The Price of Sin

The title above was from a 2005 paper authored by Princeton professor Harrison Hong and University of British Colombia professor Marcin Kacperczyk (full paper available at http://tinyurl.com/2bh7ubu).

It has been widely accepted that “sin” stocks—i.e. publicly-traded companies involved in producing guilty pleasures such as alcohol, tobacco, and gaming and politically incorrect products like weapons—make good investments because the social stigma associated with the companies tends to depress their prices, thus allowing investors with no such moral qualms to buy them at attractive prices. This was the rationale behind the creation of the Vice Fund (VICEX), which has soundly beaten the S&P 500 since its launch in 2003.

Not all sin stocks are created equally, of course. As Warren Buffett likes to say, a good investment needs “moats” around the business. By “moats,” Buffett is speaking of durable competitive advantages that rival firms have difficulty replicating. Given the complex legal and tax environment in which sin stocks operate, most do have fairly substantial moats. One notable exception is the adult entertainment industry. Much like internet file sharing wrecked the business model of the music industry, free pornographic sites have absolutely destroyed the economics of the adult media business. It’s hard to compete with “free.”

Consider Playboy Enterprises (NYSE:PLA). Hugh Hefner’s iconic creation has struggled for the past decade. In a June press release the company effectively gave up on selling magazines, instead planning to “transition Playboy to a brand management company,” which presumably means licensing t-shirts and other memorabilia with the Playboy bunny logo. We’ll see how that works out for ol’ Hef. There is no doubt quite a bit of marketability in the brand, but this does not change the underlying economics of the industry, which is likely in terminal decline.

Somewhat ironically, Hugh Hefner himself is a brand every bit as iconic as the bunny logo. He is also 84 years old. One can’t help but wonder what the Playboy brand is really worth without its founder, whose personality defines the brand. Given that Playboy’s value to investors lies almost entirely in its intangible brand assets, this particular vice stock is probably best avoided for anything other than a short-term trade.

Returning to Hong and Kacperczyk’s paper, the authors found in their empirical testing that sin stocks do indeed behave like value stocks and have soundly beaten the market over time. As Hong and Kacperczyk explain,

Importantly, we find that even after accounting the loadings of the sin portfolio on well-known determinants of expected returns such as the market, size, past return, and market-to-book, a value-weighted portfolio of sin stocks significantly outperforms the market by approximately 76 basis points per month and the alpha is statistically significant at the 1% level of significance.

Given Hong and Kacperczyk’s findings, it should come as no shock that Altria (NYSE: MO) is the most profitable stock investment in U.S. history. Both Altria and its spinoff, Philip Morris International (NYSE: PM), are recommendations of the Sizemore Investment Letter.

Many institutional investors such as pension funds, university endowments, and charitable foundations are not permitted to invest in vice stocks or choose not to in order to avoid the headache. Their loss is our gain.

Charles Lewis Sizemore, CFA

Related article: Thoughts on Hefner’s Playboy Buyout

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