Introduction
In a recent article, I interviewed a Chartered Alternative Investment Analyst for ways to reduce risk on my long emerging market positions (EWZ, EWY, PRLAX, EZA, MCHFX, and MINDX). In this article, I pick up on that subject again by considering the vice industries as a hedge.
Why vice as a hedge? Sometime back, I wrote on the economics of the global entertainment industry. I found that drinking, entertainment drugs, sex (prostitution and pornography), restaurants, movies, and gambling were the largest global entertainment industries, as measured by expenditures. And if cigarettes are included as a drug, drugs and drinking tie for first place.
There is an interesting literature on sin/vice investing.[1] In essence, the studies find that in the long run, sin stocks outperform the overall market. Why? Because some institutional investors shy away from sin stocks, sin industries have high entry barriers, and companies within sin sectors often have considerable pricing power.
But how about at different stages in the economic cycle? Do some “sin sectors” perform better than others? As I pointed out in Dangerous Addictions, the addictive sectors should show less cyclical fluctuation than other sectors. Certainly, smoking, drinking, drugs and sex are seriously addictive. And gambling can be addictive.
What does the data tell us? Equities in smoking and drinking industries are far more stable than equities overall. But US gambling stocks do not perform as would be expected if an addiction to gambling was driving performance. In fact, it is just the opposite. I estimated the beta[2] for gambling stocks relative to the S&P 500 to be 1.58 while Hong and Kacperczyk (cited earlier) estimated the beta at 1.12. Why is this? I quote from an earlier article on gambling:
“In the US, gambling is increasingly being promoted as an overall entertainment experience. In fact, a recent study has documented that more than 60% of casino revenues are generated by non-gambling activities. This makes a gambling outlay far more like a discretionary consumption item than a necessary addiction purchase.
While US gambling stocks have collapsed, Asian gambling equities have taken off. Why is that?
Two reasons:
- In Asia, gambling resorts are marketed (primarily to men) as part of a package that includes smoking, drinking, and sex.[3]
- The global recession is a distant memory in most Asian countries. As a result, gambling “resorts”, either as a discretionary consumer or business expense, are booming (Macau gaming revenues are now about 4 times those of Las Vegas).
This is a long way of saying that with the exception of gambling, sin/vice stocks should be a good hedge against global economic downturns.
To examine this hedge hypothesis in more detail, I interviewed Jeff Middleswart, the manager of The Vice Fund (VICEX). VICEX invests in four categories: drinking, gambling, smoking, and defense.
My interview with Jeff follows.
Elliott: Jeff, you have seen my long portfolio holdings. Do you see vice stocks as a possible risk-reducing hedge?
Jeff: Vice stocks have the potential to perform better when times are uncertain, leading many to view investment in “Vice” industries as a solid strategy during recessionary periods.
Elliott: Any initial thoughts on my holdings?
Jeff: Two points:
- First, Emerging markets have higher growth rates than developed countries, and they are developing internal/domestic markets instead of relying 90% on exporting to the slow growth Western nations. Moreover, you can see currencies weakening in developed countries and emerging market currencies getting stronger. Consequently, I believe the macro-themes you focus on are still swinging more favorably to developing markets.
- Second, I note that you hold some index funds. Most emerging market indices are like the Dow Jones of 1900. The largest domestic companies are normally banks, property owners, mining/steel companies, one or two big conglomerate firms like a GE, and maybe utility companies. But nearly all stock indices (foreign and domestic) are heavily weighted toward banks and real estate. These are the areas of the market that normally trigger problems that cause market meltdowns.
By investing in vice industries, you avoid these risky industries. Vice firms normally require little outside capital and pay sizeable dividends. Vice products do not need to be reinvented continually. Thus, growth is profitable and cash flow, rather than being forced back into R&D spending, is paid out to share-holders. Vice industries have consolidated and continue to do so: they operate as oligopolies. Competition is more subdued and they are able to “manage” prices.
