SIN STOCKS: AN INVESTOR’S GUILTY PLEASURE?

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Executive summary

Investors have one goal in common and that is maximizing their return for a particular level of risk. In their search for maximizing return some investors feel drawn to so-called sin stocks. A sin stock commonly refers to a publicly traded company that is either involved in or associated with an activity that is considered unethical or immoral like alcohol, tobacco, gambling, sex-related industries, weapons manufacturers and more recently marihuana. Different caveats with this definition are discussed in the article.

There are only a few funds known that openly invest in sin stocks. Examples of these are AdvisorShares Vice ETF, Alternative Harvest ETF and the USA Mutuals Barrier Fund. One of the popular arguments pro sin stocks investment is the predictability of their consumers. Smokers will smoke. Another reason is the cash generating position of these companies thanks to their long-established reputations. Another popular argument is that sin stocks are likely to be undervalued because analysts and institutional investors do not want to be associated with the activities of these firms. Finally, yet importantly, the growth of emerging markets might have a positive impact on the consumption of for example alcohol, cigarettes and casino visits.

Scientific research may shed some new light on these popular explanations. Using the 5-factor model of Fama & French, Blitz & Fabozzi (2017) show that the sin premium entirely disappears when not only controlling for the traditional factors as momentum, size and value, but also for profitability and investment. Other research shows however that there might also be a link between lobbying expenditures and legal and cultural characteristics of countries and sin stock returns.

To conclude, solving the sin stock anomaly is a complex puzzle of which some pieces possibly are still missing. More research with a strong design and methodology are required. Furthermore, the definition of sin stocks or unethical investments is a subjective matter and so is the choice whether to invest in these types of securities. Investors should have the freedom to make their own investment decisions and transparency about the financial products they are offered is key.

 Introduction

Investors have one goal in common and that is maximizing their return for a particular level of risk. The world of investing is however a complex place with an overwhelming choice to invest in and one size does not always fit all. For instance, one can choose between different types of asset classes: equity, fixed income, commodities, derivatives and so on. Subsequently, once decided in which asset class to invest, one must make a decision in which financial instrument to invest. For example, within the universe of the asset class “equity”, stocks are often clustered according to their industry or sector: tech stocks, automotive stocks, bank stocks, pharma stocks, airline stocks et cetera.

Investment decisions are driven by many different factors like an investor’s budget, economic climate, legal constraints, investment horizon and so on, but not the least personal preferences. A full discussion of all these factors falls outside the scope of this article. Regarding investor’s preferences however, ethically and socially responsible investments (SRI’s) are a hot topic in finance nowadays. More and more companies and investors are increasingly becoming aware of the environmental and social impact of their business. 

In contrast to SRI’s, in their search for return some investors feel drawn to “the stocks you don’t want your mom to know about”, as “sinstocksreport.com” call them. In short, a sin stock commonly refers to a publicly traded company that is either involved in or associated with an activity that is considered unethical or immoral. Potentials caveats with this definition will be firstly discussed. Secondly, at first glance there seems to be a case for the success of these controversial sin stocks. Is this apparent outperformance however legitimate? Or is there more than meets the eye? In an attempt to answer these questions, let us take a look today on the dark side of finance.

 Definition and the problem of categorization

According to the literature, there are large differences in the definition of sin stocks. Below contains a compilation of various definitions found on the Internet. Sin stocks (also called “vice stocks”) are often referred to as publicly traded companies that are either involved in or associated with an activity that is considered taboo, prohibited, or highly restricted, and perhaps a social stigma attached to it. Sin stocks are generally found in sectors that deal directly with activities that can be perceived as making profit from exploiting human weaknesses and frailties. Traditional sin stock sectors usually include alcohol (i.e. companies that make and sell beer, wine, liquors…), tobacco, gambling, sex-related industries, weapons manufacturers and more recently marihuana.

