Investments: Tobacco industry has long been characterised by high profit margins and powerful brands, the stuff of which, elsewhere, investment legends are made

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The Independent Online
It has been a rough few weeks for the tobacco industry, now the subject of one of its periodic bouts of jitters about the impact of litigation in the United States. Shares in the leading tobacco groups have taken a pasting since a Florida court awarded a 66-year-old lung cancer sufferer $750,000 in compensation early in August. The judgment was made against Brown & Wiliamson, a subsidiary of BAT Industries, one of Britain's largest tobacco companies. Its shares have fallen sharply over the past year and are now trading about 25 per cent below their high for the last 12 months. It is a similar story for the big two companies in the United States, RJR Nabisco and Philip Morris.

It is not the first time the tobacco companies have lost a case of this sort - an earlier judgment in 1986 was overturned on appeal - but it is still a potentially significant development for an industry which has for years successfully held the line against legal claims that it is liable for ill-health caused by smoking. It certainly could not come at a more awkward time for Hanson Trust, which plans to float its tobacco company, Imperial Tobacco, this autumn as part of a four-way demerger designed to add value for its shareholders.

The tobacco companies have always based their defence against claims of this sort on two main arguments. One is their vehement denial that tobacco is addictive. Only two years ago, seven leading industry figures solemnly appeared before a Congressional committee to swear on oath that they did not believe tobacco to be an addictive substance. The industry's argument, essentially, is that it cannot be addictive since so many people successfully give it up.

The second argument the industry deploys is that it cannot be held liable for any ill-effects caused by smoking since smokers are fully aware of the potential hazards. Health warnings have been printed oncigarette packets since the middle of the 1960s and most smokers, so the companies argue, can be assumed to know the risks they are running.

However, the Florida case is the first time that a jury has been allowed to hear evidence, which suggests the industry may have been less than honest about the addictive nature of its product. The evidence is based on a number of leaked company documents which appear to show that industry experts had privately admitted tobacco was addictive as long ago as the early 1960s.

If the Florida judgment is upheld on appeal, it could open the floodgates and land the industry with legal liabilities running to literally billions of dollars. As one stockbroker breezily admitted last week, it would make the asbestos liabilities incurred by Turner & Newell seem "like a drop in the ocean". Given that under American law, lawyers who succeed in winning legal liability cases of this sort can keep 25 per cent of any damages awarded, it is no surprise that some of the larger law firms in the US are standing by to take on the industry.

Where does all this leave investors? Exposed, is the short answer. Tobacco may not be everybody's idea of an agreeable business, but nobody can deny the attraction of its underlying economic characteristics. In the words of Warren Buffett, America's most famous investor, the economics are just "great": "You make a product for a penny, you sell it for a dollar, and you sell it to addicts. And it has tremendous brand loyalty". But the drawback is the stigma of investing in an industry whose product is known to kill people.

The industry has long been characterised by high profit margins, strong cash flow and powerful brands, the stuff of which, in any other business, investment legends are made. All the tobacco companies have huge dividend- paying capacity, and are staple holdings in most institutional portfolios. It was partly for this reason that RJR Nabisco became the subject of the biggest and most controversial takeover battle of the 1980s.

BATs' market value, even at today's depressed prices, is over pounds 13bn and it offers a dividend yield of 7 per cent. Imperial Tobacco, according to its prospectus, is aiming for a similar yield when it is floated this autumn. Unlike the Big Three, which have all diversified, Imperial will be a "pure" tobacco company. Uniquely, also, however, it has no business in the US and expects to be immune from any fall-out from the litigation shadow hanging over the rest of the industry.

All the tobacco companies suffer because of the huge question marks over future litigation. If you focus solely on the tobacco element in companies like Philip Morris, you can buy their profits for a lower price than almost any other mainstream consumer business. Assuming you have no ethical objections, the investment decision turns on your judgment about the likely course of events on the other side of the Atlantic.

Not surprisingly, the industry is fighting back strongly. It plans to appeal on the Florida case, and has taken comfort from a subsequent judgment in Indiana which went the other way. President Clinton meanwhile, for blatant political reasons, has supported moves to have the tobacco industry regulated by the Federal Drugs Administration. Behind the scenes in Washington, however, there is talk of a deal by which the tobacco companies are offered immunity from future litigation in return for making a series of one-off payments to health authorities across the US.

If that happens, it will boost tobacco shares. But for the moment, the uncertainty will continue to cripple the industry's ratings. Tobacco shares are either a bargain or a potential minefield. My hunch is that they are still the former, but a better bet would be to find a way of investing in the only certain winners - the lawyers.

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