Gerry Sullivan doesn’t have many vices. He doesn’t smoke, he rarely gambles and he only occasionally enjoys a tipple. But the portfolio manager at Milwaukee-based USA Mutuals doesn’t moralize about other people’s habits. He makes money from them, in good times and bad. Sullivan runs USA Mutuals’ Vice Fund, a portfolio made up of cigarette, alcohol, gaming and defence stocks. Or, as they’re often called, sin stocks.
It’s hard to miss the frustration in Sullivan’s voice when he talks about how investors view his portfolio. Many don’t look at sin stocks as legitimate investments, he says. They only get attention because they’re titillating to talk about. Others want nothing to do with these companies for ethical reasons. Socially responsible funds and religious investors stay far away. There are even pension funds that won’t touch a vice-related company.
But while these companies sell products that may be bad for your health or exploit human weaknesses, they can provide investors with hard-to-find income in today’s low interest-rate environment. With government bonds offering negligible returns, investors have been flocking to income-producing stocks to generate cash. Following the U.S. Federal Reserve’s recent announcement that interest rates will stay low through 2014, it’s likely dividend stocks will stay hot.
However, the usual income-generating sectors—utilities, telecoms and pipelines—now come at high prices. Because so many people won’t buy them, sin stocks are generally cheaper than other income-producing multinationals on the market. They still pay a hefty yield and are as safe as any large-cap stock. In fact, these are good companies to buy if you’re worried the market will take another dive. They sell products, especially tobacco and alcohol, that history has shown people purchase no matter what the economic outlook. “These are consumer staples stocks,” says Sullivan. “People don’t stop drinking.”
While these companies can provide some safety today, sin stocks also have long-term potential. That might seem counterintuitive considering how restrictive North American tobacco laws are becoming, but outside this continent people still smoke like a five-alarm blaze. Charles Sizemore, the Dallas-based author of the Sizemore Investment Letter, says that as Asian populations acquire middle-class, North American tastes, they’re starting to buy more expensive cigarette and alcohol brands. There, the social taboo of smoking is non-existent.
“People don’t turn up their nose at a smoker,” Sizemore says. Quite the opposite; a brand-name pack of smokes, like Marlboro, is a status symbol. “It’s a high-status gift, like bringing a nice bottle of wine to an associate,” he explains. East Asians are also starting to buy brand-name Scotches and beers. Casino gambling is beginning to take hold as disposable incomes increase. In other words, more demand from emerging markets should keep returns robust.
While tobacco, alcohol and gaming all fall under the vice heading, each sector has its own characteristics. Keith Summers, a portfolio manager at Buffalo-based Tricoastal Capital Management, explains that there’s a hierarchy of sin when it comes to these stocks. Generally, the more damaging the vice is to the body, the better it is for the portfolio.
“Tobacco is the least admired because it kills people,” says Summers, “but the sector was up by 29% year-over-year.” It also has an average yield of 3.9%, and while North American sales are flat, it has the most emerging-market potential of the three sectors. “People say the whole sector is rife with litigation, and growth prospects will be blunted,” says Peter Anderson, chief investment officer with Boston-based Congress Wealth Management. “But when you step outside of North America, it’s a totally different picture.”
Alcohol is the second-most-attractive sector, with a recent 12-month gain of 7.6% and a 2.2% average yield. While it shares many of the same characteristics as tobacco—people drink as much, if not more, during bad economic times, and there’s emerging-market growth potential—Sizemore says the industry is in flux. As North Americans age, they’re drinking less beer and more premium whiskies and liqueurs. Developing countries are just now learning about American brands. To capitalize on these changing trends, Sizemore says to buy shares in a company that makes higher-end booze. A company like U.K.-based Diageo sells everything from Scotch and rye to Irish cream and vodka, and it owns many of the big brand names, such as Johnnie Walker and Smirnoff. “This is a great play for the next decade,” he says.