The following reservations need however to be taken into consideration. Sin stock investing is not necessarily the opposite of ethical or socially responsible investing where the goal is to seek out investments that yield an overall benefit for society. Ethical investors create their own ethical definitions that may or may not include some or all sin stocks. Essentially, sin stocks can be difficult to classify with any certainty as it depends on an investor’s individual feelings towards an industry. For example, is a share in a company based in a country with a history of human rights violations a sin stock? In other words, whether or not a stock is considered as sinful strongly depends of the moral code of the investor on the issue.

Political leanings can also influence what is considered as a sin stock. For example, some investors will include all military contractors, while others may consider supporting the military a patriotic duty. In addition, taboos change constantly so a sin stock from yesterday may not be a sin stock tomorrow. Finally yet importantly, it can be argued that categorizing some stocks or sectors as “bad” or “sinful” can lead to conclude that some “non-sin” stocks are good in comparison, when they might actually be associated with controversy. For example, although Coca-Cola is typically not seen as a sin stock, questions can be raised about their mass production of plastic bottles and the impact of this on the environment. Or can McDonald’s be considered as a sin stock because of the obesity epidemic? In short, the name “sin stock” can mean different things to different people. In the next paragraph, some common arguments in favour of these stocks will be reviewed.

 Why sin stocks?

There are only a handful of exchange traded funds (ETF’s) that invest in sin stocks. An example is AdvisorShares Vice ETF that was launched in 2017 and invests solely in US-listed companies that generate at least 50 per cent of their revenue from alcohol, tobacco and cannabis. Another example is ETFMG’s $1.2bn Alternative Harvest ETF which invests in cannabis companies. The USA Mutuals Barrier Fund (VICEX) is another explicit vice funds. It primarily invests in, but is not limited to, the Aerospace/Defense, Gaming, Tobacco, and Alcohol sectors in both domestic and foreign markets. According to Jordan C. Waldrep, portfolio manager of VICEX, there are several reasons why vice investing makes sense in the long run.

The first argument he states is value. According to Waldrep vice companies are often relatively cheaper. “They are often financially sound, well run businesses with strong positions in their end markets. Yet, these companies create products frowned upon by society, and as a result, they are often ignored by significant portions of the investing community.” Some research indeed suggests that sin stocks are likely to be undervalued because analysts and institutional investors do not want to be associated with the activities of these firms. However, this doesn’t necessarily mean that sin stocks are therefore cheaper than the overall market, he says. They just tend to be relatively cheaper than their intrinsic value, Waldrep argues.

A second argument in favour of sin stocks is predictability: vice companies tend to have more predictable customers. “Smokers buying cigarettes, drinkers at happy hour and governments ordering airplanes to name a few”, Waldrep says. In other words, thanks to relative price inelasticity of demand for these type of products, sin stocks are traditionally considered to be recession-resistant and can be a savior when the mainstream market dips. “Skilled investors think about risk all the time”, Waldrep explains. “What risk really comes down to is uncertainty. Vice companies carry the same general level of risk as the rest of the stock market, but the predictability of these consumers means there is potentially less uncertainty AKA less risk.” Other proponents refer to academic research proving how uncorrelated these stocks are with the rest of the market which can provide the opportunity for above-market returns (Troberg, 2016; Fabozzi & Ma, 2008; Salaber, 2009).

Third, vice companies often operate as growing cash cows. “Cash cows are typically companies that produce large amounts of cash and have stopped growing”, Waldrep states. The latter however is not necessarily true for vice companies as there might be still significant growth opportunities, he argues. “As for culturally established positions in the market, go to a bar and listen to people order drinks. You’ll be surprised how many orders involve specific brands that the customer can name without looking at a menu once.” Thanks to their long-established reputations, these companies can demand a premium price. In turn, generated cash could be used to build new factories, pay a strong dividend or buy back stocks, according to Waldrep.

Fourth argument is the growth of emerging markets. “At first, the emerging markets were about buying cheaper products at your local store that were ‘Made in China.’ However, the story has moved onto its next stage, where consumers overseas are responsible for a larger share of global consumer growth”, Waldrep argues. As emerging market consumers make bigger incomes, they will potentially consume more alcohol, smoke more cigarettes or visit casinos more often. Consequently, vice companies have an opportunity to grow and benefit for a long time from this expanding global consumer.

