Has Big Tobacco finally run out of puff?

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On Thursday, US tobacco giant Philip Morris International saw its shares plunge by as much as 18% at one point.

Put simply, investors are starting to realise that smokers are quitting the habit. And for all the hopes that they’ll take up electronic alternatives instead, that doesn’t seem to be happening at a rate that’s sufficient to make up for the loss of “real” smokers.

So is this really the beginning of the end for Big Tobacco?

Tobacco: the perfect business model

Tobacco has enjoyed a fantastic run of things.

Many people (I’m one of them) avoid investing in tobacco stocks for ethical reasons. It’s probably the most clearcut of all industries in ethical terms. Weapons can be used for good or bad; fossil fuels might be dirty but we need energy; booze and gambling contribute to plenty of social ills, but “enjoyed responsibly”, there’s nothing wrong with a dash of vice.

But cigarettes? They’re addictive and they kill you.

Yet tobacco stocks have been great investments. As John Authers points out in the FT, City academics Elroy Dimson, Paul Marsh and Mike Staunton have found that, going back to 1900, tobacco has been the all-time best-performing sector in the US stockmarket.

Efficient market academics generate a lot of theories about why tobacco stocks have done so well over the years. I’ve heard the idea that it’s effectively because of a “reputational risk” premium – if you buy socially shunned stocks, then you are taking more risk and should therefore expect a bigger return.

But I reckon that’s massively overcomplicating things. The truth is that tobacco stocks have done well because they had a great business model.

Cigarettes may kill your customers, but they do it slowly enough that you can make a lot of money out of milking the addict in between times. So while you need to find a steady stream of new addicts to kill – school kids in emerging markets were a target for a while – you have a nice big, reliable cushion of cash flow to prop you up in the meantime.

You have a consumer who can’t stop buying, and who is also accustomed to the price going up every year, because the government always whacks more tax on. So you are effectively inflation-proofed.

The product doesn’t change much. So you don’t need to spend much on research and development.

And tighter government regulation is a godsend – it put up a huge barrier to entry. No one could even dream of setting up another cigarette manufacturer today, so the big boys had the playing field to themselves. And the tighter it gets the better. Nowadays companies don’t even have to worry about advertising or branding in lots of countries, because they’re not allowed to.

Talk about a massive moat.

So let’s see: you’re the de facto monopoly producer of a product that never really changes, and that its consumers cannot do without, and you are able to raise prices in line with or above inflation every single year.

Forget the “reputational risk premium” – tobacco stocks simply had the perfect business model.

The biggest threat to tobacco companies: innovation

You’ll note, however, that this is in the past tense. And that’s because one thing now threatens Big Tobacco in a way that no other intervention by governments around the world has achieved over several decades. That one thing is the golden word: innovation.

Technology has hit the tobacco market. There are two main “high-tech” forms of smoking alternatives.

One is e-cigarettes, which vaporise a fluid which contains nicotine. (If you’ve ever been walking down the street and been engulfed in a cloud of steam that smells like a fairground, you’ve walked passed someone who is “vaping”).

While smoking is in decline in the UK, vaping is growing pretty fast, according to the Financial Times. We’re the second-biggest market (after the US), with around three million vapers (versus eight million smokers), compared to just 700,000 in 2012.

The other “alternative” is a device that heats up tobacco, but doesn’t burn it. So you get the fumes, but you get less of the cancer-causing stuff (in theory, at least – the US Food and Drugs Administration is not so sure).

The preferred option depends on which country you are in. For example, in Japan, vaping is banned, but the tobacco-heating devices are allowed. And that’s where Philip Morris comes in.

Investors had got excited about the prospect of Philip Morris being able to switch its existing smokers over to the new devices. The idea is that you can compensate for the falling number of smokers by creating an alternative, “healthier” version.

Unfortunately for Philip Morris, it appears that Japanese customers just aren’t that excited about the idea. Overall, the growth in demand for alternative tobacco products can’t grow fast enough to compensate for the falling demand for cigarettes.

Even in the UK, where vaping appears to have boomed (vaping shops are becoming second only to charity shops in our decimated high streets, it feels), it’s important to note that growth is slowing fast – the total number of e-cigarette users is flat on 2016.

Also, a lot of those users are former cigarette smokers – people are using e-cigarettes as an alternative to smoking, rather than taking up the vaping habit. In other words, there’s a lot of substitution, rather than new customers.

In short, this is looking like a dying industry with few places left to turn.

Are tobacco stocks worth investing in?

Let’s put ethics aside for the moment. These companies pay big dividends. Are they worth investing in now?

There are some opportunities for Big Tobacco out there. The legalised marijuana market is the most obvious one. You would think that the infrastructure they have in place would give them the ideal opportunity to jump into that market and dominate it.

The problem is, there are so many hurdles to overcome in that market. Until it’s fully legal at a federal level, banks won’t touch it, and that essentially rules big business out. Even once it’s fully legal, there’ll be lots of regulatory quirks to iron out. On top of that, I imagine that shifting production over to joints rather than cigarettes will be a lot trickier than simply re-tooling a few production lines.

In other words, it’s too much of an unknown quantity and a long-term opportunity to take it into account when considering whether to invest in these stocks.

The bottom line for me is that the perfect business model that these stocks enjoyed for so long has now been broken. They have to get used to dealing with problems that they have not dealt with for a long time – innovation, faddishness, competition. That’s going to be a major culture shock.

Just a whiff of bad news knocked nearly a fifth off Philip Morris’ market value. It won’t be the last one to take that sort of hit. Maybe tobacco stocks will be worth a look again when they’re properly beaten down, but I don’t think we’re there yet.