by Charles Sizemore | August 1, 2013 9:59 am
It’s so good to be bad — at least when it comes to investing.
Vice stocks are a corner of the market where many investors — and particularly professionals — are afraid to venture. But this reluctance by many investors to embrace vice stocks is precisely what makes them such profitable investments.
Because professional investors like to avoid being associated with merchants of death and peddlers of peccadillo, these companies tend to trade at discounts to the broader market and often pay substantial dividends.
Some areas of the vice world — in particular, tobacco and firearms — have moats around their businesses that mafia dons and drug lords would envy. Government regulation and a hostile legal regime make it almost impossible for new company to set up shop in these businesses. The compliance costs would prevent them from ever getting off the ground … and the first lawsuit would bury them.
Today, we’re going to take a look at five high-profile vice stocks and evaluate their investment merits:
We’ll start with Diageo (DEO), the London-based premium spirits giant.
Diageo just reported earnings growth of 28% year-over-year, helped along by rising U.S. booze consumption.
Most of the chatter today revolves around improving U.S. sales, but the real story is in emerging markets, where Diageo already gets 40% of its revenues and soon expects to get more than half. Diageo sees “soft spots” in some of its key emerging markets — most notably in Brazil and China — but this is a short-term, cyclical cooling. Diageo’s future lies in the developing world, and the long-term secular trend toward rising consumer incomes is here to stay.
Diageo also is a serial dividend raiser, boosting its dividend every year since 1999 (Note: dividends are paid in British pounds, and the gains can be masked when translated into dollars.) Diageo raised its dividend by 9% this quarter and currently yields 2.6%.
Diageo’s core scotch whisky business has some of the best competitive moats I’ve seen. Scotch isn’t even technically “scotch” until it been aged for three years, and you can’t command premium pricing until it has been aged for at least 12 years … if not 25. Few would-be competitors have the patience or the bankroll to sink large sums of money today into a project that won’t be profitable for a decade or more.
Diageo currently trades for 18 times earnings, making it a little on the pricey side. This is a stock that should trade at a premium to the broader market and one that I expect to outperform the market over time. But you might want drip into this one slowly, or better, wait for a pullback before making any large new purchases.
Next on the list is one of my very favorite long-term holdings, Dutch megabrewer Heineken (HEINY). Heineken, like Anheuser-Busch InBev (BUD) and SABMiller (SBMRY), is a global enterprise with a portfolio of beer brands that covers every inhabited continent.
You might be surprised to see me this bullish on Big Beer. After all, beer is a mature industry in the United States and Europe, and growth — where there is growth at all — tends to be centered on smaller microbrew brands, not the big names you see advertised at the Super Bowl.
This is where Heineken’s geographic reach comes into play. Heineken already gets about a quarter of its profits from Africa. Think about this for a moment. Africa is the least developed region of the world, and the last real “frontier” market of any size. It also happens to be a rare pocket of growth in an otherwise moribund global economy and a region where incomes are still rising.
Topping it off, a disproportionate amount of alcohol consumed in Africa is of the homemade moonshine variety; in some countries, the number is more than half. As incomes rise, these drinkers will trade up to branded beer and spirits.
As Africa moves up the income ladder, the 25% of profits that Heineken already earns there will explode. Consider Heineken a long-term investment in the rise of the African consumer.
Heineken is considerably cheaper than its Big Beer peers, trading for just 10 times trailing earnings and 1.7 times sales. As a point of comparison, AB InBev trades for 20 times trailing earnings and at 3.6 times sales … and also lacks Heineken’s exposure to Africa.
No list of prominent vice stocks would be complete without mention of cigarettes. Big Tobacco is a true pariah industry and the quintessential vice investment. Unless prohibited for religious reasons — as is common with Islamic investment funds — many socially responsible investors will give alcohol a free pass. Not so with tobacco.
This is precisely why Big Tobacco has been such a profitable investment over the decades. Because they have limited potential for growth and are largely forbidden to advertise, tobacco companies have huge piles of cash to distribute as dividends. And because many investors shun the sector, the cheap valuations push the yield higher. With dividends reinvested and compounded, Altria (MO) is the most profitable company of the past half-century, as Jeremy Siegel laid out in The Future for Investors.
Unfortunately, investors seem to have caught on, and much of what made Altria such a fantastic investment in years past no longer holds true.
At current prices, Altria yields 4.9% in dividends, which still makes it one of the biggest payers among large-cap American stocks. But this is significantly cheaper than its five-year average of 6.5%, and it no longer trades at a discount to the broader market. In fact, most Big Tobacco stocks trade at a slight premium to the market.
Tobacco stocks were fantastic investments for virtually the entire investing lifetime of anyone trading today. But they were great investments precisely because they weren’t popular … and today, they are.
As compelling as the vice story is, Big Tobacco is best avoided at this time.
Next on the list is (ahem) “gentlemen’s club” operator Rick’s Cabaret International (RICK).
The adult sphere is an interesting subset of the vice universe in that the economics are very different from the rest. As I wrote earlier this year, adult media businesses like Playboy Enterprises have had a hard time competing with free and abundant competition on the Internet and have had to change their business models. Playboy is no longer a “publisher” but a brand management firm focused on selling its image and its bunny logo. The jury is still out as to whether this transformation will be a monetary success.
Rick’s is a different animal altogether in that — as an operator of strip clubs — its economics are closer to those of nightclubs, bars and restaurants. Unlike booze and cigarette sales — which tend to hold up well during economic downturns — strip clubs are more sensitive to the health of the economy and to the permissiveness of corporate expense accounts. That said, Rick’s revenues held up remarkably well throughout the lean years of 2008 and 2009 and have been growing steadily for the past several years.
Rick’s also is reasonably cheap at 10 times earnings and 0.8 times sales. And the company is reportedly considering spinning off its clubs into a REIT, which, if successful, could give a nice jolt to the stock price.
Alas, Rick’s is not going to be investable for most people reading this. Rick’s has a market cap of just $84 million and average trading volume of just 33,000 shares per day. This is a tiny small-cap stock that few investors are going to be comfortable owning. That said, the company does have some big-name institutional buyers, including Calpers (California-Public Employees Retirement System) and Dimensional Fund Advisors.
And finally, we come to “merchant of death” Northrop Grumman (NOC), a defense firm perhaps best-known for its unmanned drones.
Of course, Northrop Grumman does more than just drones. The company builds an array of defense systems and even offers logistical support and cyber-defense systems.
I come across Northrop Grumman regularly, as it has popped up on the Magic Formula screen off and on for the past several years. For those unfamiliar with it, the Magic Formula was a screen devised by hedge fund legend Joel Greenblatt to find highly profitable companies trading at temporarily low valuations. I’ve used the screen as a “fishing pond” for years and have found some real gems.
Northrop Grumman’s dependence on government contracts at a time when the government is broke and looking to downsize has dampened investor enthusiasm for the stock. It trades for just 11 times earnings and 0.8 times sales.
Yet the company has managed to navigate a difficult political environment deftly and has kept its net income stable even while revenues have been slightly down.
Northrop Grumman recently hiked its dividend by 11% and has raised its dividend for 10 consecutive years. The company also has ambitious plans to buy back about 25% of its outstanding shares by 2015, making Northrop Grumman a model of shareholder friendliness. At current prices, the stock yields an attractive 2.7%.
Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long DEO and HEINY. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.
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