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Sin Pays for the Vice Fund

By Palash R. Ghosh Alcohol, cigarettes, gambling, weapons -- some may regard them as feeding our vices, but their manufacturers are meeting a never-ending public demand. Vice Fund (VICEX), a $7 million portfolio that invests almost exclusively in stocks associated with these goods and services, has flourished since it was launched last year.

For the one year ended Oct. 31, the portfolio leaped 21.4%, vs. a 19.7% gain by the S&P 500-stock index and a 16.1% rise by the Dow Jones industrial average. Portfolio managers Dan S. Ahrens and Eric McDonald invest at least 80% of the fund's assets in four industries: Gaming, tobacco, alcohol, and defense. This represents a somewhat limited universe to choose from -- numbering a few hundred at best.

UNLOCKING VALUE. "We don't see that as a disadvantage for us, " says Ahrens. "This small number of stocks allows us to identify and invest in the best ideas for the long haul." He notes that they're neither growth nor value investors and follow Warren Buffett's investment philosophy. "We put great emphasis on unlocking intrinsic value and holding onto undervalued, growing companies for the long term. We're not model-driven, and we don't trade in and out much."

As of Oct. 31, the fund's top 10 holdings were Altria Group (MO

, 4.7% of the fund), Multimedia Games (MGAM

, 4.5%), Anheuser-Busch (BUD

, 4.1%), L-3 Communications (LLL

, 4%), Constellation Brands (STZ

, 3.9%), Shuffle Master (SHFL

, 3.9%), British American Tobacco (BTI

, 3.8%), ManTech International (MANT

, 3.6%), Northrop Grumman (NOC

, 3.5%), and United Technologies (UTX

, 3.5%).

The fund now holds 47 stocks and typically ranges from 45 to 50 holdings. The proportions of the holdings are: gaming (25.9%), alcohol (24.4%), defense (23.4%), and tobacco (16.4%).

LITTLE MARKET CORRELATION. Ahrens isn't restricted by weighting restrictions. "Our industry allocations largely reflect the growth of the stocks we have selected," he says. "We're currently overweight in gaming because of the growth prospects in that industry. Moreover, these weightings haven't varied by more than 5% since we started the fund."

Ahrens doesn't view sin stocks as defensive investments. "These sectors performed well in 2000, 2001, and 2002, when the overall market was in decline," he says. "From that perspective, you might think these are defensive sectors. But the performance of these sectors aren't at all correlated with the market. We think they can perform positively in an up market as well. Case in point, in 2003, during a favorable market climate, we have outperformed both the S&P and the Dow."

One area the fund likes is gaming, which "is enjoying phenomenal growth in this country," Ahrens says. "It's not just Las Vegas and Atlantic City anymore. There are horse tracks, dog tracks, riverboat casinos, state lotteries, and gambling over the Internet. And there's plenty of upside because an increasing number of states are legislating in favor of gaming."

GAMBLING TOOLS. One of Ahrens' favorite gaming stocks is Multimedia Games, the largest supplier of interactive electronic games and electronic player stations to Native American casinos. "They have a great niche market, which they dominate," he said. "As more states pass legislation to allow casinos on American Indian property, their business will continue to grow."

Multimedia Games' stock has doubled to nearly $40 year to date. Revenue more than doubled in the past year, while net income has more than tripled. The stock is still trading at a moderate p-e of under 18.

Also, people continue to smoke, despite the widely known health risks. Tobacco is a cash-rich business, and cigarette makers continue to pay high dividends. Ahrens notes that while the percentage of smokers in the U.S. is declining, the global market for tobacco products is huge and growing. Ahrens is bullish on R.J. Reynolds Tobacco's (RJR) recent acquisition of British American Tobacco's U.S. cigarette business. Both stocks are in the fund.

COOL ABOUT TOBACCO SUITS. "British American wants to concentrate on their booming non-U.S. business, primarily Europe, Southeast Asia, and Africa" he says. "They don't like the litigation risks in the U.S. As for RJR, their stock has been foundering for the past couple of years as they continued to lose market share in the U.S. to their main competitor, Altria, as well as to the small discount wholesalers. This deal makes RJR a strong No. 2 tobacco company behind Altria."

Ahrens remains largely unconcerned about the lawsuits facing American tobacco companies. "There are two things to remember about all this litigation activity," he noted. "It's almost entirely confined to the U.S., and tobacco companies have won the vast majority of these suits. With respect to tobacco stocks, we think the risk of litigation has already been priced in."

Ahrens notes that while the alcohol industry "is not very dynamic, it's an extremely steady grower. It's virtually a recession-proof business." The brewing industry in the U.S. is expected to benefit from a good pricing environment, improving demographic trends, and rising consumption.

BEER'S BUZZ. "Anheuser-Busch dominates the U.S. beer market," Ahrens says. "When most people thought they had peaked out a few years ago, they've actually increased market share primarily through an excellent marketing campaign. They also have extended their market share outside the U.S. The company's stock has delivered positive returns every year for the past decade, through all kinds of market turmoil."

Ahrens also owns the second-largest American beer manufacturer, Adolph Coors (RKY). "The stock has been in the doldrums for the past year, but we think it's a great buy for the long-term," he says. The stock, which trades at a modest p-e of about 13, is significantly undervalued, he says.

While most people would not consider aerospace and defense industry to be sinful, Ahrens invests in this sector because socially responsible funds screen it out. The ongoing conflicts in Iraq and Afghanistan, along with President George W. Bush's dedication to increasing the nation's military budget, ensure a very positive outlook for defense players.

UNDERVALUED DEFENSE. One of Ahrens' favorite defense stocks is L-3 Communications, which makes intelligence, surveillance, and reconnaissance systems. "They have been growing earnings and revenues consistently for several years," he says. "They have also made some smart, strategic acquisitions of companies that complement their business very well. The stock is trading at a p-e of only about 18 or 19. This is amazing. We think it should be priced much higher."

Ahrens believes defense is the most undervalued sector he invests in. "If you look at Northrop Grumman and Lockheed Martin (LMT), both of which are in the fund, the stocks are very underpriced with tremendous upside."

Ahrens doesn't invest in other "sinful" businesses like pornography and guns -- but only because not many large publicly traded companies concentrate in these activities. Ghosh is a reporter for Standard & Poor's Fund Advisor

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