When running active portfolios constructed against a benchmark, having a view on large stocks and sectors is vital. Not holding large benchmark constituents introduces a material structural underweight, while a neutral position diminishes alpha generating potential and reduces active share. Being overweight, on the other hand, uses up a larger proportion of the cash that is available to invest.
The tobacco sector in the UK market is a great example of the choices that active managers must make.
Almost anybody that you speak to will have a view on tobacco: “It’s a dying product category”; “Regulation is getting stricter”; “Younger people are not smoking as much as previous generations.” These views and opinions may be true. However, as investors we need to remember that a good company is not necessarily a good investment and a bad company is not necessarily a bad investment.
Historically low valuations
In recent years, the many concerns around tobacco stocks have pushed down share prices. The UK-listed tobacco companies British American Tobacco and Imperial Brands are trading on historically-low price-to-earnings ratios of just 9x and 8x respectively, based on 12-month forward earnings. Dividend yields are in the region of 7%-8%, if consensus forecasts are to be believed.
Looking back over recent history, though, there is an argument that these low valuations are justified. We have for some time viewed both companies as value traps, with earnings downgrades driven by declining volumes and concerns over market share losses due to new entrants in the next generation product (NGP) space. In other words, these stocks have looked cheap for a good reason—rather than being fundamentally sound, they have been operationally challenged.
Signs of stabilisation
More recently though, our view has started to evolve. Both stocks can now be found in some of our contrarian, value and income-focused portfolios. The reason is that, while valuations remain low, fundamentals are improving relative to the market’s expectations. Therefore, we see improving scope for share prices to re-rate. Better offerings in the NGP segment coupled with excessively low assumptions around declines in traditional product volumes mean that we are seeing signs of a stabilisation in earnings. Some small earnings upgrades are now coming into consensus.
We believe that for a value stock to outperform, it does not need to be the best fundamental story in the market. A bad company is not always a bad investment. If we can identify opportunities where expectations have become overly bearish, any signs of improvement—coupled with an attractive entry point—can be enough to light up a value opportunity.
Thomas Buckingham is portfolio manager of the JPM UK Higher Income Fund within J.P. Morgan Asset Management's UK Equity team.
Thomas Buckingham is portfolio manager of the JPM UK Higher Income Fund within J.P. Morgan Asset Management's UK Equity team. Find out more about the fund >
All data is sourced from Factset as at 30 April 2019
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