impressive. But the future could look very different to the past.
Is it worth the risk?
To earn £12,000 a year, investors need 4,898 British American Tobacco shares. And that number comes down as the dividend grows.
At today’s prices, that costs £218,259. That’s a lot – and it’s worth noting that the dividend yield is actually lower than it has been.
Source: Fiscal.ai
I think British American Tobacco’s core product sales will eventually fall off. And the day that happens is only getting closer.
Given this, buying the stock with an unusually low dividend yield seems risky to me. So I’m wary about the stock.
The moral question is tricky. But whatever passive income investors conclude, I think they have good reason to look at other opportunities.
Should you invest £5,000 in British American Tobacco P.l.c. right now?
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Stephen Wright does not own shares in any of the companies mentioned.
