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Market Overreacts to Menthol Risk

The road to prohibition will be rocky, but the market assumes a worst-case scenario.

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The U.S. Food and Drug Administration has announced three policy proposals that will ban menthol in cigarettes, limit the marketing of flavors in vaping liquids, and ban flavored cigars. This represents the most concerted attempt to clamp down on the tobacco industry in 20 years. Tobacco stocks moved sharply downward after the November announcement, particularly in reaction to the potential for menthol prohibition. We still believe the probability of a menthol ban is less than 50% because the path to legislation requires the FDA prove the net public health benefit of the proposed ban. This is a fairly heavy burden of proof.

Even if the FDA does bring into force a menthol ban, we think the effects of such a development are already more than priced in. Our analysis shows that the market reaction is proportionate to an unlikely outcome whereby all industry menthol volume is lost immediately after prohibition. We expect a less extreme outcome, with some volume decline but some volume migration to nonmenthol variants within brand families. In this scenario, we believe the market has overreacted to the news and has dragged down some already undervalued stocks to very attractive levels. Having said that, the potential menthol ban will now act as a new overhang over the stocks, and it may take more than a rebound in heated tobacco to deliver the upside we believe is on offer at today’s prices. Investors will have to be patient and have the stomach for further fat-tail risk, but we think  British American Tobacco (BTI) and  Imperial Brands (IMBBY) are trading at especially attractive margins of safety.

Philip Gorham does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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