Life's a drag at the top of the Footsie

It gobbled up the Germans, now it's going head-to-head with the Americans. Imperial's Gareth Davis explains why the tobacco giant is the best of British

Tobacco may be seriously damaging to your health but it could also prove a life-saving breath of fresh air for your stock portfolio.

Bear market investors are clinging to the whole sector like a rock in a storm, and Britain's baccy companies are leading this year's FTSE 100 winners by a comfortable margin. Topping the list with a 38 per cent rise since January is Imperial Tobacco, the £7.5bn group that keeps UK smokers puffing away on Embassy, Regal and John Player Special, as well as most of the rolling-tobacco brands on the market and the papers you put them in.

In March, Imperial's chief executive Gareth Davis – himself "rarely seen without a fag" – took the company to a new level and into the top flight of the four biggest tobacco groups in the world. With a swift and aggressive €5.2bn (£3.3bn) move, Imperial gobbled up Reemtsma, the German giant that has cornered its domestic market with the West and Davidoff brands.

But brute size isn't everything, and while the market is prepared to give Imperial shares a big vote of confidence, Davis is a man with a lot on his plate. "The biggest challenge is to take advantage of this merger," he says. "We are taking the Imperial philosophy into Reemtsma, and believe me, we are not the types to hang around. Integration started on day one."

Davis has certainly built up an impressive portfolio of brands, but the market clearly expects quality profits growth to come from it. A lot of hope is pinned on the group's ability to con-tinue to snap up market share in the emerging markets of central and eastern Europe, but competition is fiercer than ever. The main problem identified by the analysts is that those markets are precisely where Imperial's big rivals – Philip Morris and British American Tobacco – are looking to grow as well. This will be the first time Davis has found himself head-to-head with Philip Morris in a situation where the US giant is wholeheartedly committed to expanding its market share. In response, he is putting his faith in a mixture of merchandising schemes and a huge salesforce.

One of Davis's chief concerns is that cigarette advertising is being squeezed out of existence almost everywhere Imperial turns. The challenge is to get smokers to switch to his brands. "The outlook on the advertising front is extremely difficult, no doubt about that," says Davis. "France is a prime example of the problem. We would love to build on the 3.5 per cent market share we have there at the moment, but without advertising it's going to be very tough."

Davis is also rather less than convinced that banning tobacco advertising actually achieves the desired effect: "I don't think there's much evidence of a significant decline in smoking if you ban the advertising, but in 'dark' countries like France, you get far less switching between brands."

The worry is that before too long, most markets will effectively be "dark", and even global marketing efforts will be curtailed. As part of the Reemtsma purchase, Imperial bought its way into Formula One as sponsor of the West McLaren racing team. The irony of being back in that particular game is not lost on Davis; via John Player, Imperial was a pioneer of F1 sponsorship (remember the classic John Player Special Lotus, driven to the world title by Mario Andretti), but it was also the first to bale out of it in the late 1980s. Speaking to Davis, one has a strong sense that the relationship with McLaren might not last for ever.

"Let's be realistic," he says. "We have to work with a scenario that there will be no more tobacco advertising in F1 after 2006. For brand exposure, we'll continue to look at darts and snooker. Our line is that as long as we're welcome in a sport, we'll sponsor it."

Another of Davis's related headaches is that the business of selling tobacco is often an intensely political one. High on the agenda at the moment is the smuggling of cheap cigarettes from the Continent into the UK, and whether the tobacco companies are quietly encouraging the practice in the hunt for higher volumes. Imperial enjoys a near 50 per cent share of the UK smuggled market.

At the end of June, Davis found himself in front of the parliamentary Public Accounts Committee which, in the words of Morgan Stanley analyst Jonathan Fell, "seemed to us more of a kangaroo court than a serious attempt to discover the facts". At the hearing (to quote Fell again), "uninformed or misinformed" MPs were almost universally hostile and hit Imperial with the specific charge of not working closely with HM Customs.

"It was a shock," says Davis, "and it left us surprised and concerned. We think we've been honest all along. People just don't understand: we are very much opposed to smuggling because, to us, it represents a complete waste of overseas investment. At the last analysis, though, the smuggling issue has served to expose the huge discrepancies in tax regimes."

Despite that pressure, Imperial has remained insulated from the major political black hole in the cigarette industry: US litigation. Eighteen months ago, companies selling cigarettes to the American market were cudgelled with an almighty $130bn (£86bn) payout arising from a successful class action lawsuit by lung-diseased smokers. The staggering sums involved appeared to jeopardise the entire industry, and as a knee-jerk reflex, shares across the sector plunged.

"We never were exposed to the US, and we have absolutely no intention of entering that market – it's too dangerous," says Davis. "What hurt us was the time it took people to realise [that]. The market isn't perfect, I suppose."

He remains highly confident that the same sort of cataclysm will not happen in the UK or Europe in a few years' time. "Tobacco litigation is a peculiarly US solution to a US situation," he says.

Sitting at the top of the FTSE's biggest gainers list, with the UK and German markets sewn up, Imperial looks very much like a company that could take on more or less any trouble being dished out. It has a simple, cash-yielding product everyone understands, and that counts for a lot in a market where investors are unsure of everything. For an assurance of future growth, the company can point east: countries that had previously never known the delights of a packet of Golden Virginia and box of Rizlas have become ravenous markets, and Imperial is doing everything it can to feed them.

Davis still has enough concerns to keep him reaching for the Regals, but it's clearly a challenge he enjoys: "Yes it's a controversial industry," he admits, "but we're big now and we want to keep growing. Anyone who doesn't like guiding a ship like this ought to get out more."