Invesco Perpetual’s star UK stock picker Mark Barnett says Imperial Brands (IMB) is the pick of the London-listed tobacco stocks at present – and you can see why.

Imperial trades on a September 2017 price-to-earnings ratio of 12 according to analyst forecasts – astonishing for a high quality mega cap stock.

To recap, Imperial more than doubled earnings per share over the last decade – and management targets imply it can probably do so again over the next 10 years, with earnings per share growth projected at between 4% and 8%.

Imperial’s stock price has increased 10.9% a year over a period which included the deepest recession in 80 years.

Earnings also benefit from translation of overseas profits into a sterling – though this could reverse if the UK exchange rate strengthens.

A deal last year to acquire parts of US outfit Lorillard in a carve up with Reynolds American (RAI:NYSE) adds potential risks and rewards in North America.

Overall, Imperial, which boasts brands including Davidoff and Gauloises cigarettes as well as Cohiba, Montecristo and Romeo y Julieta cigars, looks like a great business.

Knock-down price

So what’s the reason for the knock-down price?

Berenberg analyst Jonathan Leinster says Imperial’s latest set of results showed  tobacco volumes contracted 7%. Volume decline is expected in tobacco as smoking rates fall across the world but Imperial’s performance looks a little weaker than its rivals.

All of the volume decline was recouped by price increases: pricing power is the way companies like Imperial are able to increase profit year-on-year even as volumes decline.

Imperial aims to arrest volume decline with more competitive pricing, which led to Leinster reducing 2017 earnings per share forecasts by 1% to 284p. And the market remains undecided on the strategy.

‘This is unlikely to be an area where management is given the benefit of the doubt until proved otherwise,’ writes Leinster in a 9 November note following Imperial’s full-year results to 30 September.

‘However, first half organic sales growth in fiscal 2017 is expected to be negligible as the investment will include a considerable reduction in stock keeping units (SKUs) or different variants of the same brand within six to eight markets, temporarily reducing shipments, as well as additional price promotions, which will reduce price/mix temporarily.’

Price-to-mix

Price-to-mix is where a company sells the same number of units but sales increase because customers are buying more expensive products.

Overall, we think Imperial chief executive Alison Cooper is more than capable of managing these issues and improving volume performance.

Risks investing in tobacco stocks include the potential for regulatory penalties, with all companies in the sector incurring substantial legal expenses to defend them against claims.

Cheap for no reason at £34.96.

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