business

The Wages of Sin Stocks

The Vice Fund's Dan Ahrens says shares in alcohol, tobacco, gaming, and defense outfits have many virtues for investors' portfolios

Are "sin stocks" a good bet for risk-free investing? Dan Ahrens thinks so -- and he launched the Vice Fund (VICEX ) two years ago to focus on stocks in alcohol, tobacco, gaming, and defense. The strategy has worked: In the year ended Aug. 31, the fund was up 21.06%, against 11.45% for the Standard & Poor's 500 index.

"No matter what the market's doing, no matter who wins the election, people continue to drink, people continue to gamble, continue to smoke," says Ahrens. He first noticed the relatively better showings of stocks in those areas during the downturn of 2001 and 2002, and that led to establishing the fund.

On the tobacco sector, for example, Ahrens shrugs off the litigation risk, which he thinks is mostly in the past, and points to worldwide demand for tobacco and, in the case of Altria (MO, the former Philip Morris), diversification into other businesses such as Kraft and Nabisco.

These were a few of the points Ahrens made in an investing chat presented Sept. 9 by BusinessWeek Online on America Online. He was responding to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. A full transcript is available on AOL at keyword: BW Talk.

Q: What's your overall view of this market? When will it get rolling again?

A:

I think the most important thing is that there's a lot of uncertainty right now -- that's obvious. There's an election coming up, the situation in Iraq is unknown, and it all points out the need more than ever for a type of all-weather portfolio. To add, I'm looking forward, hopefully, to a more bullish market in the fall. I'm never one, however, to give a prediction as to what the market will do in a given short period of time.

Q: Dan, why would "sin" stocks be a good place to invest now?

A:

The basic premise of our fund is that, no matter what the market's doing, no matter who wins the election, people continue to drink, people continue to gamble, continue to smoke. These areas have a great history of doing well through thick and thin. These stocks don't necessarily do better during a down market...but they do continue to perform, as through 2000 and 2002. They didn't show phenomenal returns, but they continued to grow at a respectable pace.

Q: What's the risk going forward for tobacco stocks?

A:

That's a very interesting question, and I think tobacco is one of the most misunderstood industries in America. Investors hear the word "tobacco" and assume it must be a bad investment. They don't realize the worldwide demand for tobacco and don't realize that the majority of litigation risk is in the past. Everyone knows tobacco is bad for you, and moving forward, tobacco's expected to win litigation, as they have done in recent times.

Q: What are your top holdings in tobacco?

A:

Altria (MO ) is in our top 10. As I mentioned earlier, I think people don't realize the huge worldwide business that they do, and many people forget that Altria also owns Kraft and Nabisco. A couple of other favorites are British American Tobacco (ETI ) and Imperial Tobacco (ITY ). Now, because these are foreign stocks traded in the U.S. as American depositary receipts, they're off the radar screen of many U.S. investors. They have very little of the litigation and regulation problems that we think of in the U.S., but they still have the huge profit margins, a large dividend, and the huge worldwide demand for tobacco.... I bet very few investors in the U.S. would realize that Reynolds American (RAI ) (the former R.J. Reynolds) has returned over 100% in the past 12 months.

Q: Gaming stocks got a nice lift earlier this year on consolidation news. What's your outlook for the group? What are your favorites?

A:

Well, gaming actually did great in 2003 and led the way for our fund. It has been a little bit more mixed in 2004. We're very bullish on the industry, and what's driving it mostly is that additional states...continue to add gaming at the same time that we all know Vegas itself is booming.

So, looking at simple supply and demand, there's still additional upside left in gaming, even though it has already had a terrific run. Investors need to also remember to include the lottery business when they're looking at gaming stocks.

At the big casinos, we like MGM Mirage (MGG ), and we do like Harrah's (HET ). More than the big casinos themselves, we like manufacturers and suppliers. One of our favorites is Shufflemaster (SHFL ). One that we think is particularly undervalued and has great upside right now is Multimedia Games (MGAM ). I'd also just suggest that people take a look at the holdings of the Vice Fund. It's a low-turnover fund, and it's fairly concentrated. We only own 10 or 11 gaming stocks at a time.

Q: The Vice Fund has been out there almost exactly two years. How has its performance compared with the broad indexes?

A:

It has beaten the broad indexes by a wide margin. In the past one year, for instance, it's the No. 1 fund in its Lipper category. For the full two-year period, Lipper said it's in the top 14% of its category. The Vice Fund's one-year return through the end of August was 21.06%, while the S&P returned 11.45%.