               As an example, below figures show the growth of USD 10.000 & annual returns of the VICEX against the S&P 500 Index from April 2002 until end of June 2019:

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In line with what has been discussed, at first glance the VICEX outperforms S&P 500 for most of the years. During and after the big financial crisis in 2008 and 2009 the fund performed significally lower than S&P 500. This observation doesn’t support the conviction that these stocks are recession-resistant. In 2018 and the beginning of 2019 the fund also shows an underperformance relative to S&P 500. In the latest annual report several reasons for this underperformance are given. In the overall market, the strongest performing sector was firstly Real Estate, followed by Information Technology and Health Care. Given some specific challenges every vice industry underperformed the market, especially Gaming:  “… the long-term growth in the China region brought pressure on shares both domestically and abroad despite relatively positive news from Japan (casino legislation) and the U.S. (sports betting)”, as written in the report.

Past these popular explanations, what is the outcome of scientific research on this so-called sin premium?

 

Scientific research and sin stocks

Using the 5-Factormodel of the two famous economists Fama and French, research of Blitz and Fabozzi (2017) may shed new light on previous conclusions. For a better understanding of the the results of their study, let’s first go back to basics by refreshing the principles of the Capital Asset Pricing Model (CAPM). An extensive theoretical explanation of CAPM, the 5-Factormodel, and their shortcomings are however out of scope of this article. To summarize, CAPM uses the principles of Modern Portfolio Theory to determine if a security is fairly valued or priced. More specifically, it describes the relationship between market (or systematic) risk and expected return for assets, particularly stocks. The formula of CAPM for calculating the expected return (ER) of asset i given its risk is as follows:

ERi = Rf + βi (ERm-Rf), 

whereas ERi is Expected return of investment i, Rf is the Risk-free rate, βi is Beta of the investment, ERm is the expected return of the market and (ERm-Rf) is the market risk premium (i.e. the expected return of the market minus the risk free rate). β reflects a stock’s reactivity to market movements, it’s the covariance of stock i with the market. If the market goes up with 5% and stock i with 10%, β equals 2.

Fama and French developed in 1992 a 3-Factor model to expand the original CAPM. In their 3-Factor model, Fama and French added additionally to market risk β, size and value as explanatory variables. In short, this model considers the fact that small-cap and value stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for this outperforming tendency.               In 2015, Fama and French added two other factors to their original model: profitability and investment. The formula of their 5-Factormodel is as follows:

The profitability factor implies that stocks of profitable companies perform better. The investment-factor was included to adjust for the underperformance of stocks of companies directing profit towards major growth projects.

Controlling only for the traditional factors, various studies have investigated the historical performance of sin stocks and observed that they have delivered significantly positive abnormal returns (Blitz & Fabozzi, 2017). Using the 5-Factormodel, research of Blitz and Fabozzi (2017) shows however that the key to explaining the sin stock anomaly might be found in the latter two factors, profitability and investment. In line with previous scientific research they find that sin stocks show a significant outperformance in American, European and global samples using long-term sin stock return data (July 1990 – December 2016). However, this sin premium entirely disappears when not only controlling for the traditional factors as momentum, size and value, but also for the two new factors profitability and investment. As previously discussed, profit margins of for example tobacco producers are usually high given that demand is relatively inelastic and given that their cash generating position allows them to (re)invest in their business.

Blitz and Fabozzi conclude that there is no prove for a specific sin premium as the performance of sin stocks is fully in line with their exposures to factors included in current asset pricing models. Adamsson and Hoepner (2015) also argue that the apparent return on vice stocks found by an influential study of Hong & Kacperzyk’s (2009) is an illusion created by research design, statistical inaccuracies and that it’s not representative for the real investment world. For example, the sample included predominantly US sin stocks and for most of the stocks in their sample common investment criteria like market capitalisation, liquidity and trading volume were not taken into account. Adamsson and Hoepner (2015) further state that an equal-weighted portfolio of sin stocks was compared against a value-weighted market benchmark and no sub-sample analysis between 1965 and 2006 was conducted, so any outperformance could have stemmed from decades ago.

