Category: Personal Finance

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

Diversification: A look at Ray Dalio’s All Weather Portfolio and the place for fixed income in the portfolio

After reading Principles, by Ray Dalio, this past winter (which I highly recommend as it gave me many, many things to think about) I have been reconsidering my position on being highly underweight fixed income. Perhaps you are similar to me and kept waiting for rates to move up for an attractive entry point.

Now the ten year treasury is hovering around 3% and as I noted previously, is not that far off from long-term averages. Does it make sense to allocate more of our portfolios to fixed income now?

Perhaps you have heard of Ray Dalio’s “All Weather Portfolio” in which he allocates a surprising amount to fixed income, as shown below. His rationale centers on a few factors. One is that by having weighting your portfolio at 80% stocks / 20% bonds is actually heavily weighting “risk”, given the volatility of stocks vs. bonds and for someone like Ray Dalio who is trying to build wealth over the long, long term, performing well in down markets matters. Bonds should go up when stocks go down due to “flight to quality” impact in a down market. The allocation to gold and commodities provides extra diversification, plus these assets perform well during periods of high inflation, whereas bonds will not perform well.

  • 40% long-term bonds
  • 15% intermediate-term bonds
  • 30% stocks
  • 7.5% gold
  • 7.5% commodities

“The principles behind All Weather relate to answering a deceptively straight-forward
question explored by Ray with co-Chief Investment Officer Bob Prince and other
early colleagues at Bridgewater – what kind of investment portfolio would you hold
that would perform well across all environments, be it a devaluation or something
completely different?”

The results are pretty surprising. Dalio says he’s back-tested the portfolio from the great depression, to the Weimar Republic when hyperinflation set into Germany. If you choose not to read Principles, then I implore you to read the white paper on Bridgewater’s website on the background of the strategy.

Using portfoliovisualizer.com, I decided to see the results for myself and ran different 3 portfolio cases from 1978-2017.

The first is based on Dalio’s All Weather portfolio, though admittedly, I had to do a 15% allocation to gold as a general commodities fund was not available that far back. I then ran a 60% stocks / 40% intermediate treasuries portfolio and then an 80% stocks / 20% intermediate treasuries portfolio.

Let me first say that it shouldn’t be too surprising that the higher stock portfolio wins out. Stocks have been a terrific asset class over this time period. Its higher risk, so higher return makes sense.

But look at the results of portfolio 1, the All Weather Portfolio. Results over this time period are not too shabby, logging a 9.4% CAGR and growing $10K to $380K. But the really interesting thing to me is the worst year and worst drawdown. The worst year was only down ~4%! Compare that to the stock heavy portfolio of -25% and having a near 40% loss in portfolio value during the year. Makes me think of “Slow and steady wins the race”

PV All WeatherPV ALl Weather Chart

This analysis isn’t perfect for a host of reasons. Bonds have been in a bull market for 30 years and were at much higher rates during this time period and subsequently went way down. I do like a quote from the white paper though, in which it states,

“In the US after peaking above 15% in the 1980s, cash rates are now zero. Stocks and bonds price relative to and in excess of cash rates. A 10-year bond yield of 2% is low relative to history but high relative to 0% cash rates. What is unusual about the recent environment is the price of cash, not the pricing of assets relative to cash.”

For further analysis on portfolio outcomes that aren’t tied to back testing, I decided to build a monte carlo spreadsheet analyzing a 50/50 portfolio of stocks and bonds. I then ran 10 random simulations over 40 years to see where the portfolios would shake out. This was pretty simple analysis and I probably should’ve added a component that says, “if stocks are down, then bonds are flat or up”, but decided to keep it random.

Given how high the standard deviation is for bonds, it is no surprise that the highest returning situations are driven by bonds outperforming, but we should also not ignore the simulations where in year 38 out of 40, stocks fall 45%, as shown in scenario 3. Bond provide decent offset to a devastating scenario.

Monte Carlo assumptions

Monte Carlo

I think the takeaway I have is that bonds / fixed income can make sense in the portfolio, depending on what you buy. So far, all I’ve shown is buying treasuries, but think there are solid opportunities in high yield and municipal bonds which are much more stable than stocks, but provide good returns.

I’ll follow up in another article on a bond fund that I think makes a lot of sense to buy for a pretty attractive return.

-DD

Is it time to rotate into consumer staple stocks? (And a digression on interest rates)

Consumer staple stocks had a great run following the Great Recession. It makes some intuitive sense. Bond yields were forced to at or near zero, which meant investors had to push out into the risk spectrum in order to hit their prior return thresholds. If you can’t get a 5%-7% return via bond yields, then maybe buying very stable high dividend stocks makes more sense. As a result, utilities, REITs, and consumer staple stocks all enjoyed high returns.

That is, until bond yields recently broke out following the passing of the Tax Plan in 2017, which was a strong form of fiscal stimulus. Yields on the 10yr broke out from their stubborn below-2.5% band and finally topped 3%. This 3% threshold number doesn’t necessarily mean anything,  but the market tends to focus on round number (e.g. DOW 20,000! – new market top!). The quick rise (or fall in bond prices since they move inversely) was really more of a sign to investors that the era of ultra low interest rates may be coming to an end.

I10YTR_chart

As a result, investors extrapolated the recent news into the future and sought to get out of the way of rising interest rates. As a result, they also sold off the bond proxy sectors. They also may have moved back into some fixed-income investments that became more attractive. As shown in the next chart, it is interesting how similar the charts are for these sectors when compared to the 7-10 year treasury stock chart shown in the bottom.

