Yahoo Finance Can you profit from the sin stock anomaly?
Every investor has their own goals, strengths, weaknesses and investing style. Some investors will have no trouble taking large risks, while others will shy away. Other investors may prefer to stay away from unethical investments, or “sin stocks” as they’re known. Of course, how you decide to invest, or not invest, is up to you but it’s always useful to observe market trends, even if you don’t agree with them. You never know where you will find your next trade idea.
I’ve recently covered the relative outperformance of some sin stockscompared to more ethical investments but the data does not stop there. A study published within the 2009 Journal of Financial Economics, written by H. Hong and M. Kacperczyk and entitled, The price of sin: The effects of social norms on markets, provides evidence that the stocks of publicly traded companies involved in producing alcohol, tobacco, and gaming have long acted differently to the rest of the market.
The Boycott effect
Not only do Hong and Kacperczyk study the performance of sin stocks but the paper also looks into the effect that socially responsible investing has on corporations. Simply put, the paper tries to ask the question; is socially responsible investing actually justifiable and having an effect on companies?
On this topic the paper cites the work of Teoh, Welch, and Wazzan (1999), who set out to examine the effect of the shareholder boycott of South Africa’s apartheid regime. They found that there was little discernible effect on either the valuations of South African corporations, or on the South African financial markets following the boycott. However, it should be said that these results were impacted by the fact that South Africa was not a desirable place to invest before the boycott, so there was little in the way of liquid international investment that could be easily withdrawn.
Nevertheless, Hong and Kacperczyk found that sin companies, on average, have a higher cost of capital than non-sin companies. They conclude that a higher cost of capital is a result of ethical investing trends.
What’s more, they found that because many institutional investors avoid sin companies, these companies find it hard to raise capital on equity markets. As a result, sin stocks tend to rely more on the debt markets than equity markets to finance their development plans. The paper found that the average sin company has a 19.3% higher leverage ratio than the typical company.
Becoming a sin
One of the most interesting sets of results that is brought to light by Hong and Kacperczyk is the performance of tobacco companies.
Up until the 1960s, tobacco was not considered to be a sin. With the dangers of smoking still unknown, investors, fund managers and analysts continued to cover the sector as they would any other. What’s really interesting is that before the detrimental health effects of tobacco became widely known, (around 1965) the tobacco sector underperformed the market by 300bps, or 3% per year. Over the period 1947 to 1965, the sector underperformed the market by around 40% on average.
But after 1965, when the health effects of tobacco became well know and the sector earned sin status, it really began to outperform. Moreover, even though U.S. tobacco companies faced a barrage of litigation during this period, they actually outperformed their international peers.
Hong and Kacperczyk find that between 1985 and 2006, international sin companies outperformed the market by 21 bps per month, around 2.5% per year. However, domestic U.S. sin companies outperformed by 28 bps per month.
Notably over the same period tobacco had the lowest beta of the sin group. The three portfolios of interest, beer, smoking, and gaming had betas of 0.94, 0.63, and 1.12, respectively.
Analyst avoidance
While Hong and Kacperczyk found that sin stocks on average outperform the market, they also found that between 1976–2006, for which the data is available, sin stocks were typically avoided by analysts. The typical stock received coverage from about 1.7 analysts, while sin stocks were only followed by 1.3 analysts on average -- a 21% decline in coverage relative to the mean.
Additionally, the research showed that the valuation ratios of sin stocks were about 15% to 20% lower than those of other companies, after controlling for differences in other stock characteristics between 1965 and 2006.
This revelation goes some way to explaining why sin stocks outperform. Typically, stocks that have less analyst coverage and media attention outperform. However, a lack of analyst coverage makes it harder for investors to arrive at a suitable price target for the company in question. As a result, valuations can be lower. Another explanation for the lower valuations is the fact that these highly regulated sin businesses could see their businesses disappear overnight, if regulators decide to clamp down.
Conclusion
All in all, Hong and Kacperczyk found that on average, over the period 1962 to 2006, sin stocks around the world outperformed the market by 2% per year. And over the past ten years, this performance has only improved.
In the chart below, the returns of two companies from each sector, tobacco, gaming and alcohol are shown. Including reinvested dividends, all six companies have performed exceptionally well against the market over the past decade. Given the behavioural drivers of this historic outperformance, it would take a brave, or perhaps virtuous, man to bet against it continuing.
Company | 5-Year Performance Reinvesting Dividends | 10-Year Performance Reinvesting Dividends |
114.9% | 457.6% | |
240.0% | 527.1% | |
357.9% | 40.7% | |
382.2% | 401.9% | |
107.1% | 193.1% | |
207.1% | 274.9% | |
S&P 500 | 110.8% | 111.4% |
FTSE-All-Share Index ex. dividends | 33.7% | 50.4% |
Note: Las Vegas Sands narrowly averted bankruptcy during 2008. Figures correct as of 30/10/2014.
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Read more investing articles & commentary from Rupert Hargreaves
