Why British American Tobacco is the perfect Brexit play

It’s three months since the UK voted to leave the EU. In that time we have in place a new Prime Minister, a looser monetary policy and sterling is the weakest it has been versus the US dollar in over a decade. All in all, it’s been a dramatic quarter. While the FTSE 100 has risen by over 10% since 23 June, investors are nervous about the future for the UK economy. All of this plays perfectly into the hands of tobacco stocks such as British American Tobacco (LON:BATS).

Monetary Policy

According to the Bank of England, the UK economy is about to flirt with recession. Unemployment is forecast to increase and economic growth is due to flat line for much of 2017. In response, the Monetary Policy Committee has cut interest rates by 25 basis points and will implement further QE. It has also hinted at further stimulus should it prove necessary over the coming months.

This plays into the hands of British American Tobacco. It is wholly unsurprising that the company’s share price has risen by 15% since the EU referendum. That’s because a looser monetary policy will exert downward pressure on the value of sterling. It already trades at £1/$1.30 following the referendum and a fall to $1.20 or lower is on the cards. As British American Tobacco reports in sterling and yet relies on non-UK sales for the vast majority of its top line, a weaker sterling will boost its reported profitability.

Wider Fears

Concern about the macroeconomic outlook is not limited to the UK. Brexit could cause challenges for the EU as well as further afield. Although talk of a global recession caused by Brexit may be premature, the vote has left Central Banks feeling more nervous than they perhaps otherwise would have been had the UK voted to remain in the EU. This has been a factor to at least some degree in the Federal Reserve’s decision to keep interest rates on hold. Rises in future are almost inevitable, but for now at least they are adopting a dovish stance.

This is a great help to British American Tobacco. That’s because its balance sheet is heavily leveraged, as evidenced by its net debt to equity ratio of 299%. A lower cost of debt for longer will mean improved profitability. It will also mean that investors who had been becoming increasingly concerned about heavily indebted companies will adopt a more relaxed viewpoint on their valuations. This could allow British American Tobacco to trade on a higher multiple than at present.

Defensive Income Stock

While fears about highly indebted companies such as British American may have subsided, fears among investors regarding the outlook for the global economy have increased. The Vix volatility measure has been as high as 25.8 since 23 June (versus 17.3 on 22 June) and it would be unsurprising for this number to rise yet further. This could happen when the UK invokes article 50 of the Lisbon Treaty, or at any point during the two year negotiation period when the terms of Brexit will be decided.

The tobacco sector will almost certainly have appeal during this time. Investors are likely to adopt an increasingly risk-off attitude as the prospects of a slowdown in Europe and the knock-on effects elsewhere take hold. With tobacco products having a price elasticity of demand of around minus 0.5 and being a staple good for their consumers, the prospect of a decline in sales from higher unemployment or higher prices seems slim.

British American Tobacco also offers geographic diversity since only 24.4% of its sales are derived from Western Europe. This should help to shield it from the region where the biggest negative effect of Brexit could be felt.

Its yield of 3.4%, which is forecast to be covered 1.5 times by earnings this year, will also have appeal in a world of (even) lower interest rates. Given the consistency of its dividend and its annualised growth rate of 5.4% in the last five years, British American Tobacco’s yield could be compressed to far less than the FTSE 100’s yield by high levels of investor demand. After all, the FTSE 100’s yield is less reliable than British American Tobacco’s given the former’s greater association with what could turn out to be a contracting UK economy.

Valuation

British American Tobacco trades at a premium valuation compared to its more UK-focused sector peer, Imperial Brands (LON:IMB). British American Tobacco has a prospective P/E ratio of 20.3 against 16.2 for Imperial.

The difference between them can be explained by British American Tobacco’s greater geographical diversity. This lowers its risk profile due to the potential for changing regulations towards smoking in multiple regions across the globe. It also means that British American Tobacco has less exposure to the UK than Imperial. For example, British American Tobacco has a market share of 8% of the UK tobacco market, while Imperial has a 45% share. This reduced exposure to the UK could prove to be a good thing given the political instability which is currently present.

British American Tobacco’s valuation compares favourably to other global consumer stocks. For example, Unilever (LON:ULVR) has a prospective P/E ratio of 23.5 and Diageo’s (LON:DGE) prospective P/E ratio is 21.5. Neither stock has EPS forecasts which are as high as British American Tobacco’s 12% forecast growth rate for financial year 2017. This means that British American Tobacco offers better value for money based on the PEG ratio than Unilever or Diageo.

Outlook

So far, Brexit has worked out well for British American Tobacco. If the future is a case of ‘more of the same’ in terms of an increasingly loose monetary policy, weakening sterling, increasing investor fears about the global economic outlook and a flight to perceived safer stocks, then its share price should keep beating the wider index.

While there is no guarantee that this will happen, the reality of Brexit is that there will be a prolonged period of uncertainty. During this time, risk-off trades are likely to gain in popularity as investors become more concerned about income return, lower volatility and the return of capital. In this landscape, British American Tobacco is the perfect investment. It is the perfect Brexit play.

Disclosure: Robert Stephens, CFA owns shares in British American Tobacco, Imperial Brands and Unilever.