I10YTR_XLP_XLU_RWR_IEF_chart

Is this warranted? Is it time to step into one of these sectors? I would argue it is, though I would try to be choosy. Utilities still seem just too expensive to me. These are highly regulated industries that obviously provide stable cash flow and high dividends, but little opportunity for upside. I also just find the yields offered by REITs just isn’t that great for what you get for a cyclical industry (although admittedly the spread between REIT yields and treasuries is wider than average).

There is one thing I’d like to address before we get to consumer staples: 1) No one can predict interest rates and 2) investors should separate what the Fed is doing with what long-term interest rates are doing.


I’ve been hearing interest rates are “definitely going up” for about 10 years now. Even pre-crisis, people were saying interest rates were too low (relative to long term history).  But in recent memory, remember at the end of 2013 when the yield on the 10 year ended at 3% (following the “taper tantrum”) and subsequently went as low 1.6% in 2016? Rates really haven’t gone up that much despite the fiscal deficit and inflation fears.

If you had to guess, no, if you had to invest your portfolio on it – where do you think long-term interest rates will settle at? 4%? 5%? Higher? What do you think the long-term rate has actually been? I’d actually like for you to guess that in your mind before reading further….

The long-term average from 1900 is…. 4.69%. But that also includes some significant outliers, so when we look at the median, its actually 4.02%. BUT… that also includes the 1980’s. Really when you look at the long-term, it actually just seems like the 1980’s and ’90s were the outliers… but either way, do you think 4% vs. 3% changes the calculus much for equity valuations? Probably some, but not as dramatically as I’ve heard pundits call for (I actually did a simple DCF of a 0% growth company. The equity valuation moved lower by about 8% when the discount rate went up 1%, to 11% from 10%. However that could already be priced into a stock / stocks).

10 yr treasury

This all brings me to my second topic on interest rates, that I hear quite often as well: “The Fed is raising interest rates so rates are definitely going up.”

Well, hold on now. Didn’t I just mention the 10 year was at 3% in 2013? At that point, the Fed was still buying $85 Billion in bonds each month and its balance sheet swelled to $4.5 trillion (from $0.8 trillion pre-crisis) and kept the fed funds rate at zero in order to stimulate growth. And yet, here we are with that bond buying spree over and the Fed raising the Fed Funds rate and as of today the 10 year sits at 2.88%.

So what gives? One, NO ONE can predict interest rates. And the Fed generally signals very clearly what is planning on doing, so don’t think additional rate rises aren’t priced into the market.

So many factors come into play with interest rates. The main reason pointed to these stubbornly low interest rates has been stubbornly low inflation. That why the Fed has been doing what its doing. However, demographics and even technology play a role in inflation. As noted in an ECB report,

“When the working-age population shrinks and life expectancy increases, the number of wage earners relative to the total number of consumers is expected to decrease. The longer retirement period incites households to save more to smooth out consumption in the future. This puts downward pressure on the equilibrium real interest rate.”

This could be one reason why our inflation and interest rates remain low in the US as the baby boomers age. Another topic I want to make clear is that the Fed impacts the Fed funds rate. This is different than the long-term treasury rate.

The Fed Funds rate is the rate at which banks will lend to each other overnight, so it is very short term. Therefore, it effects other short-term rates as well, like T-bills, since they are substitutes for lenders. That can have an impact on similar tenors of bonds. The Federal Reserve of St. Louis describes it as such:
Fed Funds

“Given that movements in the fed funds rate are closely linked to movements in short-term interest rates, but less so to movements in long-term interest rates, changes in the policy rate are likely to impact the yield curve.”

If the past is any evidence, the projected increase in the fed funds rate will successfully raise short-term interest rates but have a limited impact on long-term interest rates. This will imply a reduction in the term premium for bonds and loans.

These observations rely on the Fed not letting inflation stray significantly away from its annual target, which has been set at 2 percent. It is thus likely that, despite the continuing rate hikes, the government, firms and households will all continue to enjoy historically low interest rates on their long-term liabilities.”

That leads us to the current situation, where the yield curve is very flat. That is, the difference in yield between the short-term rates and long-term rates is pretty low. This has historically preceded recessions in the US, though is not perfect. And to be clear, I don’t think we are going into a recession this year.

Yield Curve - flat

Unemployment is low which imply less slack in the system, so why do long-term rates refuse to move? No one knows for sure, but one reason could be that long-term investors are not convinced inflation will be a strong as people suspect. In fact, if inflation moves to 3%, holding a 3% 30-year treasury bond would be a real-yield of 0%


So quickly back to consumer staples stocks. Is it time to move back in? I will try to address that in future, company-specific write-ups, but if you are thinking of avoiding the sector now because of interest rates, I hope this write-up challenges your assumptions.

These are generally high-margin sectors that grow very consistently and generate good FCF. There is some disruption going on, but its nothing in the context of the tech sector. At ~15x forward earnings, the sector now appears cheap and I’m thinking of adding to the sector, but will be avoiding more challenged names. For example, before Campbell Soup’s sell off, it was clear that they’re organic trends were challenged and consumers are avoiding high sodium foods. There’s chatter that they may be bought out by Kraft-Heinz, a name I will be doing work on, but for now I’ll pass on Campbell.

Anyway, I digress. Let me know what you guys think

-DD