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Menthol health issues

Nowadays menthol cigarettes are feeling the heat in other ways. They are due to be banned in the UK in 2020, although not until 2022 throughout the EU, prompting – one imagines – a marvellous opportunity for smugglers. More important, in the US, where their sales account for 35 per cent of the $100bn a year tobacco market, the food and drugs regulator is now targeting them.

Earlier this month, the regulator, the Food and Drug Administration (FDA), said it wanted to ban menthol flavoured cigarettes. Its announcement was vagueness itself but still left investors in British American Tobacco (BATS) gasping because the UK-based group owns RJ Reynolds, which generates over half its US sales from menthol cigarettes primarily via Newport, the biggest menthol brand in the US.

As a result, the price of BATS' shares dropped 20 per cent in no time and, at the current 2,708p, the shares offer a dividend yield clear of 7 per cent. True, if menthol cigarettes were banned in the US, then the 190p a year payout would be threatened. But that’s for the future, and probably a fairly distant remove since there is little evidence that menthol cigarettes are more harmful than the regular variety. Besides – and, honestly, this is true – it’s likely that various African-American pressure groups would oppose the ban because almost half of black smokers in the US drag on menthol cigarettes.

Among young blacks the proportion is much higher – maybe over 80 per cent – largely due to long-running targeting campaigns run by big tobacco. Much of the controversy revolved around the Kool menthol brand, which used to be owned by BATS but has been in the roster of Imperial Brands (IMB) since 2015. Brand campaigns from the 1960s and 1970s – “Smoking a Kool? Like riding a Rolls-Royce” – may once have been, well, cool but now sound stupid, tacky and nasty.

Which pretty well sums up the tobacco industry. Generally, I’m not at one with the ethical investing lobby – too much patronising intolerance – but for big tobacco I will make an exception. At least I will until I have proof that a sizeable minority of their main-board directors are committed smokers. If they feel tobacco products are so disgusting that they won’t let them in the house, why should they expect anyone to buy the equity that helps sustain the miserable industry?

Booze, however, may be another matter. Sure, there is an argument for saying that alcohol consumption has worse societal impacts than tobacco; if in doubt, pop into the A&E department of any big city hospital on a Saturday night. Yet, if consumed sensibly, that does not apply. Which might be why a holding in spirits producer and distributor Stock Spirits (STCK) could contribute to the Bearbull Income Portfolio, while one in BATS – despite that yield – could not.

The underlying aim here is to add a holding that will not be a hostage to Brexit. Two of the income fund’s three newest holdings – pubs operator Greene King (GNK) and retailer Topps Tiles (TPT) – are exposed only to the UK, which presents a clear and present danger. BATS is internationally diversified and, meanwhile, Stock – named after its 19th century Italian founder, Lionello Stock – does almost no business in the UK even though its headquarters is here. Primarily it makes and distributes spirits – mostly vodka – in eastern Europe; last year 54 per cent of its revenues came from Poland and 25 per cent from the Czech Republic.

Obviously that brings some limitations – mainly dealing with the corruption and questionable property rights that permeate much business done in former Soviet satellites. It also implies a currency risk since much of Stock’s revenues are in Polish zloty and Czech koruna, while it makes up its accounts – and pays its dividend – in euros.

Added to those, Stock generates only marginally acceptable returns on capital. Sure, its profit margins are wide enough but, whichever metric you choose for capital performance, you will find a disappointing figure. For example, return on assets in the five years since Stock was sold out of private equity and got its London listing has averaged just 4.5 per cent. Chiefly this is because Stock’s balance sheet is stuffed full of goodwill and intangible assets. That’s to be expected of a marketing-led brands company where distribution rights are paramount, although the ordinary capital returns imply that some intangible assets – despite annual impairment tests – are overvalued. Nor does it help an assessment that, from the outside, it’s impossible to know how much intangible asset was acquired for cash – and therefore a real capital cost – and how much is effectively a bookkeeping item.

Despite all this, the good news is that Stock looks well capable of funding its dividend. In the past two years it has generated €90m (£78m) of free cash but distributed just €29m of dividends. So its shares may well have Brexit-free merits. But, once more, I might be buying a holding in a company whose financial performance – and therefore its value – does not look completely convincing. I know that bargains out there are rare; even so, it’s not a good habit to get into.