Profiting From Vice

Vices such as tobacco, alcohol, and gambling will always be in demand, because no matter what difficulty the economy finds itself in, people will always drink alcohol, smoke and gamble. Furthermore, with human nature and geopolitics as what it is, national security will remain a perennial concern.

The defence industry can therefore look forward to a benign future. In a thought provoking book, titled ‘The post American Word’ by Fareed Zakaria, he describes how the forces of global growth are potentially turning into the forces of global disorder and disintegration. As the economic fortunes of developing countries rise, so does nationalism. Understandably, countries will feel more confident to extend their reach and exert power abroad. And with the march towards a globalized world, most problems will spill across borders. The need for cooperation is greater, yet as nation states grow in power and confidence, the prospects for agreement are diminishing. Therefore the bullish argument for aerospace and defence remains firmly intact.

Sin stocks are seen as the epitome of defensive investments. Their recession proof characteristics are made more attractive by the fact that most of the developed world is on the cusp between modest growth and recession. John Authors’, FT’s long view investment writer, estimated for 2012 a 70% likelihood of a “crab” market, which moves sideways through high volatility. The recent market rally he believes is driven chiefly by the two ‘longer-term refinancing operation (LTROs)’ by the European Central Bank. The LTRO is essentially a cheap loan scheme for European banks. John Anther’s believes this liquidity fuelled rally lacks conviction, and rests on shaky foundations. He justifies this with low trading volumes, the large amounts of cash waiting on the sidelines and no great switching into equities by fund managers. With markets caught in a ‘crab-like pattern’ and fragile economies facing years of sluggish weak growth, vice stocks are an ideal protection against future downturns and uncertainties.

Characteristics of sin stocks

Companies providing alcohol and tobacco usually have strong cash flows and robust balance sheets. They have a steady demand for their goods and are generally insensitive to economic downturns, the likelihood of which remains high in this environment.

Alcohol, tobacco, arms industries have high barriers to entry. These are the result of economies of scale, strong brand loyalty and strict government regulation. Tobacco and alcohol in particular are consistently profitable, due to high pricing power and low production cost. In the US for example, a pack of cigarettes cost just under 30 cents to produce. Because the government are such large beneficiaries from these businesses, they have a financial incentive to see these businesses do well and stay around.

Gaining exposure

British American Tobacco, the world’s second largest tobacco company by market share, would be an ideal sin stock, although the valuation at present looks a little pricey. Tobacco companies have been facing smoking bans and poor health publicity in the developed markets, but they are persistently seeking new opportunities in the emerging markets, which today account for 70% of cigarette growth. This offsets the stagnating demand in the developed economies.

For alcoholic beverages companies, the key driver will be emerging market growth. Companies with strong brands and distribution such as Diageo (maker of Johnny Walker and Smirnoff vodka) will be ideally positioned to grow in these markets. Just over 33% of their sales stem from the emerging economies, they are targeting sales of 50% in the emerging markets in five years time. Again valuations look inflated, and it would be wise to drip-feed cash into the crab like market at a lower price.

Alternatively, investors could gain exposure through investment funds. One such example is ‘Invesco Perpetual High Income Fund’, managed by Neil Woodford, who’s been described as one of the best fund managers in the UK today. This fund has Tobacco companies and Defence contractor BAE as their top holdings. For international exposure, I would recommend Newton Global Higher Income Fund, managed by James Harries. Global tobacco companies are also included in his top holdings. Both funds are included in Investment broker, Hargreaves Lansdown’s ‘wealth 150’; this is what they have identified to be the best 150 investment funds. They achieved this through a rigorous selection process using both quantitative and qualitative analysis.

This is a politically incorrect and controversial area to invest in. But from an investor’s perspective, vice is good because you can be sure your sins will be paying a handsome reward!

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