The wages of ‘sin’ are higher returns

It may not be moral to invest in so-called sin stocks but it sure is profitable.

Tobacco has been the best-performing sector in the US over the last 115 years, according to the latest Credit Suisse Global Investment Returns Yearbook, returning 14.6 per cent annually, compared to 9.6 per cent for the overall stock market.

To put that in perspective, a dollar invested in the US market would be worth $38,255 today; $1 invested in the tobacco sector would be worth $6.2 million.

Tobacco stocks have also outperformed handsomely in the UK, but the best performance comes has come from another sin sector – the alcohol industry.

The outperformance of sin stocks – commonly regarded as companies in the tobacco, alcohol, gambling, and arms industries – appears to be a global phenomenon. A separate study which looked at sin stocks returns over the 1970-2007 period noted that double-digit returns were to be found in 16 of 21 countries studied. A global sin portfolio would have generated double-digit returns in 31 of those 37 years. Negative annual returns occurred on just two occasions, despite the overall market being down in nine years.

Unsurprisingly, investors in the controversial Vice Fund, which offers a portfolio of "booze, bets, bombs, and butts", have done nicely since its 2002 launch. A $10,000 investment would be worth $33,655 today, notes yearbook co-author and London Business School finance professor Elroy Dimson, compared to $26,788 for the ethical Vanguard FTSE Social Index Fund.

Wary investors

Large investors are well aware of the appeal of sin sectors like tobacco. “It costs a penny to make,”

Warren Buffett

once said of cigarettes. “Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”

Despite that he has long steered clear of the sector, which is “fraught with questions that relate to societal attitudes”.

Buffett’s wariness is increasingly shared by institutional investors. “The laissez-faire approach is losing ground,” writes Dimson, who cites the example of Norway’s Government Pension Fund Global. The largest sovereign wealth fund in the world, managing $850 billion, it says that owning shares in ethically questionable companies “may be regarded as complicity” in their actions. The UN-supported Principles for Responsible Investment now lists 1,349 signatories with assets of over $45 trillion, adds Dimson, accounting for around half the assets of the global institutional investor market.

Ordinary investors have also reservations. Despite its inferior performance, the Vanguard FTSE Social Index Fund manages five times as much money as the Vice Fund. Indeed, the latter recently changed its name to the Barrier Fund in an effort to broaden its appeal, and now markets itself as an investor in industries “that exhibit high barriers to entry”.

While it manages a relatively modest $290 million, the Barrier Fund has at least survived. Not so the FocusShares ISE SINdex Fund, an exchange-traded fund made up of various sin stocks. Launched in 2007, it attracted little interest before being wound up just 11 months later.

Ironic

Ironically, this investor disinterest is likely the main reason that sin stocks outperform. While sin stocks tend to be high-margin, almost recession-proof businesses, these factors do not guarantee outperformance – after all, US tobacco stocks actually badly underperformed during the 1947-65 period. Over the following four decades, however, tobacco companies outperformed by more than 3 per cent per year.

What changed? During the first half of the 20th century there was no taboo around smoking. By the mid-60s, however, the deadly health consequences of smoking had become well known, and pressure to steer clear of investments in tobacco firms mounted in the intervening decades.

Unpopular stocks tend to become cheap, and a low stock price means a higher dividend yield. Over time, the reinvestment of these dividends alone leads to impressive outperformance.

In other words, sin stocks are destined to remain underpriced, but investors will continue to earn handsome profits in the form of higher dividends. “Contrary to conventional wisdom,” writes Dimson, “this gives ‘sin’ investors an incentive to have longer investment horizons.”

It also means that they are likely to continue outperforming. Various market-beating strategies have been uncovered over the years, but there is usually no guarantee they will continue to do so. Usually, when a strategy or anomaly becomes well known, the resulting influx of investor money leads to the performance differential being eroded away. In the case of sin stocks, however, investor distaste is likely to persist, ensuring the stocks remain cheap, high-dividend affairs.

Corruption

Incidentally, the same phenomenon may mean the best investing returns are to be found in corrupt countries, suggests Prof Dimson. Corporate governance concerns mean stocks are (rightly) cheaper in more corrupt countries, but investor caution may lead to them becoming periodically underpriced. Dimson notes a portfolio of the most corrupt countries would have returned 11 per cent annually over the last 15 years, compared to returns averaging 5.3 to 7.7 per cent in other countries.

There may be all kinds of reasons for this, and Dimson admits it may simply reflect a period of emerging market outperformance. However, he is “sympathetic to the view that low standards of governance may be regarded as a priced risk factor”.

Avoiding certain countries on ethical grounds can therefore be costly. The California Public Employees’ Retirement System (Calpers) lost over $400 million by blacklisting certain countries between 2002 and 2006, causing it to abandon its withdrawal strategy in 2007.

Institutional investors, suggests Dimson, may be better off by following Calpers’ example, using their voice to engage and influence companies rather than adopting a costly blacklisting approach. It’s known as the washing machine model – buy dirty companies, help clean them up by taking an activist approach, and benefit when the companies are eventually rewarded for their improved governance with a higher stock price. Research indicates it works, with stocks typically enjoying a nice share price pop after making the required changes.

Cheap

Still, while the washing machine model may work with some sin stocks, it can hardly be applied to others. For example, one in every two smokers dies from the habit, so it’s difficult to see how tobacco firms will ever be candidates for ethical portfolios. That means various sin stocks will likely remain cheap, and their investors will continue to collect their outsized dividends.

It is hard to imagine a more obvious irony: by depressing sin stock prices, ethical funds have helped line the pockets of less scrupulous investors. As Prof Dimson puts it, "responsible investors should recognise that they may be partly responsible for the higher returns from sin". The four categories of sin stocks: Booze, bets, bombs and butts Tobacco: Philip Morris International; Altria; Reynolds American: British American Tobacco; Lorillard; Imperial Tobacco Group.

Gambling: Wynn Resorts; MGM Resorts International; Las Vegas Sands Corp; Casino 888; William Hill; Paddy Power. Alcohol: Diageo; Heineken; Anheuser-Busch InBev; Carlsberg Group; Molson Coors; Pernod-Ricard.

Arms: Lockheed Martin; Raytheon; Northrop Grumman; BAE Systems; Smith & Wesson.

The four categories of sin stocks Booze, bets, bombs and butts

TOBACCO Philip Morris International; Altria; Reynolds American: British American Tobacco; Lorillard; Imperial Tobacco Group.

GAMBLING Wynn Resorts; MGM Resorts International; Las Vegas Sands Corp; Casino 888; William Hill; Paddy Power. ALCOHOL Diageo; Heineken; Anheuser-Busch InBev; Carlsberg Group; Molson Coors; Pernod-Ricard.

ARMS Lockheed Martin; Raytheon; Northrop Grumman; BAE Systems; Smith & Wesson.