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ITC shares have fallen at an annual average rate of 14% in the past three years, at a time when the Nifty 50 index has gained at an annual rate of 5.4%.
ITC shares have fallen at an annual average rate of 14% in the past three years, at a time when the Nifty 50 index has gained at an annual rate of 5.4%.

MFs keep faith in ITC even as stock lags benchmark

  • ITC has said it will complete existing projects and not start any greenfield projects in the cash-guzzling hotels and paper biz

People get trolled for various things on social media; a recent inclusion to the list is standing in support of an investment in shares of tobacco company ITC Ltd. No, it’s not the ESG warriors, worried about the harmful health effects of cigarettes, who make up the troll army. Rather, it’s investors whose ITC holdings have dropped in value. The fact that the rest of the markets are getting along fine is just rubbing salt into their wounds. ESG is short for environmental, social and governance investing.

ITC shares have fallen at an annual average rate of 14% in the past three years, at a time when the Nifty 50 index has gained at an annual rate of 5.4%. Among other things, the company’s management has been blamed for poor capital allocation, with investments in capital-intensive businesses such as hotels and paper being particularly frowned upon.

In this backdrop, the domestic mutual fund industry’s fondness for the stock stands out. In the past three years, mutual funds have more than doubled their holdings in the so-called sin stock.

Recently, PPFAS Mutual Fund began to ratchet up its holdings in the stock, with as much as 7% of its 4,800 crore AUM (assets under management) now invested in ITC. A year ago, its holdings in the stock were nil.

At HDFC Mutual Fund, about 4.5% of AUM worth 69,000 crore in three large funds is invested in ITC, besides a spattering in some of its other funds.

Likewise, Nippon India Mutual Fund, SBI Mutual Fund and ICICI Prudential Mutual Fund have an overweight position in the stock in some of their large funds.

Satish Kumar/Mint
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Satish Kumar/Mint


ITC has a weight of about 3% in the Nifty 50 index and about 2% in the Nifty 500 index.

Mutual fund managers typically don’t discuss individual stock picks, but Rajeev Thakkar, chief investment officer at PPFAS, discussed its position in the ITC stock at an annual unitholders’ meeting on Saturday.

“An underperformance in the last three or five years does not mean that the stock will underperform in the next three or five years," he said.

In other words, market cycles are far longer, and investors should have patience till the value in the ITC stock is fully appreciated by the markets.

ITC supporters also point out that some stocks that are now popular, such as Reliance Industries Ltd and Hindustan Unilever Ltd, had had very long periods of underperformance in the past. But investors who held on patiently have been richly rewarded in recent years.

While there are no signs of a turnaround in the ITC stock yet, there appears to be a shift in the company’s response to investors’ complaints about poor capital allocation. It has said it will only complete existing projects and not start any greenfield projects in the cash-guzzling hotels and paper businesses. Instead, it is increasing payouts to shareholders. In FY20, ITC paid out 82% of its net profit as dividend, compared with 68% in FY19.

Thakkar also pointed out in the unitholders’ meeting that ITC has actually done fairly well on revenue and profit growth.

“From 2009 to 2020, net profit has gone up every single year," he said.

Adjusted for one-time items, ITC’s net profit expanded at a rate of about 10% annually in the past five years, while HUL’s net profit grew at 13.5% annually. ITC supporters say the underlying earnings growth itself will push up the stock, now that most of it is being returned as dividend.

While there is a perception that incrementally higher taxes on cigarettes have hurt ITC’s earnings, the difference in growth rates isn’t as high as one would have imagined. However, each rupee earned by HUL gets a monumentally higher valuation than that earned by ITC. The former’s market cap is 2.5 times that of ITC, even though its profits are about half in size.

If ITC’s profit growth isn’t too bad and if it is mending its ways with regards to capital allocation, what ails its valuations?

“Management initiatives to improve capital allocation will help improve investor sentiment and valuations. But that said, the increasing significance of ESG investing is a big overhang on tobacco stocks globally. Consequently, ITC’s valuations will likely remain at a discount to the FMCG sector," says Bharat Iyer, a senior markets analyst.

Thakkar isn’t too perturbed by the ESG issue. “They get a medium risk rating on ESG. It’s not just a matter of tobacco or no tobacco; you have to look at how they are dealing with the environment, what is their carbon footprint, etc. They are also into a lot of businesses that are positive to society," he told unitholders.

But note that total returns, including dividends, for British Tobacco and Philip Morris shareholders stood at -36% and -18%, respectively, in the past three years, compared with -32% in the case of ITC.

Tobacco stocks are being shunned the world over. An October 2019 report by Russell Investments showed that the ESG overhang comes even from funds that don’t have a specific ESG-mandate. About 70% of all large-cap funds in the US had tobacco-free portfolios in mid-2018, compared with 52% in mid-2012. This shows that tobacco stocks are being shunned by fund managers, even in cases where they were not specifically asked to do so by clients.

Of course, Indian mutual funds don’t seem to be too particular about having tobacco-free portfolios. Until they get another set of large investors to agree on this stance, returns on ITC shares may continue to lag the market.

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