 

Discussion
Blitz and Fabozzi conclude that the fact that there is no sin stock anomaly does not imply that such an exclusion policy has no effects on performance. As long as sin stocks have positive exposures to factors that are rewarded with positive premiums, their raw expected return remains higher than that of the market, and therefore excluding these stocks will have a negative impact on raw expected portfolio return, the authors argue. Which lessons can investors take from these findings?         

Blitz and Fabozzi suggest that if we can trace the outperformance of sin stocks to exposures to certain factors, investors may restore their portfolios’ expected return by making sure that the portfolios’ factor exposures do not deteriorate when excluding sin stocks. “Investors could increase the weights of stocks that are able to compensate for the loss in factor exposures that results from excluding sin stocks—that is, by investing more in non-sin stocks that have exposures to the same factors that drive sin stock returns”, Blitz and Fabozzi argue. In other words, investors that prefer to avoid investing in sin stocks can replace them by other stocks with high exposure on Fama & French factors, especially the factors profitability and investment. One possible win-win solution could be to seek for green or ESG (Environmental, Social and Governance) stocks that show a high exposure on the discussed five factors. Results of a study of Harvard Business School show that companies that perform high on sustainability can be a profitable investment.

It’s interesting however to take the following into consideration. In his review on existing research on the sin premium, author Larry Swedroe argues that as more investors express their personal beliefs through their investments, by among other things shunning sin stocks, it seems likely their prices would be further depressed, further raising their forward-looking return expectations. This possibly means that the sin stock premium could not only persist, it could increase, and the investment and profitability factors may no longer be able to fully explain sin stocks’ returns, he concludes. Other recent research shows that indeed other factors might be into play that can possibly explain the outperformance of sin stocks. Ghouma and Hewitt (2019) show that there might be a relationship between lobbying expenditures and the market performance for sin stocks. Using a sample of US listed sin stocks the authors find evidence that firms in controversial industries spend more money on lobbying. They further find that lobbying sin stocks show higher average annualized returns than non-lobbying sin stocks and a higher return compared to a benchmark of non-sin stocks. Other interesting research of Salaber (2017) shows that there might be a link between sin stock returns and legal and cultural characteristics of countries. For example, Salaber finds that Protestants are more "sin averse" than Catholics and require a significant premium on sin stocks. She also finds that sin stocks have higher risk-adjusted returns when they are located in a country with high excise taxation and that sin stocks outperform other stocks when the litigation risk is higher, even after controlling for well-known risk factors such as market capitalization and book-to-market ratio.

 Conclusion

To conclude, solving the sin stock anomaly is a complex puzzle of which some pieces possibly are still missing. More research with a strong design and methodology are required. Furthermore, the definition of sin stocks or unethical investments is a subjective matter and so is the choice whether to invest in these type of securities. The most important here is due diligence. In line with the principles of MIFID II, investors should have the freedom to make their own investment decisions and transparency about the financial products they are offered is key. The challenge nowadays however is that green investing is booming and almost every listed company has a chapter in their annual report about how incredibly responsible they conduct their business. There is also the risk of greenwashing, which means that companies present their business as “greener” or more socially responsible than it really is. Acknowledging the importance of a clear definition of sustainable investments, on a European level work is now put into developing a taxonomy of sustainable investments, a list of criteria that a sustainable investment must meet. This could be used for financial legislation, supervision and rating of portfolios. A good and clear definition of (un)sustainable investments provides clarity to all stakeholders.

 Disclaimer: this article does not offer investment advice and should not be construed as investment advice. Your investments are your responsibility. Seek professional advice if required.


AUTHOR

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Sophie Tromp completed a master in Clinical and Health Psychology and attained an MBA in Finance & Risk Management at KULeuven. Given her educational background, Sophie has a special interest in the role of psychology in finance. Before joining Initio in 2019, she worked successively as an analyst in the middle office of BNP Paribas Asset Management and in the Underwriting department of Credendo ECA.

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