The stock market has no shortage of names, products, or categories that try to classify stocks in order to give them greater exposure. Whether that exposure is good or bad is up to the individual investor or money manager to decide. Today we have thousands of exchange traded funds (ETFs) for whatever flavor of investing could possibly be desired. Interested in agriculture? You can find an ETF for US agricultural stocks, global agricultural stocks, or even bet against agricultural with an ETF that goes short agriculture.
Another category of stocks, which can go by various different names, are affectionately known as sin stocks.
What Are Sin Stocks You Ask?
Well, the reality is that sin stocks can mean different things to different investors. To many, a pharmaceutical company that manufactures or promotes an abortion pill is deemed a sin stock. To others, it's a company that drills for oil near environmentally sensitive locations. A retailer whose clothing may be connected to abusive third world factories may be a sin stock to another group of investors. It truly is a matter of preference.
Yet if one were to categorize the most commonly labeled sin stocks they are likely to include companies that deal in tobacco, alcohol, and other products deemed inappropriate or "harmful" to the social well-being of society. To many people tobacco simply means cancer; alcohol means intoxication and the consequences that come of it; adult magazines and films mean degradation. In other words, these types of businesses are labeled "sin stocks" because of the belief that such enterprises offer no value to society.
In the stock market, businesses are ultimately valued on their ability to generate profit and cash flow over a sustainable period of time. One of the most common valuation metrics is the price to earnings, or P/E, ratio. The P/E ratio is as simple as the name sounds: it's the multiple of earnings that investors are willing to pay for a share of stock. The higher the P/E ratio the more investors are willing to pay for a company. Another sometimes useful metric is the price to book, or P/B, ratio. Book value is the net asset value of a company - what a company is worth after subtracting out all liabilities. A company trading below book value may often reveal an undervalued business or a business where investors have lost confidence in the company's assets while a business trading above book value implies that the market likes the assets enough to pay more than stated value.
SEE: How To Use The P/E Ratio And PEG To Tell A Stock's Future
Are Sin Stocks Valued Differently?
But does the market assign valuation equally amongst companies? The obvious answer is no. Just look at Mexican restaurant chain Chipotle (NYSE:CMG) which is trading at a price to earnings ratio (P/E) of 42 versus Panera Bread (Nasdaq:PNRA) at a P/E of 26 versus McDonald's (NYSE:MCD) trading at a P/E of 18 (P/E ratios are as of July 2013). Clearly the market is very fond of Chipotle due to its impressive growth potential in the years to come.
So how does Mr. Market treat the so called "sin stocks" with respect to valuation? Even though we have established that the market values all manner of stocks differently, are sin stocks treated even more differently? Phillip Morris (NYSE:PM) is one of the largest cigarette manufacturers in the world with brands like Marlboro and Virginia Slims. Phillip Morris has, for decades, been a steady dividend payer and has generated stable cash flows. As of July 2013, the dividend yield is 3.8%, a very attractive number in today's low interest rate world. Shares in Phillip Morris currently trade near a 52 week high at a P/E ratio of 17. Over the years from 2008 to 2013, Phillip Morris shares have appreciated by 70%. When you add in the near 4% annual dividend, an investment in this "sin stock" has done very well and is clearly not being held back by the market. Another tobacco company, Reynolds American, currently has a P/E ratio of 18 and a P/B ratio of 5.3. Shares have advanced 83% in the past five years.
SEE: Socially Responsible Investing Vs. Sin Stocks
Let's look at another so called sin stock, Anheuser-Busch InBev (NYSE:BUD) one of the largest producers and suppliers of beer and alcohol. Shares in BUD trade for a P/E of 19. In the past five years, shares have appreciated by over 130%, well exceeding the return generated by the S&P 500 over the same period of time. In addition shares trade for nearly 4 times book value, clearly indicating the investors are willing to pay a premium for the assets of an alcohol business.
Let's compare these numbers with those of more traditional consumer stocks:
Coca-Cola (NYSE:KO) currently has a P/E ratio of 21 and a P/B ratio of 5.6. Shares have advanced by over 52% in the past five years.
Procter and Gamble (NYSE:PG) maker of things like Gillette razors, Crest toothpaste, and Pampers diapers currently has a P/E ratio of 18 and a P/B ratio of 3.3. Shares are up 24% in past five years.
Kraft Foods (Nasdaq:KRFT) has a P/E ratio of 21 and P/B ratio of 9. Kraft was recently split into two new companies so a five year return is not a good comparison but over the past year shares have advanced by 25%.
The Bottom Line
One can draw a few conclusions from the above data. First, the notion that sin stocks are valued differently because of their specific line of business is a myth. The performance data and valuation metrics suggest that the market is not valuing tobacco and alcohol blue chip stocks differently from traditional consumer stocks. Second, over the long run the market seems to get it right and assign valuations based on earnings growth. Ironically, it seems that the inelastic demand of products like cigarettes and alcohol - people don't smoke or drink any less during a recession - causes the market to occasionally value these stocks at a premium to other businesses who are more sensitive to economic trends. In sum, the stigma that a sin stock receives seems to be more concentrated among individual investors who are certainly entitled to avoid them. The overall market, on the other hand, seems to look favorably on the stability that these companies' products possess and value them appropriately over the long run.
At the time of writing, Sham Gad did not own any shares in any of the companies mentioned in this article.