Q: Which liquor stocks do you like?

A:

I'm going to give you a pretty wide range here. We like Anheuser-Busch (BUD ) a lot -- it's our No. 2 holding. It's a very steady, boring, lower-risk, dependable stock. We're confident that it'll have simple, positive returns year in and year out, just like it has every year for the past 10 years.

On the other end of the spectrum, here's a small-cap, fast-growth stock we like a lot: It's called Central European Distribution (CEDC ). Those two stocks are a good example of our fund. We think we have some up-and-coming smaller growth companies, mixed in with some large, value-oriented industry leaders that can perform well through good markets and bad.

Q: Among alcohol stocks, do you own any winemakers? What's the outlook for them?

A:

We don't own any pure winemakers. Robert Mondavi (MOND ) is a great winemaker stock we don't own. We do like Constellation Brands a lot (STZ ). They're a very diversified company that imports Mexican beers. They also distribute some distilled beverages, but the largest part of their revenue comes from the wine business. They do own some fine wines, but they own and distribute a large amount of the high-volume cheaper wines. Although I wouldn't want to drink it myself, that high-volume wine is where the profit margins are.

Q: You also invest in aerospace and defense. Which stocks there? And has war in Iraq helped?

A:

Defense stocks actually lagged in 2003, and we told people that historically defense stocks do well toward the end of, or following, conflicts. Defense stocks have done very well so far in 2004. Something interesting that's helping to drive defense stocks is the fact that Kerry and Bush are both wanting to appear very strong on defense.

A couple of our favorites -- our No. 1 holding -- is L3 Communications (LLL ). We love their acquisition strategy, their growth, and the fact that they're a very technology-based contractor. Another favorite is Northrop Grumman (NOC ). A smaller-cap defense contractor is United Defense Industries (UDI ).

Q: What about Boeing (BA )?

A:

We don't own Boeing, and they've rebounded fairly nicely recently, but just because they've been so beaten up the past few years, and because we have so many other great choices in that industry. Others that we own that I haven't mentioned yet include Lockheed Martin (LMT ) and United Technologies (UTX ). General Dynamics (GD ) is another. We simply like these better than we like Boeing, and we continue to be fearful of Boeing's exposure to the airline industry.

Q: How do the fund's holdings divide up among the sectors you invest in?

A:

Fairly evenly. We have about 26% to 27% in gaming, about 26% in defense, and about 24% in alcohol. We have less than 20% in tobacco -- actually, closer to 16% in tobacco, mainly because there are so few stocks to pick from. We do have less than 10% of the portfolio in what I would just call "other," but they're mainly leisure-oriented stocks, and there are just a few.

Q: What gave you the inspiration for the Vice Fund?

A:

Well, I do manage three other mutual funds, and we've been managing money at mutuals.com since 1994. For the inspiration, very simply, when we were managing money through the downturn of 2001-2002, in mid -'01 we really started to take notice of certain industry names popping up near the top of the three- and five-year performance rankings. Alcohol, gaming, tobacco -- these were all near the top, since the rest of the market had fallen off badly...we actually began to joke that these so-called sin-stock industries would have greatly outperformed the majority of the socially responsible funds. Then we turned it into serious research.

Q: You mentioned smaller-cap growth -- what are some of your stocks in that area that you might not have talked about yet?

A:

There are actually two stocks outside of our main industries that I like a great deal -- SCP Pool (POOL ) and Guitar Center (GTRC ). Again, they're both leisure-type stocks. They have great upside potential. It's pretty rare that we go outside our four main industries -- we have to like a stock a lot to do so.

In gaming, there are a number of small-cap growth stocks in addition to what we've already mentioned. We like Scientific Games (SGMS ). They're mainly in the lottery and parimutuel business. Penn National Gaming (PENN ) is another.

Q: What criteria do you use to pick stocks for the Vice Fund? Do you lean toward growth vs. value?

A:

I actually am very much against some fund managers who seem to let their computer screens manage their funds more than they do.... We very much believe in old-fashioned fundamental stockpicking, and when we buy a stock, we buy it with the intention of owning it indefinitely.

Q: How big a chunk of a portfolio do you think an investor should put into "sin stocks" -- or your fund?

A:

I think it depends on each individual's situation. We think our fund can make a sizable portion of someone's portfolio -- only because it has built-in diversification between large cap and small cap, and growth and value. Other than that, they have to realize that they're investing largely just in four industries, but once again we think our fund has built in diversification over what most people think are sector funds [which are largely in one industry only.]

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