Gaming is a riskier sector than the other two, says Sullivan. It’s more susceptible to economic ups and downs—people have less money to gamble with during a recession—and the firms also have a lot of exposure to real estate. Anderson adds that many casino companies are over-leveraged. Still, gaming is booming in developing markets. Three of the top-five-biggest gaming companies are based in Asia, and the richer the population gets, the more it’ll gamble. Summers explains that investors need to be choosy when it comes to gaming. “It’s a more company-specific story,” he says. The sector didn’t do as well overall during the past 12 months, losing 1.6%, and the average dividend is 2.48%. But some individual companies saw huge returns, including Churchill Downs Inc., which rose 27% over the past year.
When it comes to buying a sin stock, dividend yield is more important than price-to-earnings ratio. While it is better to buy a low-P/E company over a high one, in today’s low-return environment paying a little more for a high-yielding investment can make sense. “Instead of growth at a reasonable price, it’s dividend at a reasonable price,” says Anderson. These days, even the sin sectors are more expensive than their historical norms. The gaming sector is cheapest, trading at 14 times earnings; alcohol and tobacco are trading closer to 16 times. But that doesn’t bother Sizemore, who advises looking for companies that pay more than the S&P 500 index, which yields about 1.9%. As well, buy companies that increase their dividends regularly, preferably on an annual basis, adds Anderson.
Investors should also pay attention to cash flow and debt. As with any large-cap purchase, cash flows must be stable. The cleaner the balance sheet, the better, says Sizemore. But a lot of these sin stocks do carry debt. That’s less of a problem in the predictable tobacco and alcohol sectors. It’s a bigger deal in the gaming industry, where cash flows are predicated on strong tourism seasons and a recovering economy. So, while a low debt-to-equity ratio is always better, it’s a must for investors buying into casinos.
More than dividends and debt ratios, though, owning brand names matters. “Between aspirational brands and discount brands,” says Summers, “you want the aspirational.” Consider the companies that own names like Wynn, Crown Royal, Marlboro and other recognizable labels to which status-conscious consumers in newly affluent countries will gravitate.
For people looking to buy income-producing investments, sin is in. “People wonder whether it’s a serious portfolio,” says Sullivan. “It’s very serious.”
Diageo PLC (NYSE: DEO)
Vice Fund manager Gerry Sullivan likes this London-based alcohol business because it owns a host of brand-name beverages. Crown Royal, Baileys, Guinness, Dom Perignon—the company sells all of them and more. Diageo’s also acquiring, most recently buying Meta Brewery, the second-largest beer seller in Ethiopia. Diageo’s 2.8% yield is attractive too.
Philip Morris International Inc. (NYSE: PM)
There are three reasons to own this famous New York–based cigarette company, says investment newsletter publisher Charles Sizemore: emerging-market growth, brand-name holdings and an attractive dividend. Philip Morris owns most of the big brands, including Marlboro and Virginia Slims. It’s these names that the growing Asian middle class wants to buy. It also pays an impressive 4% yield.
Wynn Resorts Ltd. (NASDAQ: WYNN)
Though synonymous with its home base of Las Vegas, Wynn Resorts is an emerging-markets play, says Sullivan. It owns two of the world’s top five casinos based on market share, including the Wynn Macau casino in China. Opened in 2006, Wynn Macau is already raking in the dough. The casino’s revenues increased 41.7% year-over-year in Q3 2011 and brought in more money than its legendary Las Vegas counterpart.
Molson Coors Brewing Co. (NYSE: TAP)
Many Canadians buy this Denver-based company’s beer, but it may be better to spend the money on the stock. Portfolio manager Peter Anderson likes the business because it’s large and stable. Molson Coors won’t give you much growth, but you will earn a solid 2.2% yield. The company recently made analysts happy by announcing a $1.2-billion stock repurchasing program, plus it’s cheaper than many other alcohol companies, trading at 13 times earnings.
Brown-Forman Corp. (NYSE: BF.A)
Investors will instantly recognize Brown-Forman’s brands. The Louisville, Ky.–based company owns Jack Daniels, Canadian Mist and Southern Comfort. At 1.7%, the yield isn’t as strong as it is for other alcohol companies, but Anderson expects share repurchases and dividend hikes this year. In December, the company announced that in Q2 2011 it surpassed $1 billion in sales for the first time ever.