Why do “sin” stocks outperform?

Do you know what the best stock of all time is? You may be surprised to hear its a business in a secularly declining industry.

It’s Altria – the tobacco company that owns Philip Morris. Take a look at the returns on that one!

Altria

Altria isn’t the only “sin” stock that’s performed well. Sin stocks are stocks of companies that benefit from human vices, such as alcohol, fire arms, gambling, and tobacco. As shown below, I picked a few of these sin stocks and plotted them against the S&P500 over the past 10 years. Those stocks are:

  • Altria – Tobacco
  • RCI – Strip Clubs
  • Anheauser-Busch – Alcohol
  • Diageo – Alcohol
  • Wynn Resorts – Casinos
  • Las Vegas Sands – Casino

SIN Stocks Returns

Note, the chart above is total return so it includes dividends, which I think is important given sin stocks typically have high payouts.

So what gives? I know plenty of people who have invested in the next social benefit (such as solar or water infrastructure) and lost money. One theory of why socially-beneficially stocks under perform is that they try to do good, but do not do it well.

But in my opinion, and what has been discussed elsewhere, the reason why sins stocks outperform comes down to 4 factors:

  • operate in monopolistic¬† or oligopilistic markets
    • Consider cigarette companies which were told they could no longer advertise via new regulation. That essentially eliminated their marketing teams, increasing earnings and cash flow, but also eliminated any new entrants into their space (i.e. if you can’t advertise, you can’t enter)
  • managers may overlook them or underweight them
    • One theory that is that fund managers underweight sin stocks or simply avoid them in order to please their shareholders or their own ethics. In essence, by all the socially responsible funds avoiding these stocks, they make them cheaper at the same time.
  • they also happen to be “bond proxy” stocks
    • As interest rates fell from all time highs in the 70s & 80s to essentially zero following the Great Recession, stocks that are “bond proxies” performed demonstrably well. These sectors include utilities and consumer staples.¬† Sin stocks (outside of casinos) are also very stable businesses and have nearly inelastic demand. As such, as investors were pushed out of bonds and into stocks, these stable businesses with high dividends were solid opportunities.
  • there may be an embedded risk premium
    • Similar to the “avoiding” bullet above, financial theory would tell us that the because there are lots of funds out there that actively avoid these stocks, that should drive the cost of capital up for sin stocks (and drive it down for non-sin stocks). As a result, investors expect a higher return given the elevated risk premium.

To be clear, I am not advocating that you invest in these companies, but I find it fascinating and not something that one would necessarily expect. I also am always trying to understand any biases I may have that prevents me from generating the best returns I can.

-DD

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