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Local investing

Equity Fund update: Taking a look at British American Tobacco

“In the short run, the market is a voting machine but in the long run it is a weighing machine.” – Benjamin Graham

2018 was a disappointing year for South African equity investors, with the FTSE/ JSE All Share Index returning -9%. The good news is that based on our research the companies we hold in the Allan Gray Equity Fund should generate healthy returns going forward under most scenarios. British American Tobacco (BAT) is a share that detracted significantly from returns during the year and therefore I thought it a good one to discuss.

BAT, in my opinion, is a good example of a company where the market’s ‘voting machine’ (valuing companies like a popularity contest) and ‘weighing machine’ (valuing companies on their actual worth) are in conflict. The voting machine part of the stock market is arguably trying to anticipate investors’ reactions to the next regulatory announcement from the US Food and Drug Administration (which wants to ban menthol cigarettes). What the voting machine ignores is the company’s long track record of compounding earnings for investors through various regulatory changes, as well as evidence that BAT’s investments into next-generation products are starting to bear fruit. BAT has grown its earnings by 12% p.a. since 2001, while paying out 63% of earnings in dividends and investing heavily to develop and distribute next-generation products that significantly reduce the health impact of smoking. A recent update from the company shows it is gaining traction in rolling out these products: BAT’s vaping volumes in the USA, the largest vaping market globally, grew about 40% in the second half of 2018.

Three scenarios could play out for BAT. Assuming BAT’s portfolio of next-generation products helps it to sustain its 17-year track record, an investor today would earn 20% p.a. (growth of 12% p.a. + dividend yield of 7.8%). One could argue that sentiment towards tobacco shares will remain subdued, but there is a scenario where the weighing machine takes over at some stage over the next four years. This would cause the share to price in its track record, resulting in a higher return (assuming a re-rating to a 5% dividend yield results in 32% p.a.). Under a bad scenario (the FDA succeeds in banning menthol and BAT doesn’t retain any menthol-smoking customers) regulatory intervention dampens growth. Under such a scenario the company may only grow earnings by inflation over the next four years. At the current price this still results in a good outcome with a total return of 14% p.a. (6% growth + 7.8% dividend yield). The weight one should place on the 14%, 20% or 32% p.a. scenarios is ultimately subjective, but these scenarios illustrate the impact of the ‘voting machine’ on BAT’s current share price and the opportunity that this offers to long-term investors.

BAT, or any of the shares we own, could experience unforeseen events outside the scenarios considered. However, at a portfolio level I think now is a good time to be an Equity Fund investor.

During the quarter we bought Richemont and Glencore and we sold Sasol and Old Mutual.

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