To the extent that you can actually remember anything about it, think back to the last bachelor party you went to. Look around the room. OK, peel your brain away from the stripper, and what do you see? Bourbon? Cigarettes? A bunch of guys losing their shirts at a blackjack table? There’s a good chance you and your buddies dropped a lot of cash in a short period of time. Here’s your chance to win it back.
Your loss, of course, is someone else’s gain. So if only you could invest in, say, bourbon, cigarettes, and blackjack, it’d be a good move, right?
A recent academic study suggests the answer is yes.
Now, we’d never, ever, endorse the use of products that destroy your body, especially cigarettes, perhaps the most odious consumer good ever conceived. But we do endorse sound financial health, and even we couldn’t ignore a stunning chart by Credit Suisse comparing stock performance by various industries from 1900 to 2014. For a baseline, know that a dollar invested in the stock market back at the turn of the previous century would have grown to $38,225 by last year. Not bad. But one industry crushed all the others: Big Tobacco.
A dollar invested in smokes then is a whopping $6.2 million today. Why? Well, if a company or industry is popular, then investors will bid up the price of the stock. And the biggest predictor of future returns is current valuation. The lower the value relative to earnings, the higher it can go in the future. So, while popularity pays off for a time, eventually even the hottest companies either disappoint or fanboy investors bid up the price beyond their ability to deliver profits.
Tobacco, however, was viewed with suspicion long before people knew it was deadly. It faced various social stigmas. In 1900, the Supreme Court upheld a Tennessee law banning cigarette sales, citing the suspicion they were laced with drugs; in 1950 three medical studies linked smoking to cancer. So enough investors shunned the stocks for various reasons that they were almost always cheaper than they should have been based on the firms’ earning potential.
And cheap stocks often pay nice dividends. (A stock that pays $1 in dividends each year yields 10% to investors who pay $10 per share. If the shares run up to $20, however, that $1 dividend is just 5% of the share price.) Thanks to their scruples-depressed price, tobacco stocks have traditionally given shareholders generous annual payouts—which, when reinvested, compound returns.
And it’s not just tobacco. It turns out this phenomenon plays out across a whole Vegas-esque portfolio of vice. The authors of the new study, a trio of London Business School professors, found that “sin pays”—basically because these companies, according to the professors, have steady demand from customers all around the world in both good times and bad. They tend to earn high profits and boast what Wall Street calls “high barriers to entry,” meaning, it’s no simple matter to launch a casino or a distillery. And despite all these attractive qualities, enough investors avoid the stocks that their share prices remain attractive.
Fun With the Vice Fund
The professors were not the first ones to notice this phenomenon. In 2002, an intrepid investor launched the Vice Fund, a mutual fund that holds a bachelor-party portfolio ranging from MGM Resorts and Las Vegas Sands to Brown-Forman and Anheuser-Busch to the Marlboro Man’s parent company, Altria. Ensuring an even wider group of people will be offended, Sturm, Ruger & Co., a firearms manufacturer, also has a place in the portfolio.
The professors compared the returns of the fund with the Vanguard FTSE Social Index Fund, which shuns such companies and instead holds shares in firms screened for meeting socially responsible criteria ranging from human rights to environmental concerns. Such things as gambling, guns, and adult entertainment don’t make the cut.
After 12 years, an investor who’d parked $10,000 in the socially responsible fund in 2002 had a clear conscience and $26,788. The fun-loving fellow who’d gambled on the Vice Fund saw his stake grow to $33,655, according to the study. And here’s a nice bit of irony: The socially responsible investors are inadvertently helping the sin portfolio outperform, the professors say. By shunning those stocks, they contribute to their lower valuation, giving an advantage to other investors who can then buy in at a lower price.
Yet despite this great record, investors haven’t flocked to the fund. It holds just $275 million, fairly meager for a 14-year-old market-beating fund. Which may just prove the point: If investors were eager to join the party, the very phenomenon that makes it work might disappear. The fund changed its name last year to the USA Mutuals Barrier Fund. Maybe that will help with marketing.
How to Capitalize on Sin
If they were so inclined, the easiest way for investors to add some sin to their holdings would be through a portfolio such as the Barrier Fund (VICEX). The Rydex Leisure Fund (RYLIX) also owns a lot of vice, but Disney is its top holding. In both cases you’ll pay a fairly high expense ratio of more than 1%, which means the fund has to beat the market, on average, by more than that each year.
You can buy individual stocks—Altria, Lorillard, and Reynolds American all pay dividends of close to 4%, and the Las Vegas Sands, which earns half its revenue in the Asian gambling mecca of Macau, yields nearly 5%. The trade-off is a lack of diversity: One crooked CFO or a few adverse court rulings could torch your investment.
Now, I’m not suggesting you dump all your retirement savings into sin stocks. For starters, they can be volatile. China’s recent crackdown on corruption, for example, has hammered gaming stocks with exposure to Macau. Budweiser and Heineken are feeling the heat as beer drinkers switch to craft IPAs and Maker’s Mark.
Most important, you shouldn’t put all your chips in just one industry or even group of industries. The core of your retirement savings should be invested in low-cost index funds that give you exposure to the entire stock market, here and abroad. There’s overwhelming evidence that indexing beats stock picking, and last year 80% of actively managed stock funds did worse than the market, including the Vice—I mean Barriers—fund.
Still, there’s also a broader investing lesson here, useful even if you avoid “sin stocks” on principle: The only way to beat the market—and it’s not easy—is to go against the grain. Warren Buffett says to buy fear and sell greed—in other words, to buy when the market is plummeting and sell when it’s run up. Others look for out-of-favor sectors—home builders, for instance, were cheap during the Internet bubble. Some investors searched through the ruins for energy stocks after the price of oil plummeted this past winter. Eventually, such bets pay off, but they take a strong stomach. And when they get popular, as home builders did in the housing bubble, you may need to sell.
The nice thing about sin is that it’s been out of favor for 114 years. I’ll drink to that.