TCS Daily

Is There Virtue in Vice?

By James K. Glassman - April 2, 2004 12:00 AM

In a classic exchange in Episode 40 of "The Sopranos" on HBO, that renowned financial analyst Anthony "Tony" Soprano Sr. says to his colleague Silvio Dante:

"Sil, break it down for 'em. What two businesses have traditionally been recession-proof since time immemorial?"

"Certain aspects of show business and Our Thing," Sil replies.

Our Thing, of course, is the Cosa Nostra, or organized crime, many of whose activities exploit the vices of frail humanity.

All of which got me to thinking about a column I wrote eight years ago about Burton D. Morgan, who in 1979 put together a private partnership to invest in a profitable and provocative theme: sin. He called the venture "Sin Shares," and it turned out to be very lucrative. In 1994, he took it public as a closed-end fund with a more upbeat name: Morgan Funshares.

In 1996, Morgan, whom I described as a "jolly and candid entrepreneur," told me bluntly, "Fun has nothing to do with it." The portfolio was loaded with companies that, in his words, sold "habit-forming" products, including Harrah's Entertainment (HET) casinos and Philip Morris Cos., now Altria Group (MO), cigarettes. Alas, Morgan -- who had one of the great investment credos of all time ("Buy low and never sell") -- died a year ago at age 86, and the fund was dissolved at the end of 2003.

Sin-based investing, however, survives in the Vice Fund (VICEX), launched in August 2002 by a Dallas investment firm called With just $9 million in assets, the Vice Fund is tiny, but its manager, Dan Ahrens, looks like he's on to a good thing. In 2003, its first full year, the fund returned 34 percent, and through Wednesday it was up another 3 percent for 2004 -- easily whipping the benchmark Standard & Poor's 500-stock index for both periods. (One drawback is that the Vice Fund, like many young funds, has a high annual expense ratio: 1.75 percent, according to Morningstar.) Ahrens, writes Caroline Waxler in "Stocking Up on Sin," a fine new book about vice-based investing, "is a big believer in the economic power of the not-so-nice things." Ahrens has adopted the investment strategy of Tony Soprano and of experts like Tom Galvin, who, Waxler notes, studied vice stocks when he was chief investment officer of Credit Suisse First Boston in 2001 and found that these shares did particularly well when the economy was sour.

"Some sectors," said Galvin, "tend to show better business performance during economically weak periods. They are beneficiaries of mere flaws in human character. It turns out that demand for drinking, smoking and gambling remains pretty steady and actually increases" during tough times.

Are these tough times? Probably not, with the economy growing at better than 4 percent. But, for that very reason, it may make sense to purchase vice stocks now rather than when the economy is cold and sin shares are likely to be relatively hot. Buy umbrellas when the sun is shining; sell them when it rains.

A stock like Altria, however, may be one you never want to sell at all. Altria is the Vice Fund's top holding. Despite the tobacco settlement, which cost cigarette-makers a quarter-trillion dollars, the stock has performed exceptionally well, rising from $33.45 to $53.61 in the past year (as of Friday). Despite this big move, Altria trades at a current price-to-earnings ratio of 12 (about half the P/E of the average Dow Jones industrial stock) and carries a generous dividend yield of 5.1 percent.

If Altria increases its dividend over the next 10 years by just 7 percent annually (the average for the past 10 years has been 13 percent), then the annual yield in 2014 on an investment in the stock you make now will be a whopping 10 percent -- and rising.

Philip Morris, with its popular Marlboro brand, represents about three-fifths of Altria's revenue, and, while cigarette sales are declining in the United States, they are rising internationally, and the company's market share is increasing rapidly.

No. 3 among the Vice Fund's holdings is British American Tobacco PLC (BTI), which operates 85 plants in 66 countries, making such cigarette brands as Benson & Hedges and Kent. The stock is up more than 50 percent in the past year, and it yields a spectacular 6.9 percent.

The Vice Fund also owns Harrah's; Anheuser-Busch Cos. (BUD), the world's largest brewer; Alliance Gaming (AGI), a diversified gambling company that makes machines and owns casinos; Fortune Brands (FO), which sells Jim Beam bourbon as well as Master locks and Titleist golf balls; and Lockheed Martin (LMT), the huge defense contractor.

