Finding A Win In Sin

By Aaron Levitt | October 30, 2009 AAA

Socially responsible investing, or investing that takes on certain "moral" characteristics, has become the hot trend in recent years. Pax World Investments created the first socially responsible fund back in 1971 and plans to issue new social ETFs based on its funds. iShares' recently launched both the KLD 400 Social Index (NYSE:DSI) and the KLD Select Social Index (NYSE:KLD) to track the largest two social investment indexes.

However, investors wanting to make the world a better place may be selling themselves short in the process. Responsible investing mandates the elimination of alcohol, tobacco, gambling and defense companies from their portfolios and indexes. In the world of profit-driven investing, choosing a stock for what it doesn't do may not be the best strategy for a winning portfolio. In fact, sin stocks seem to have an edge. According to a recent study published in the Journal of Financial Economics, companies related to alcohol, tobacco and gambling have produced yearly returns 3.5% higher than other stocks. (For a quick refresher, check out A Prelude To Sinful Investing.)
Cashing in on Corruption
Investing in vice industries comes with other benefits aside from the higher average returns. Alcohol and tobacco tend to sell well even in economic downturns. Consumers may trade down to less expensive brands, but they still smoke and they still drink. Institutional managers also own, on average, only 23% of the outstanding shares of a sin company versus 28% for an ordinary firm. This could be the reason that sin stocks tend to have a 15-20% discount on valuation metrics, allowing many of them to offer outstanding dividends. In addition, many of these companies, with the exception of casinos, have very conservative balance sheets. After all, if your product is at risk of being regulated, it pays to not overspend. (For more, see Survival Tips For A Stormy Market.)

Cigarettes, Booze and Gambling
This is one area of the market in which individual companies shine over a broad sector approach. There is an active mutual fund in the space, USA Mutual's Vice Fund (VICEX), but individual investors may have better results picking quality companies on their own. (For related reading, see Socially (Ir)responsible Mutual Funds.)

When Altria (NYSE:MO) spun off its international division in order to free itself from an increasingly unfavorable U.S. regulatory market, Philip Morris International (NYSE:PM) became the dominant player in the tobacco world market, selling approximately 870 billion cigarettes in 2008. The company's products are sold in more than 160 different countries, including the ever-coveted BRIC nations. The stock makes a perfect addition to play the consumers in those nations. The company trades at a price to earnings ratio of 15, and yields a market-beating 4.7%.

The percentage of U.S. adults who consume alcohol is holding steady at 64%. However, what they are drinking is changing. Whiskey is making a huge comeback, with 1.3% in total worldwide volume growth. This bodes well for London spirits maker Diageo (NYSE:DEO), which receives a huge portion of its revenue from whiskey. The company owns such brands as Captain Morgan, Johnnie Walker, Tanqueray and the world's top selling spirit, Smirnoff Vodka. Shares of Diageo yield an impressive 4.6%.

In gambling, "the house" always wins, and this is true for the suppliers to the casinos as well. International Game Technology (NYSE:IGT) produces slot machines and other gaming products, including movie-based slots, and Wheel of Fortune branded games. Gambling has become a favorite pastime in China as well, and new casinos are being built in Macau. International Game Technology is seeing increasing revenues from these projects. Shares of IGT yield 1.30%.

Bottom Line
While socially responsible investing has its merits, investors adopting a pure moral portfolio maybe missing out some nice gains. This sector of the market has traditionally produced solid returns, despite the economy. The preceding three companies make wonderful additions to any portfolio. (For related reading, check out The Evolution Of Sinful Investing.)

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