Are Vice Stocks Losing Their Allure?

Shares of alcohol, tobacco, gambling, and other vice vendors have gained during recessions. But the sinful strategy hasn't paid off lately

Companies that make money from sin and vice may be naughty, but that rarely prevents investors from trying to profit from them. Such stocks—especially alcohol, tobacco, and gambling companies—are often touted as great investments during economic downturns. Other vice stocks include weapon makers, defense contractors, and sex businesses.

Bad times may force people to cut back spending, the argument goes, but they will set aside cash for their vices and addictions. "Consumers do not kick their habits in tough times," Merrill Lynch (MER) strategist Brian Belski wrote in November. When Merrill Lynch examined the performance of alcohol, tobacco, and casino stocks in all recessions since 1970, it found that while the broader S&P 500-stock index fell 1.5% on average, those addictive stocks rose an average 11%.

In the current downturn, however, the naughty are still waiting for their reward. Though the recession—which started December 2007—is still underway, sinful stocks so far haven't matched their past performance. In 2008, the S&P 500 fell 39%; some vice stocks have barely kept pace while others have plunged deeply into the gutter.

Casinos Took A Dive

Tobacco makers are often cash-rich—an important attribute in tough times—and they cater to customers who can't shut off their nicotine cravings in a recession. Yet Altria Group (MO) dropped 35% in 2008, Lorillard (LO) lost 34% and Reynolds American (RAI) fell 39%. One stock that wasn't hit so hard is Philip Morris International (PM), which fell 11% since its spin-off from Altria in March.

The casino industry has seen the most damage. Take the stock performance of the five largest U.S. public casino and gaming operators in 2008: Wynn Resorts (WYNN) fell 62%, Las Vegas Sands plummeted 94%, MGM Mirage (MGM) is down 84%, International Game Technology (IGT) fell 74%, and Penn National Gaming (PENN) lost 64%. All bad bets.

In the sex industry, adult nightclub operator Rick's Cabaret (RICK) dropped 85% in 2008. Defense contractors generally did better than the market, though Boeing (BA) shares lost half their value last year.

Meanwhile, some alcohol stocks have managed to beat the market. Molson Coors (TAP) slipped 5.7% and SABMiller (SAB.L) fell 18% for the year. However, InBev (INTB.BR) has tumbled 33% just since the November merger of InBev and Anheuser-Busch, while Diageo (DEO), the British maker of Smirnoff vodka, Captain Morgan rum, and other spirits, moved down almost 34% in 2008.

"unprecedented" Consumer weakening

There are several theories as to why sinful stocks haven't held up. Many companies were hurt by high debt levels while investors worried about exposure by others to troubled emerging markets.

A key concern is the suspicion that consumers are cutting spending far more than in past slowdowns. "The recession itself is different in its nature," says Keith Hembre, chief economist at First American Funds. Consumers are permanently altering spending patterns amid job shrinkage and vast losses in the markets for stocks and residential real estate. "We've had an unprecedented weakening in the household balance sheet," he says.

In fact, consumers are even cutting back small purchases like lottery tickets, notes Morningstar (MORN) fund analyst David Kathman. "This recession is pretty different from the last couple that we've had," he says.

The fundamentals of Vice: Ignored?

The effect on casino revenues has been striking. In October, gaming revenue at Las Vegas Strip casinos dropped a record 26% from the year before, according to the Nevada Gaming Control Board. In addition to the weak economy, an aggravating factor was the high price of gas, which discouraged drives from California to Sin City.

The USA Mutuals Vice Fund (VICEX) is one of the few mutual funds that specialize in the more disreputable part of the stock market. It focuses on tobacco, beverages, gaming, and aerospace and defense. In the past year, the fund is down almost 42%, about three percentage points worse than the S&P 500 benchmark. Charles Norton, Vice Fund manager, admits gambling operators have not performed well. However, he argues that the stock market is missing the resilience of fundamentals at tobacco, beverage, and defense companies. "The fundamentals don't really matter in this current market," Norton laments.

Some investors might be worried that alcohol and tobacco makers will see a slowdown in a key growth area: emerging markets. But despite the global recession, newly affluent consumers continue to upgrade to premium cigarette or alcohol brands, Norton says. "Even though these are premium brands, they're still highly affordable compared to other consumer products," he says.

Is this recession more "moral?"

In the beverage industry, consumer tastes may shift a bit, but sales and balance sheets will remain strong, Norton says. Last month, UBS (UBS) analyst Kaumil Gajrawala named Molson Coors a top pick, noting that the company is benefiting from a shift away from more expensive wine and spirits. "In tough economic times, we expect consumers to shift alcoholic consumption to the 'tried and true,' or what we would refer to as premium or sub-premium American beers like Coors Light, Miller Lite and Bud Light," Gajrawala wrote.

It's wise to bear in mind that, on average, alcohol, tobacco, and gambling earnings have held up in recessions. During downturns since 1970, as the Merrill Lynch study recently found, earnings growth for the group was 25% greater than for the market as a whole.

Because of the shocks to the global economy in the last few months of 2008, investors are still waiting to learn their impact on end-of-the-year results. Looking ahead, few economists foresee much improvement until at least the middle of 2009, with Hembre predicting "a fairly meager pace" of growth in the second half of the year.

So it remains to be seen if alcohol, tobacco, and other vices continue to prosper as affordable luxuries for many people. Or if, desperate to cut costs, consumers decide to clean up their act.

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