Markets

The Virtues of Vice Stocks

Worried about the growing risk of recession? Use sin stocks to gin up your portfolio.

By Thomas M. Anderson, Associate Editor

From Kiplinger's Personal Finance magazine, February 2008

Hard times won't stop gamblers from betting, partygoers from drinking and smokers from puffing. In fact, economic turbulence might give them even more reason to indulge. That makes so-called sin stocks, or shares of alcohol, gaming and tobacco companies, a safe bet as the U.S. economy slows.

The roar of a bear market rings hollow with sin stocks. During the 2000-02 downturn, Standard & Poor's Casinos and Gaming index gained 115%, while the S&P 500-stock index plunged 47%. Shares of tobacco giant Altria (then known as Philip Morris) more than doubled, and the stock of Anheuser-Busch, the largest U.S. brewer, advanced 87%.

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One reason shares of alcohol, gaming and tobacco companies perform well is that it's hard to break into those businesses. Governments limit the number of casino licenses and crack down on Internet gambling. Tobacco companies face an array of marketing restrictions and lawsuits, and those legal burdens discourage fresh competition. Alcohol is heavily regulated, especially in the way it is distributed.

Meanwhile, the mushrooming middle classes in developing nations such as China and India are boosting demand for booze, casinos and smokes. Although tobacco consumption in the U.S. and Europe has declined for decades, it continues to grow modestly in emerging markets. The prospect of expansion to Asia has been a key factor driving up casino stocks. Beverage and food companies are gobbling up hometown brewers and distillers in fast-growing foreign locales.

Indulging sinners is highly profitable. A cigarette costs about 1.25 cents to manufacture. A single serving of liquor, including packaging expenses, costs 3 cents. An average casino slot machine keeps 12 cents for every dollar fed into the device.

Sin stocks with the most potential share some common traits. Each company is large and has a global reach -- the more exposure to emerging markets, the better. The companies have enough clout to make acquisitions in their consolidating industries and generally are so strong that they don't have to tap unstable credit markets for financing. With that in mind, let's look at some virtuous -- or at least profitable -- opportunities in vice.

Lucrative liquids

The alcoholic-beverage industry is highly regulated. It is heavily taxed throughout the world, and it must comply with scads of quirky local laws. For example, Brazilian bars must sell beer in 600-milliliter returnable bottles. In the U.S. and other countries, beer and liquor producers have to work through middlemen who distribute the product to retailers.

The big fish swim in these tightly controlled ponds by creating powerful brands and establishing exclusive distribution networks. Diageo, the world's largest spirits maker, is a prime example. The London-based company owns nine of the world's top 20 brands, including Smirnoff vodka, Johnnie Walker scotch whisky and Captain Morgan rum (it also owns Guinness stout).

Diageo (symbol DEO) has a large network of U.S. distributors that sell only its brands. Ongoing negotiations of its distributor contracts should boost Diageo's market share, says UBS analyst Melissa Earlam.

Diageo, which operates in 180 countries and territories, focuses on premium brands. That enables the company, Earlam says, to boost prices and maintain profit margins even as costs rise, as those of barley and corn have done the past three years.

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