Since the turn of the century, public interest in issues such as climate change and socially responsible corporate conduct have led to the creation of ethical businesses – and ethical investment vehicles.

However, at the other end of the spectrum, ‘sin stocks’ remain popular among professional investors. These are listed companies operating in industries that profit from human foibles such as alcohol, tobacco and gambling.

Major tobacco and alcohol stocks, such as British American Tobacco and Diageo (manufacturer of Guinness, Johnnie Walker and Smirnoff) commonly feature in the top ten holdings of investment funds the world over.

Recession-proof stocks

“Cigarette brands have loyal customer bases, for whom price is barely a consideration, and the state of the wider economy doesn’t matter. As a result, tobacco companies have untapped pricing power,” says Russ Mould, investment director at AJ Bell.

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“The pricing power enjoyed by cigarette manufacturers translates into huge profit margins, which can be used to pay sizeable dividends to shareholders. It’s no wonder so many income funds invest.”

This pricing power allows cigarette companies to continue making vast profits, despite declining rates of smoking prevalence, decades of tobacco control laws and initiatives, and a tax escalator ensuring prices increase annually. In the UK, the proportion of the population that smokes has fallen from 82 per cent in 1948 to 19 per cent today (although this means around 12 million people remain smokers).

Cigarette manufacturers can benefit from other attempts to curtail their businesses, too.

“Bans on cigarette advertising actually strengthen the position of tobacco companies,” explains Nick Davis, lead manager of the Polar Capital European Income fund.

“Profits increase because they no longer spend collective billions on marketing every year – and the inability of newcomers to advertise sets very high barriers to entry for the industry, killing competition.”

Alcohol advertising, while heavily regulated, is not banned yet – and its own tax escalator was scrapped in the 2014 Budget.

“Although consumer spending on alcohol is more discretionary than cigarettes, there’s a high, stable demand for alcohol no matter the state of the economy,” says Laith Khalaf, senior analyst at Hargreaves Lansdown.

“Like tobacco firms, listed alcohol companies have large global footprints, generate high margins and strong cash flow. The highly capital-intensive nature of its production, and economies of scale, also mean competition is fairly minor.”

Global reach

The global nature of ‘sin stocks’ is key. Alcohol and tobacco firms alike look to the developing world as the source of their future prosperity. This is primarily because laws around plain product packaging, fines for drivers who smoke with children in their cars and mandatory rehabilitation programmes for problem drinkers – all common in developed economies –  simply aren’t on the agenda in most emerging markets.

“Developed markets may be far down the path of regulation, but regulation in emerging markets ranges from limited to non-existent,” says Khalaf.

“For every door that closes, there are many others wide open.”

In addition to laxer environments, the rise of emerging markets has created legions of new affluent middle classes who desire Western consumer goods.

Some ‘sin stocks’ already have significant standing overseas – BAT products are sold in over 200 countries across the globe, for instance.

Others, such as Diageo and Pernod Ricard (distiller of Absolut and Chivas Regal), have acquired local spirit brands and spent years trying to popularise their existing ranges in Brazil, China, India and Turkey.

Dangers

While expansion into emerging markets seemed an obvious move for companies a decade ago, growth rates are now faltering in many countries, and analysts forecast tough years ahead.

There have already been some notable cases of Western brands failing to expand in the emerging world.

In 2011, Diageo acquired a majority stake in Shui Jing Fang, a premium Chinese distiller with much fanfare. However, by 2014 Shui Jing Fang sales had collapsed by 78 per cent, and the world’s largest spirits company was forced to write down the value of the purchase. That year, it suffered its first fall in operating profits in nine years. Pernod Ricard suffered its first fall in six years after it increased its marketing spend by 36 per cent year-on-year, without a resultant rise in sales.

Khalaf, however, believes faltering emerging market sales are a short-term blip.

“Despite the setbacks, the long-term growth strategy of these businesses remains same – it just won’t pay off straight line,” he says.

“It’s a long-term growth story spanning decades, not a few years.”

Ian Forrest, research analyst at The Share Centre believes these firms’ troubles may not be entirely emerging market-related.

“Alcohol’s a tough sector – there’s been lots of consolidation in the past few years, and there’s more to come,” he says.

“Growth for wine and spirits manufacturers in established markets is behind us.”

Nonetheless, Forrest believes Diageo is the best of the bunch.

“The company has the sheer range and scale to deliver, and it yields at 3.3 per cent, not far behind the tobacco majors,” he concludes.

While Tobacco and alcohol companies have survived restrictions before, regulation in these sectors is only set to increase. Plain product packaging for cigarettes is already in operation in Australia, is scheduled to be introduced the UK and Ireland in May 2016, and is advocated by official bodies and governments across the Western world. Similar measures have been mooted for alcohol. A number of countries have banned smoking in private vehicles.

These changes represent significant challenges to the industry in many parts of the world – and their profits as a result. While emerging markets were originally embraced due to their lack of regulation, the number of countries without restrictions on smoking indoors is rapidly dwindling. Plain packs and other limitations aren’t on the agenda in India or China, but it could only be a matter of time. The latter recently introduced a ban on smoking in some public areas.

Sin-vestment options

While the potential rewards of investing in ‘sin stocks’ are sizeable, no fund concentrates on either tobacco or alcohol, or both. In fact, Khalaf notes there is only one fund in the entire world with an explicitly stated unethical agenda. USA Mutuals launched its ‘Vice Fund’ in 2002, specifically to invest in in tobacco, gambling, armaments and alcohol stocks (in 2014 it dumped its ‘Vice’ moniker and rebranded to ‘Barrier Fund’).

However, many investors will already hold sin stocks without realising due to their prevalence in UK and global equity funds. Consumers with a private pension, or investors in income funds, likely have exposure to BAT and Imperial Tobacco, if not Diageo.

Investors seeking funds with significant tobacco holdings have many to choose from.

“Experienced managers that know these companies, and the associated risks, can deliver value. BAT is a top-five holding in the Royal London UK Equity Income fund, while Mark Barnett’s Invesco Perpetual High Income Fund has BAT, Reynolds American and Imperial Tobacco in its top five,” says Mould.

“Neil Woodford has also long been bullish on tobacco – British American Tobacco is the third biggest holding in his equity income fund, at 6.2 per cent, Imperial Tobacco fifth at 5.3 per cent.”

For those attracted to ‘sin’ returns who object to openly investing in stocks, it’s possible to secure indirect exposure through a number of different avenues.

“A revival in the gin and vodka markets has also benefitted high-quality soda and tonic producers,” says Khalaf.

“The AIM-listed Fevertree has done very well out of it, for instance.”

Mould also suggests looking at broader sectors that have associations with alcohol consumption.

“Most people would be hard pushed to describe Tesco, Sainsbury or Morrison as ‘unethical’ – but they sell beer, spirits and cigarettes,” he states.

“The hospitality industry, including restaurants, nightclubs, hotels and resorts, and even airlines, all have associations with alcohol.”

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