Buying tobacco shares such as Imperial Brands (LSE: IMB) and British American Tobacco (LSE: BATS) at present may seem to be a risky move. After all, sales of cigarettes around the world are declining, and consumers are waking up to the damaging effects smoking can have on their health.
However, it appears that many of the risks facing the tobacco industry have already been priced in by investors. For example, shares in Imperial currently trade at a forward P/E ratio of just 7. This makes the stock the cheapest company in the FTSE 100. It also suggests that there is a wide margin of safety on offer for investors who are willing to own this deeply discounted blue-chip.
Shares in British American also appear to offer a wide margin of safety. The stock is currently changing hands at a P/E multiple of 10. It recently hit a 52-week high on improving investor sentiment.
Major changes
Looking ahead, both of these companies are making significant changes to their business models. Both firms are aiming to cut costs significantly over the next few years to improve profit margins and free up cash to improve their market positions.
Although both Imperial and British American are struggling with declining sales volumes at their core tobacco businesses, new initiatives such as reduced-risk products, and investments in the cannabis industry show promise.
These initiatives are expected to be a cornerstone of both companies’ long-term growth prospects over the next few years. Indeed, analysts expect these actions to help British American achieve earnings growth of 13% in 2019 and 7% in 2020. Imperial’s net profit could rise as much as 140% over the next two years.
Even though the threat of regulatory change could impact sentiment, analysts believe that increased oversight of the sector could actually be good news for both Imperial and British American. More regulations will make it harder for small peers to profit from e-cigarette sales, giving these two tobacco giants a free hand.
As such, while these two tobacco companies may be relatively unpopular stocks in the near term due to the regulatory risks surrounding the tobacco industry, they have the potential to deliver high returns in the long term.
Dividend yields
As well as their low valuations, both stocks offer market-beating dividend yields. The FTSE 100’s cheapest company, Imperial, offers investors a dividend yield of 11.1% at the time of writing. British American’s investors are entitled to an income yield of 6.5%.
All in all, while these companies might be facing uncertainty in the near term, I believe they have the potential to deliver high total returns over the long run. That’s why I think they could both be great buy-and-forget ISA investments. In the meantime, shareholders will be paid to wait for the stocks to recover with those market-beating dividend yields.
