The Virtues of Vice Stocks

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

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.

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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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At $87 in mid December, the stock trades at 18 times estimated 2008 profits -- the average price-earnings ratio for distillers and wineries -- and yields an above-average 3.7%. Earlam rates the stock a buy and says her one-year target price is $108.

AmBev (ABV) dominates Brazil's beer market, the third largest in the world, with a 68% share; its closest rival has a 13% slice. In addition to beer, AmBev, formally known as Companhia de Bebidas das Américas, is the largest Pepsi bottler in Latin America and produces soft drinks and other nonalcoholic beverages.

Rather than compete on price, AmBev, like Diageo, aims to sell premium products with strong brand appeal. "The company knows who buys its beers and the weak spots of its competitors," says Mark Greenberg, manager of AIM Leisure fund, which holds alcohol and gaming stocks.

The company also employs strong cost controls, which gives it an edge over competitors. To avoid unnecessary expenses, AmBev requires managers to build budgets from scratch rather than tweak the previous year's plans. The stock, at $76 in mid December, soared 59% in the first 11 months of 2007.

When it comes to exclusive distribution, no one plays the game better than Anheuser-Busch (BUD). The St. Louis company, which produces half of the beer consumed in the U.S., uses its considerable clout to demand exclusivity from about 60% of its domestic distributors. By contrast, SABMiller and Molson Coors have exclusivity agreements with about 10% of their distributors.

Although its distribution is top-notch, Anheuser-Busch's product lineup has slipped. Budweiser, its flagship brand, has lost one-third of its market share over the past decade as U.S. consumers have shifted to microbrews, imports, liquor and wine.

The company has ventured into spirits and specialty beers to juice up its U.S. sales, but those businesses are tiny compared with the revenues its vast empire of everyday beer generates. International sales, especially in China, Mexico and Canada, have kept the company's overall revenue rising.

Shares of Anheuser-Busch have been as flat as a day-old pitcher of Bud Light. "Its earnings have gone up almost 40% over the past five years, but its stock is in the same price range," says Tom Meehan, manager of the Meehan Focus fund, which holds the stock.

Another investor is Berkshire Hathaway, the holding company for investing superstar Warren Buffett. At $53 in mid December, Anheuser-Busch shares trade at 17 times estimated 2008 earnings. That's slightly less than the average brewer's P/E of 18.

High-stakes stocks

Stocks of large casino operators cooled this past fall, but the declines are relatively minor compared with the previous run-ups. Consider, for example, Las Vegas Sands, which, at $119 in mid December, still trades for nearly three times what it fetched only two years earlier. So investors still must ask whether buying shares of Sands, MGM Mirage and Wynn Resorts is like joining a hot blackjack table just before the cards run cold.

The island province of Macau, China's only legal casino destination, is the reason for much of the froth. Macau's gaming revenue is growing at a 46% annual clip, compared with 5% in Las Vegas. And in 2006, total revenues from casinos in the former Portuguese colony eclipsed those on the Vegas strip for the first time.

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Whether MGM, Sands and Wynn deserve their lofty share prices depends on their ability to generate rapid revenues and profit growth at their Macau properties. And that, in turn, depends on their ability to sell Las Vegas-style gaming in Macau.

Most of Macau's gamblers are day-trippers who bet big at table games. In Vegas, the average visitor stays for nearly four days, and slot machines generate the most gambling revenue. "Las Vegas Sands could falter, but it also may hit some home runs with future projects," says Dan Ahrens, manager of Ladenburg Thalmann Gaming and Casino fund.

Ahrens also likes Wynn's chances because chief executive Steve Wynn has a proven ability to lure high rollers to his casinos, although the company's pipeline of new projects isn't as large as that of Las Vegas Sands.

Macau overshadows other avenues for gaming growth. Las Vegas Sands plans to open its first casino in Singapore in 2009. Moreover, "Japan, Thailand and many other Asian countries are considering casino gaming," says Charles Norton, manager of Vice fund, which invests mainly in sin stocks. "They have all seen what's going on in Macau and want a piece of that action."

In the likely event that Japan approves casino gambling, Wynn will have an edge because Aruze USA, a subsidiary of Japanese gaming-machine manufacturer Aruze Corp., is a major Wynn shareholder.

Estimating profits from Asian casinos that haven't been built yet is like drawing for an inside straight in poker: You may succeed, but don't count your winnings too soon. Casino operators have to line up financing and gain approval from fickle governments. "Gaming expansion always takes longer than you think," says AIM's Greenberg.

Nevertheless, governments have a stake in making sure casinos thrive. Taxes on gaming provide funds for popular services, such as schools, highways and economic-development programs. In the U.S., casinos contributed more than $5.2 billion in 2006 tax revenue to the state and local governments of the 11 states with large gaming operations.

You need the nerves of a contender in the World Series of Poker to hold shares of Las Vegas Sands and Wynn. Sands trades at a sky-high 50 times the $2.38 per share that analysts expect the company to earn in 2008. Wynn trades at 38 times estimated 2008 earnings of $3.24 per share. The average casino stock sports a P/E of 26 (U.S. stocks on the whole trade at about 15 times forecasted profits).

MGM Mirage (MGM) offers a steadier hand. The Las Vegas-based company owns some of the newer properties on the Strip, including the Bellagio, Mandalay Bay and the MGM Grand. MGM has also struck a $5.4-billion deal with a company controlled by Dubai to develop the CityCenter property in Las Vegas. "MGM's Macau business is more of a bonus," Ahrens says.

Lehman Brothers analyst Felicia Hendrix rates MGM, at $93 in mid December, a buy and thinks the company will generate significant growth in earnings by developing casinos on land it owns.

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You can avoid the hassle of picking winners and losers in the high-stakes casino business by investing in a company that supplies its slot machines. If you've ever pulled the handle on a one-armed bandit, odds are International Game Technology (IGT) made it. The Reno, Nev., firm produces nearly 70% of all slot machines in North America.

IGT's ace in the hole is server-based machines. Traditional slot machines are self-contained computers; but slots controlled by a central server allow casinos to choose from a wide array of games and easily customize odds and game prices. That technology is expected to increase revenues for IGT in 2009.

"We are at the front of an accelerated expansion cycle over the next three to five years," says David Barteld, an analyst with Nollenberger Capital Partners. Barteld says the new round of purchases should boost IGT shares, which, at $44 in mid December, were down 5% in 2007. He rates the stock a buy and gives a one-year price target of $62.

Unseemly product, great stocks

Tobacco has a track record that's tough for even the most ardent nonsmoker to ignore. To be sure, smoking is the single biggest preventable cause of death. So whether to invest in these stocks is surely a personal decision.

But the best-performing stock in the S&P 500 from 1957 to 2003 was Altria, the world's second-largest maker of cigarettes (behind government-owned China National Tobacco). Over the past 30 years, shares of Altria have gained an annualized 21%. That beats the S&P 500 by an average of 11 percentage points per year.

Public-health programs and high taxes have diminished smoking rates in the developed world. But tobacco companies can still generate growing profits by raising prices and diversifying to products beyond cigarettes. Altria and Imperial Tobacco Group (ITY) are branching out to the lucrative cigar business. Altria plans to buy cigar maker John Middleton for $2.9 billion, and Imperial has offered $18.5 billion for Altadis, the world's largest seller of cigars.

Yet opportunities in emerging markets, where tobacco use is still growing, dwarf these side ventures. The World Health Organization estimates that the number of smokers will grow from 1.3 billion today to 1.7 billion by 2025, with the bulk of new puffers coming from developing countries in Asia and Eastern Europe.

Tobacco companies with the most business in developing markets should fare best. British American Tobacco (BTI) generated more than 60% of its sales of $20.2 billion over the past year in Africa, Asia, Latin America and the Middle East. Imperial received more than one-third of its $25.4 billion in fiscal 2007 revenues from emerging markets.

Altria, whose fastest-growing markets have been Africa, Asia, Eastern Europe and the Middle East, plans to spin off its international operations to shareholders. Norton, who has made Altria his fund's biggest holding, plans to keep shares of both companies after the spinoff. Philip Morris International will be a faster grower, but Altria's U.S. operations should benefit from significant cost savings and will likely buy back tens of billions of dollars' worth of stock, he says. Altria's shares, at $78 in mid December, yield 3.9%.

Unpredictable legal actions can cause tobacco stocks to smolder. However, U.S. tobacco companies have won court battles in the U.S. that have reduced litigation risk. "The legal environment is the brightest it's been in years," Norton says.

Foreign tobacco companies have shunned the U.S. because they don't want to hassle with lawsuits. But Imperial bought Commonwealth Brands, a Bowling Green, Ky., company, last April. That could be a sign that foreign tobacco companies now see reduced legal risks in the U.S.

NEXT: The Fund Route to Sin Stocks

Contributing Editor, Kiplinger's Personal Finance