Why Neil Woodford was right to sell British American Tobacco plc

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British American Tobacco cigarette making equipment

Last Friday, Woodford Investment Management released its monthly update to investors. It was a fairly standard update, discussing market drivers and positions that were added to during the month. 

There was however, one trade that may have surprised a few investors - the sale of the entire position in British American Tobacco(LSE: BATS). The update read: "We completely sold the fund's position in British American Tobacco which has been present in the portfolio since its inception and has been a part of Neil's mandates practically throughout his career. Neil owned stakes in tobacco companies before the dot.com bubble of the late nineties, but it was that episode of market history that marked a significant increase in tobacco exposure which has prevailed until recently. During the bubble, old economy stocks like British American Tobacco became completely unloved by the market - at the peak of the dot.com bubble in March 2000, you could have bought shares in British American Tobacco for just £2.25 per share. We have recently disposed of the holding at over £50 per share."

Having been a tobacco bull for so long, this sale will have no doubt raised a few eyebrows among the investment community. However, in my view, the sale makes sense for a number of reasons. Here's why.

Strong share price run

For starters, the firm had enjoyed a very strong share price run over the last three years. Indeed, three years ago the stock could be bought for around 3,500p mark, yet in early June this year the shares traded above 5,640p, a gain of over 60%.

A 60% capital appreciation over three years is an impressive return, and one that would be respectable for a growth stock, let alone a defensive consumer staple. And a look at the long-term chart suggests that perhaps the share price had run a little ahead of itself in the last 18 months or so, climbing away from the long-term trend in an exponential fashion.

While stock market experts often recommend cutting losses and letting winners run, sometimes there's no harm in selling a winning position and locking in a huge profit, especially if there seem to be other attractive investment opportunities in the market, as Woodford believes there are at present. 

Lofty valuation

Looking at the valuation, the share price run had pushed the stock up to a level that perhaps looked a little stretched. Indeed, in early June, the stock's P/E ratio was almost 23 times FY2016 earnings. For a defensive company exhibiting low revenue growth over the last five years, that valuation was no doubt a little high.

Low dividend

Furthermore, the rise in the share price had also pushed the stock's dividend yield down significantly and in early June, the stock's yield was just 3%. While the tobacco giant has been a dividend growth legend in the past, the company had often traded with a yield significantly higher than that.

Cheaper rival

Lastly, Woodford clearly believes that rival Imperial Brands offers considerable more value than British American Tobacco right now, stating "we still retain some exposure to tobacco through Imperial Brands, which remains undervalued in our view."

This looks to be a wise decision in my view, as Imperial's metrics look more appealing at present, trading on a P/E ratio of just 13.7, with a trailing dividend yield of a healthy 4.5%.

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Edward Sheldon owns shares in Imperial Brands. The Motley Fool UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes