British American Tobacco (LSE:BATS) and Imperial Brands (LSE:IMB) are two FTSE 100 dividend stocks that are currently among the highest-yielding in the index.
They both have a long history of increasing their dividends annually. But due to their payouts going up while their share prices have struggled in recent years, their yields have been steadily rising.
Their capacity to sustain generous returns to shareholders is due to the huge amounts of cash that they generate each year. Cigarettes and tobacco-related products are cheap to make. And their addictive nature means manufacturers can charge high prices.
Passive income stocks: our picks
Do you like the idea of dividend income?
The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?
If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…
Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.
What’s more, today we’re giving away one of these stock picks, absolutely free!
As well has having similar yields, their price-to-earnings ratios are nearly identical. Both stocks trade at around 6.5 times earnings. The average for the FTSE 100 is approximately 14, which could be seen as further evidence that they’re in bargain territory.
But despite these apparently attractive valuation metrics, I think there are three reasons why both could be value traps. These are stocks that appear attractively priced but, in reality, I think they’d make poor investments over the longer term.
Reasons (not) to be cheerful
First, most ethical investors won’t invest in the tobacco industry. In Europe, it’s estimated that sustainable funds account for 20% of all fund assets. This means there’s a fifth less money available to invest in these two companies, compared to more ‘socially acceptable’ stocks. No matter how compelling the investment case might be, these funds will never invest.
Second, they’re transitioning away from traditional cigarettes towards other revenue streams. British American calls these “reduced-risk” and Imperial terms them “next generation”. But the World Health Organization warns that all tobacco-based products are harmful, and has called for increased restrictions on their use and promotion.
Finally, the investment required to develop and market these new products could restrict the amount of cash available for dividends. Both companies currently return approximately half of their earnings to shareholders.
In my view, all three of these issues are likely to stunt future share price growth. In a worst-case scenario, revenue from existing products could fall faster than that generated from the new ones.
And I don’t want to be buying high-yielding stocks if the value of my shareholding is likely to decline over the longer term due to falling share prices.
Other views
But forecasts from independent analysts, compiled by Imperial, suggest my fears might be misplaced.
The consensus forecast of nine analysts covering the stock is for post-tax earnings of £2.58bn in FY23, £2.67bn in FY24, and £2.78bn in FY25. Although 7% growth over the next two financial years isn’t spectacular, it doesn’t suggest terminal decline.
Similarly, according to Market Screener, nine of the 15 analysts covering British American rate the stock a ‘buy’.
But I’m not convinced.
I don’t want to buy stocks in companies whose products attract such negative publicity. There’s too much uncertainty surrounding the industry for me to part with my hard-earned cash. To answer my original question, yes I think these stocks will stay cheap, but I won’t be buying.
