Imperial Brands (IMB) Stock Purchase – The Value of Sin Stocks 4

The value of owning sin stocks cannot be denied – research has shown that investing in sin stocks generate higher returns. From 1900 through 2012, tobacco stocks delivered annual returns of 19.7%. From the end of WWII through 2012, alcohol stocks delivered returns of 11.5%. Since the creation of The Standard Oil Trust in 1882, the average integrated oil company has delivered 12% annual returns. If you remove tobacco, alcohol, and energy from the U.S. stock market from 1926 through 2012, those 10% annual average returns that you hear about become 7% annual returns instead. Over a half-century long investing life, the difference between 7% and 10% is the difference between a terminal value of $327,000 and $1.4 million.

But whilst sin stocks do outperform the morality of owning them is a dilemma most investors face. Many people these days want to own only ‘socially conscious’ companies that only make products for the betterment of mankind? But in doing so you reduce the amount of securities you are able to invest in substantially.

Mixing ethics and investing will leave you with a smaller choice of firms for you to invest in. Out go miners who discard health and safety, energy companies that contribute to global warming, fast food and confectionary companies that lead to obesity, drinks and food companies that lead to diabetes, security companies that run private prisons, defence companies that make weapons, alcohol companies that lead to societal problems. tobacco companies that lead to adverse health effects, financial institutions lending at obscene interest rates, manufacturers using cheap labour…the list can go on and on. I think it would be quicker listing all the companies that are indeed ethical.If morals drove in vestments decisions there would be nothing to invest in.

In the end, you need to chose what you as an individual are comfortable holding. Don’t listen to others who tell you that you shouldn’t own tobacco companies or oil conglomerates. Instead, you should look at your own moral compass. I for instance think the worst of society is brought out from alcohol and gambling and thus I do not invest in companies that derive their income from these sources.

The big trend towards socially responsible investing is the result of a misunderstanding of how capital markets work. If you buy a share of British American Tobacco (BAT) on the London Exchange, you aren’t facilitating additional production of tobacco. You are buying a one share claim out of the 1,864,313,759 shares that already exist.  Now, if there is a capital raising event in which British American Tobacco issues new shares to fund growth, then you can argue that your contribution is furthering the expansion of cigarette sales and it would be immoral to participate because you are spreading the ill effects of tobacco. But if you buy a pre-existing share on an exchange, you are just swapping ownership positions with another investor are not doing anything that actually enables British American Tobacco to sell more cigarettes.

Besides, If you don’t like adverse effects of tobacco, it if far better for you to buy shares in a tobacco company and use the dividends it pays you to give to a charity such as cancer research.

Imperial Tobacco (IMB) Analysis

In a previous post, I have already discussed why tobacco company tend to outperform over long period of time. It is due to regulation driving down competition in the tobacco industry as well as shares in tobacco companies being perpetually undervalued due to large pensions funds not being able to own them due to ethical considerations. I recommend you read that post to get a true flavour of the tobacco industry. Here I will aim to talk in specific about imperial tobacco.

When I bought shares at £33.80, Imperial traded at a very low P/E of 12– astonishing for a high quality mega cap stock. The company is trading at more attractive levels as compared to the industry wide multiple of 16.9x. That indicates a 40% discount based on comparative P/E analysis.

Normally, when a company trades this cheap, there is a reason as to why it is so. This could be deteriorating profits, bleak forecasts or high debt amongst many things. But in Imperials case, the market has penalised it in recent month for conducting a huge investment drive that will reduce costs. This should be a good thing but the market being fickle and short-term as it is, IMB has been punished.

But make no mistake, Imperial Tobacco is a wonderful business. The company has more than doubled earnings per share over the last decade – and management targets imply it can probably do so again over the next 10 years, with earnings per share growth projected at between 4% and 8%. Imperial’s stock price has increased 10.9% a year over a period which included the deepest recession in 80 years.

The current weak Great British Pound is a massive tailwind for a company like Imperial which makes vast swathes of cash overseas. Earnings are set to benefit from translation of overseas profits into a sterling – though this could reverse if the UK exchange rate strengthens.

From a dividend point of view, Imperial is akin to a printing press. IMB keeps throwing increases wards of cash to its shareholders. Over the past 6 years, the dividend has increased at a rate of 10% per annum. As an investor in the company, you get a pay rise of 10% just for holding on to the shares. When’s the last time you got that sort of pay rise at work?

Whilst talking about a company’s dividend history can prove beneficial, it is more prudent to talk about future dividend payouts. Have a look at the picture below to see that Imperials impressive dividend growth is not over,.

Imperial Brands is a Free Cash Flow machine. Ever rising levels of cash-flows indicate the safety of the dividend.

The chart above shows the total amount of dividends paid, free cash flow generated, and resulting free cash flow payout ratio over the last five years. It shows that Imperial is generating plenty of free cash flow. This implies that dividend increases have a lot more room to run and investors in the company will be well rewarded

Another aspect of Imperial Brands I like is its strong position in the Cuban cigar market. Depending on what happens with US – Cuba relations under President Trump, this could open up a big market. Cuba provides an opportunity for Trump to put into action his much touted deal making ability he so often talked about on the campaign trail. Cuba would be a great test case to see what kind of bilateral trade agreement can be reached since he’d be more or less starting from scratch. Cuban cigars combined with increasing American demand could be a match made in heaven.

My purchase of Imperial Brands (IMB)

I bought 33 shares in IMB at a price of 3380p each. For this, I am expecting to get £51 in dividend over the course of this year. And the great part is, I expect the dividend of £51 to grow at 10% per year for the next three years at least. This means that in 2018, I will be set to collect £56.10, in 2019 £61.71 and in 2020 £67.88. From now till 2020, I am set to collect a total of £236.69 in dividend . This is over 20% of my purchase price. The company is paying me back my initial investment at a decent rate. Who said investing has to be risky.

With a company like Imperial, I am happy for it to become a lifetime holding as I know the underlying economic engine is good and profits healthy. If you understand the economics of big tobacco, you will appreciate this holding. But then again, there are many people who will give up the high returns produced by tobacco stocks even if they know it will be profitable for many years to come. The reason for this is due to their own ethical considerations.

It is important to remember that companies in the sin sector will still operate and churn out profits whether you own the shares or not. You need to understand how capital markets work. You need to understand that buying or selling tobacco stocks does reduce usage by one single cigarette. Once you come to this level of thinking, your decisions are guided by looking at assets that will give you the best risk adjusted returns for your money. Sin stocks have proved over the years to be the best returning investments .People love their vices, and I love getting paid!!