Can You Maintain Virtue In Vice Stocks?

By Stephen D. Simpson, CFA | July 14, 2010 AAA
Can You Maintain Virtue In Vice Stocks?

It is easy to invest in companies that do good and are still very successful by conventional business standards. After all, who would not like to own a company growing at a mid-teens rate that pays its employees fairly, is a good corporate citizen, treats the environment well and sells a product that makes people's lives better?

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But what about the other side of the coin? What about investing in companies that sell products you do not like, or engage in practices that are perfectly legal but strike you as unsavory? Can you learn to love a business you do not like, and is it worth it? The reality is that some companies are phenomenal investments, but carry undeniable social costs. You can reap a great deal of profits by investing in sin stocks, but there are other costs you must consider.

Vice Is Big Business
Whether you look at booze or tobacco, there is a great deal of money in catering to people's habits, vices and addictions. If you look at the liquor, beer and tobacco sectors, you will see low growth, but generally high returns on capital and solid dividend payouts. Moreover, you will find that these stocks tend to hold up well in tough economic times - people do not abandon life-long habits just because times get a little harder. (Sin stocks may seen as outright undesirable to some, but these "naughty" industries bring stable returns - even in hard times. Check out Sinful Investing: Is It For You?)

Exploitation Can Pay Well
Investors may be able to say that companies satisfying traditional vices are simply giving people what they already want. That is a much more difficult argument to make for companies that base their entire operation on some form of exploitation.

Exploitation can come in many forms, and the objections tend to be very different across these forms. Payday lending and various rent-to-own operations are often cited as preying upon the poor and exploiting a mix of desperation, a lack of alternatives and a lack of financial sophistication, to charge interest rates and price premiums in excess of 300%.

Sweatshops offer companies the chance to compete aggressively on price in their home markets by taking advantage of cut-rate labor in the developing world. Mining and energy companies operate yet another type of exploitation - digging deep into the earth for hard assets and often making a mess of the surrounding area.

In all cases, these companies often post eye-popping runs of profit growth. The trick, though, is that it never lasts - non-traditional finance companies often run into regulatory blockades and legal challenges, sweatshop operators face consumer boycotts and race-to-the-bottom price competition, and mining companies face the cyclical swings of commodity prices. (Learn how to pick the right point in the cycle in The Ups And Downs Of Investing In Cyclical Stocks.)

Some Trends Are Inevitable
Another type of unsavory-but-successful company is one that harnesses trends that are seemingly inevitable, yet still controversial. Among scientists, there is no real debate about whether or not genetically-modified (GM) agriculture is here to stay and whether GM crops are going to be increasingly standard for farmers across the world.

Likewise, offshoring appears similarly entrenched in our future. If people "somewhere else" can do a particular task at nearly the same level of proficiency but for only 10% or 20% of the pay, it is inevitable that those jobs are going to migrate. (Is it better to be bad than to be good? Find out in Socially Responsible Investing Vs. Sin Stocks.)

Clearly there is money to be made by investing in the vanguard of new trends. Unfortunately, the road is often rocky. Companies developing GM crops are reviled by environmentalists. Similarly, offshoring has always been extremely unpopular. When a business becomes unpopular enough with a large enough section of the population, there comes a risk that people pressure the government to "do something" about it - creating regulatory risks and headaches that no investor needs.

Investing Is About Making Money
How, then, should investors reconcile their approach to these companies? First, there is a big difference between illegal and distasteful. I can see no argument for investing in an illegal enterprise, as sooner or later the government will catch up and shut down whatever loopholes are allowing that situation to continue.

Distasteful, though, is a much different story. Distasteful is a matter of opinion and what bothers one person may be perfectly acceptable to another. Nonetheless, companies that operate in distasteful businesses may find themselves constantly fending off attempts to regulate their operations.

Investors can also look at these investments as opportunities to pursue their beliefs in different ways. A successful investment can produce profits that can be put towards other ends - including donations to causes that improve the world. Along a similar line, ownership of shares gives you a vote and a voice within a company - a voice you can use to attempt to get the company to change their ways.

Plenty of Other Options
There is no such thing as a must-have investment; there are always other investments available and the differences in performance may not be all that significant. Moreover, if you invest in a company that is clearly on the up-and-up you may find that you sleep better - you may have considerably less worry about the government moving to regulate, restrict or prosecute one of your holdings, and there is less headline risk.

The Bottom Line
The question of whether you should dabble in controversial industries comes down to a simple point - you should always be comfortable with what you own. If you think a stock is too expensive, sell. If you think that what a company does is morally wrong, sell (or do not buy in the first place). It may be impossible to come to some universal definition of what a "bad business" is, but the reality is that, however you define it, you should never invest in a bad business.

Catch up on the latest financial news; read Water Cooler Finance: I-Spy, IPOs And iPhones.

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