DURING recent meetings with our clients it became clear that the tobacco sector is universally loathed. This contrasts with the wider staples sector, which seems to be over-owned and overvalued to us.

Since the start of 2018 global tobacco has underperformed the broader staples sector by 37 per cent and the overall stock market by 39%. Part of this is due to the derating of tobacco shares and the rerating of the remainder of the staples sector. The price earnings ratio (PER) for the tobacco sector declined from 17 times to 11 times and staples’ PER increased from 18 times to 20 times. Dividend yields on tobacco shares, meanwhile, have grown to 7% versus 2.8% for staples.

There are various widely known reasons for tobacco’s underperformance, such as the acceleration of volume declines in traditional combustible cigarettes, concerns about over aggressive pricing and potential new regulation from the US Food and Drug Administration.

For these reasons we have never been big fans of the tobacco sector. Nevertheless, everything has a price and we see the current valuation anomaly as an outstanding investment opportunity for the long-term investor as current share prices discount these businesses going bust. In reality their earnings and dividends are expected to grow, which warrants a higher PER.

Two companies in the global tobacco sector currently look attractive: Imperial Brands, the deep value play on developed markets, and Philip Morris International, the growth play on emerging markets and new ‘heat not burn’ technology.

In the case of Imperial, the company’s more streamlined cigarette portfolio is very well positioned in its top five markets – the US, Germany, the UK, Australia and Spain. Its brands are towards the value end of the spectrum and should benefit from the expected consumer downtrading.

The company has a £1 billion-plus disposal programme, including its luxury cigars business, which will be complete by the end of May 2020. Part of the proceeds will be used to reduce debt, meaning leverage will reach more comfortable levels over time. A management commitment to scrap the 10% dividend growth rate will also help to lower leverage. Additionally, the company announced a £200m share-buyback programme, with scope for even bigger programmes in outer years.

Valuation is the key. Imperial’s six times PER and 11.4% yield implies that its business model is broken and the company is in financial distress. We disagree. On the conservative view that the shares hold their current valuation, our assumption of underlying earnings per share and dividend growth of 2 to 3%, accretion from the share buyback and the yield the total annual shareholder return is in the high teens. If the company can deliver on its targets the shares will also re-rate from the current low levels.

The investment case for Philip Morris is different. It has no direct exposure to the US and is a play on emerging markets. Its biggest markets include Turkey, Russia, the Philippines and Indonesia.

We have followed Philip Morris for some time and listened to the company’s growth strategy for its heat-not-burn product IQOS with interest. While we always liked the strategy, we were never comfortable with the lofty valuation of the shares. However, after two profit warnings in 2018, the shares derated massively and we initiated a holding in July last year.

We believe the guidance is now much more conservative and expect upgrades to come through over the next year or two, driven by continued growth in IQOS combined with slight margin expansion and the potential of a share-buyback programme in two years’ time.

Philip Morris has first-mover advantage, by some distance, in heat not burn, has strong market shares and continues to lead innovation in this space. We see it as a long-term winner in the non-combustible nicotine space. We expect Philip Morris to be able to grow its earnings by approximately 6% per annum, which, combined with a 6% yield, should give a double-digit total return.

Despite the uncertain backdrop, valuations in tobacco shares are now reflecting a huge amount of pessimism about future earnings and cash generation. Given that dividends are secure, we think the sector is massively over-sold.

Bettina Edmondston is a global investment analyst at Saracen Fund Managers.