Looking Into Sin Investments

By Sham Gad AAA

The stock market has no shortage of names, products or categories that try to classify stocks 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 U.S. agricultural stocks, global agricultural stocks, or even bet against agriculture with an ETF that goes short agriculture.

Another category of stocks, which can go by various different names, are affectionately known as sinful 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 with 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. Regardless of my personal and professional views on the matter, the purpose of this article is to comment on the value of these businesses.

In the stock market, businesses are ultimately valued on their ability to generate profit and cash flow over a sustainable time period. One of the most common valuation metrics is the price to earnings (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 (P/B) ratio. Book value is the net asset value of a company - what a company is worth after subtracting out all liabilities and intangible assets. 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. On the other hand, a business trading above book value implies that the market likes the assets enough to pay more than the stated value.

Are Sin Stocks Valued Differently?
But does the market assign valuation equally among companies? The obvious answer is no. The great investor Benjamin Graham astutely observed that in the short run the stock market is a voting machine, while in the long run it is a weighing machine. What Graham meant was that over shorter time periods, stock prices move according to the daily preference of buyers and sellers. Over the longer run, stock prices react to the fundamental characteristics of a business.
 
When one observes the market returns of the so-called sin stocks - alcohol, tobacco and gambling - it also affirms that so-called sin stocks are not valued any differently in the long run. However, understanding why this is so involves a bit of irony.

Empirical evidence has shown that companies engaging in the business of tobacco, alcohol and gambling are to some extent excluded from investment consideration by many individuals who simply view tobacco, alcohol and gambling as societal vices that should be avoided and eliminated. Also, some socially specific mutual funds have banned themselves from investing in any company that violates the social premise or belief of that fund. Additionally, in a study titled The Price of Sin, the conclusion is that other traditional investment entities such as pension funds avoid sin stocks to conform to societal norms.

However, those constraints are not present in mutual funds and hedge funds that are purely focused on maximizing return. These investment vehicles have one mandate: to generate the greatest possible return while taking the least amount of risk. Sometimes that philosophy doesn't work out, but the goal is clear: invest in what looks to offer a promising return.

Because of knowledge that societal norms don't look favorably to the partaking of tobacco, alcohol or gambling, market participants are aware that the opportunity for arbitrage could exist in sin stocks. In other words, hedge funds and mutual funds see potentially higher returns from owning these businesses, so they are happy to invest in them. And over the course of time, these companies' performance has been similar to other high-quality companies. In summary, the market has enough investment vehicles looking for opportunities, that the aversion of many individual investors or pension funds to sin stocks creates attractive investment opportunities for other investment entities that are more than happy to exploit them.

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 has some validity in the short run, but not in the long run. 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 that 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 values them appropriately over the long run.

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