Of course, vice is in the eye of the beholder. It's unclear to me why a company that makes military aircraft should be considered sinful, but many mutual funds that practice what's called socially responsible investing (SRI) specifically bar defense stocks, as well as tobacco, alcohol and gambling stocks. So, think of the Vice Fund as the anti-SRI brand.

Waxler's book highlights a few stocks that are far seamier than Altria and Fortune Brands. For example, I had never heard of New Frontier Media (NOOF), which sells what it calls "adult" content through Internet sites and pay-per-view television over such networks as TeN (the erotic network), Pleasure, Extsy and True Blue. New Frontier, based in Boulder, Colo., is a small company ($154 million in market capitalization) with a decent balance sheet and a P/E ratio, based on expected 2004 earnings, of just 15.

"Another porn biggie," writes Waxler, "is Barcelona-based Private Media Group [PRVT]. The company doesn't produce original content but rather buys photos and movies and uses the images in various other media, including DVDs, videotapes, and magazines." Its top adult publication, "Private," made its debut in 1965, so this is a firm with tradition. Shares have doubled in the past year, but they are down 80 percent from their high in 2000. Market cap is about $100 million.

In a similar niche, but larger and more conventional, is Playboy Enterprises (PLA), founded by Hugh Hefner, now 77, and headed by his daughter, Christie. Playboy's market cap is $367 million, and shares have risen about 60 percent in the past year. But the stock is far, far below its 1999 high, and its forward P/E ratio, at 24, indicates that shares are pricey.

The smallest of the vice stocks, as far as I can tell, is Houston-based Rick's Cabaret International (RICK), with a market cap of just $8 million. Rick's operates nine "upscale adult nightclubs serving primarily businessmen and professionals that offer live adult entertainment, restaurant and bar operations" around the country as well as a few Web sites, including, an auction site for naughty goods (or bads).

Rick's is one of the most volatile stocks in America. Through Thursday, it was up 36 percent for 2004. But last year the stock dropped 19 percent, and the year before, it lost 33 percent. In 1998, Rick's fell 90 percent; in 1999, it rose 369 percent; in 2000, Rick's fell 62 percent; and in 2001, it rose 172 percent.

Remember that 2001 marked the only recession in a decade. Does Rick's prove Galvin's point about vice stocks thriving in recessions? I am not sure that Rick's proves much of anything, except that investing in strip joints can be exciting. By the way, check out the corporate Web site at Nowhere else in our great financial universe can you find a Form 10-Q offered in such salacious surroundings.

In fact, investing in tried-and-true vice stocks can be the opposite of exciting. Unexciting is what you want in a portfolio.

For instance, David Dreman, the veteran value investor, says that "tobacco stocks have been a core holding of ours for several years." He added, in a letter to shareholders of his Heritage Value Equity fund (HSTVX), "We believe tobacco litigation will be significantly lower in the future, resulting in these stocks gaining much higher P/E ratios. . . . Our sum-of-the-parts valuation of Altria implies an expected return of 50 percent or more from current prices."

Or consider UST Inc. (UST), maker of smokeless tobacco products (Copenhagen, Skoal) and wines (Chateau Ste. Michelle, Columbia Crest). In an interview in Outstanding Investor Digest, money manager Tom Russo talks about why he loves the stock: It has powerful brands; "it generates an enormous amount of free cash that they split between dividends and buybacks"; and "it has a very serious opportunity for volume growth as smokers substitute smokeless tobacco for cigarettes." Russo runs Semper Vic Partners, which has produced average annual returns of 18.5 percent over the past 20 years.

And then there are unlikely vice stocks like Church & Dwight (CHD), which not only makes Arm & Hammer baking soda but also owns half of the company that makes Trojan brand condoms, with a 65 percent market share in the United States, and Limited Brands (LTD), which owns, among other retail chains, Victoria's Secret, purveyor of frilly underwear.

This is not to say that condoms and thongs are sinful. But, like cigarettes, alcohol, gambling and anti-tank missiles, they are items that enjoy consistent sales and reap consistent profits in good times and bad.


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