Are Sin Stocks Recession-proof

By Kirk Shinkle

"Sin" stocks have had a rough go during this recession despite a reputation as one of the safer spots to park your money during downturns.

Gambling, booze, and cigarette firms all have loyal (addicted, even) customers who are supposed to keep coming back no matter how bad the rest of the economy gets.

Unfortunately, as with many other bits of the market, this time is different.

Americans are cutting back on vice, though the reasons are very likely more economic than puritanical. They're reconsidering spending on a drink, a smoke, or an hour at the tables and trading down on everything from six-packs to weekend jaunts to Vegas as looming uncertainty and rising joblessness take some of the fun out of recreational abandon.

Here's a quick survey of the head winds facing popular vice-related sectors.

Casinos

The gambling industry has suffered its worst run of luck in decades during this recession.

Customers cutting back on everything from gambling cash to travel budgets have left major markets like Las Vegas and Atlantic City struggling. Both cities have seen gaming revenue fall steadily and sharply for more than a year and a half, with only scant signs that the decline has hit bottom. At the same time, the banking crisis has ripped away easy access to credit that kept casinos expanding at a breakneck pace through much of the past decade. The industry, which gorged on easy real estate financing during the boom, simply won't be able to finance the sort of marquee projects that attract hordes of growth investors, analysts say. Credit defaults are up as well. Craig Parmelee, a gaming credit analyst at Standard & Poor's, notes that there have been 16 defaults by gaming companies since May 2008, and the worst most likely isn't over. Plus, competition is fierce. Two decades ago, Las Vegas and Atlantic City were pretty much the only gaming centers in the country. Now, 37 states have casinos. "Over the last couple of decades, gaming has grown at a much faster rate than the population has. In this particular downturn, you've got a lot more competition for the consumer wallet," he says.

Brewers

For investors right now, it's beer before liquor.

Alcohol sales are off at bars and restaurants as Americans decide to do their drinking at home, and sales of premium liquor and high-end beer are slumping as people trade down to cheaper brands. That has hurt sales at many of the best-known booze companies, which spent the past several years consolidating high-end brands. Ann Gilpin, an analyst at Morningstar, says the shift to drinking cheap beer at home does give Molson Coors (symbol TAP) an advantage, while spirits giant Diageo (DEO) and the Boston Beer Co. (SAM), home to Samuel Adams, face tough competition from cheaper rivals. Gilpin says the trade-down effect will be temporary, however, and the equation could reverse quickly once the economy begins to recover. "If you can believe it, Keystone Light is growing faster than Blue Moon in this country, which is something that hasn't happened for a long time," she says. "I don't think anybody woke up and decided Keystone Light was delicious and Blue Moon was not. They woke up and felt their jobs weren't safe or their money was tight or their house was in foreclosure and they had less to spend at the grocery store. As the economy improves I think you'll see that consumer switch back."

Tobacco

At the moment, tobacco is a case of eyeing what won't go wrong.

Historic legislation just passed by the Senate means clashes between a newly strengthened Food and Drug Administration and the tobacco industry are on the way. Questions remain over regulations for smokeless tobacco products, and a ban on menthol cigarettes is still possible.

Ironically, though, the net effect of tighter regulation could benefit the largest tobacco firms, which are better positioned to pay for higher regulatory costs than smaller peers, many of which have undercut larger rivals on price in recent years. Lastly, in the vice stock universe, smokers are still some of the best customers. "I just don't think people are going to give up their cigarettes," says Patricia Edwards, an investor in the Seattle area. She owns Philip Morris because its international exposure could outpace struggling U.S. sales, and the company boasts a healthy 5 percent dividend. Charles Norton, who manages the USA Mutuals Vice Fund (VICEX), says global cigarette demand is proving "exceptionally resilient," especially in emerging markets.

Is there still a case for vice?

In late 2008, analysts were expecting the recession-vice connection to hold.

Merrill Lynch looked at the above sectors during recessions dating back to 1970 and found they rose 11 percent on average during those periods while the S&P 500 dropped 1.5 percent. That's obviously different this time, since many vice-related companies fell further than the S&P's 39 percent drop last year and have bounced back more slowly than the market during the recovery from the current lows set during March.

Still, while the current environment for vice stocks is overshadowed by consumer woes, there may be reason to keep the sector in mind in the future.

Research by Harrison Hong of Princeton University and Marcin Kacperczyk of New York University found that vice really does pay.

Their study of 41 years of alcohol, tobacco, and gaming stocks through 2006 shows share in unsavory sectors beat other stocks by about 3.5 percentage points, partly because more high-minded investors shun such stocks, which creates a bargain for buyers willing to jump into the vice arena.

They also found that big investors like pension funds own fewer vice shares, and fewer analysts follow them compared with other stocks. A less savory profile means lower valuations and more generous dividend yields as companies try to entice investors to overlook their less-than-sterling reputations.