Elliott: Two questions on Aerospace and Defense (A/D):
1. In what sense is A/D a vice industry?
Jeff: To us, a vice industry faces an inelastic demand curve (people buy, even if the price goes up but not much less if the price falls), consolidation among the competitors, large and growing cash flows that are used to reward shareholders with dividends, share repurchases, and acquisitions to bolster the high barriers to entry, and a negative taint that causes these stocks to be undervalued relative to the market. A/D is a classic vice industry because its companies must be able to bid and win large government contracts. That is a sizeable barrier to entry. And being the original provider of an airplane or vehicle makes it likely that maintenance, spare parts, and upgrade contracts will flow to the same company. They have to show the ability to survive downturns in commercial aerospace which has been a boom-and-bust business for generations. These companies have the taint of Vice in that many investors do not want to own companies that produce missiles or fighter planes. However, they produce enormous cash flows and have been actively acquiring other companies and pay above average dividends. Keep in mind that these companies don’t just build planes and tanks. They also work on many projects for Homeland Security, satellites, terrorism screening, and cyber-warfare defense. And remember the exposure these companies provide to emerging market companies where arms purchases are growing. Every day there are deals announced for more airplanes overseas and more cyber-defense, both in the emerging markets and the developed world. When older US military weapons/vehicles are approved for sale in developing markets, the resulting contracts are long-term and they cover maintenance, upgrades, and spare parts. They do not disappear if these economies have a recession for a year or two.
2. With government budget cuts coming in the US as it moves into “austerity” won’t your A/D companies lose out?
Most of the US military budget is spent on salaries and care for personnel (food, housing, and benefits). So if and when an “austerity” period comes, reducing troop levels is the easiest way to cut the defense budget. If we pull troops out of areas like Okinawa, Korea, and Europe, we save a fortune on travel and supply plus base maintenance. And very few of our companies earn much income from these activities.
Elliott: As you know, I believe in betting against the US dollar and investing in the rapidly growing and nearly debt free emerging market countries. Specifically, how do you holdings help me “bet against the dollar” and get exposure to emerging markets?
Jeff: As an anti-dollar bet, the vice industries have already targeted the rapidly growing foreign markets that interest you. For alcohol and cigarettes, there has been a rapid consolidation of assets and cost cutting. The capital spending and acquisitions focus has centered on Brazil, India, and China. The merger of Anheuser Busch and Inbev was driven largely by Anheuser Busch’s incremental cash flow that Inbev could tap to grow and Anheuser’s huge exposure to Brazil. The break-up of Philip Morris into Altria in the US and Philip Morris internationally was designed to create one solid cash cow company (Altria) and another that would realize tremendous growth in emerging markets (Philip Morris) as consumers earned more money and traded up to better brands. Diageo has had a similar focus in the sense of finding that foreign consumers are trading to higher quality (and priced) liquor. The Chinese gaming market already does more business than the entire Las Vegas strip and China continues to grow. Even Wynn Resorts is talking about moving its headquarters to China to be closer to its growth areas. So the Vice companies are very aware of the emerging markets and have made tremendous inroads there over the last 10-15 years. The other nice part about these stocks is getting huge cash flows that benefit shareholders in high dividends and EPS growth via share repurchases.
I guess that 85% of the companies in which the Vice Fund invests have business in emerging markets. Even our ADRs, like Diageo and British Tobacco, are actively developing their business lines in China, India, Brazil, etc. Remember that an ADR is a claim on an equity traded overseas which means that if the dollar weakens, the weakening should be reflected in the ADR price. Also, if an American company makes a profit in a country whose currency strengthens relative to the US$, that strengthening should be reflected in the company’s profits when converted back to US$ .
As mentioned above, Altria focuses on the US market but has a 28% stake in SABMiller, a company actively developing markets in Africa and Russia. All of our beer, spirits, major defense contractors, and gaming plays (except Churchill Downs) have exposure to emerging markets. As an anti-dollar bet, the vice industries have already targeted the rapidly growing foreign markets you are talking about.
Concluding Comments
What do the numbers say? From Jan. 2, 2008 to March 9, 2009, the S&P went down 50.7% while VICEX lost 50.9%. That does not sound like a good hedge to me. What happened? It is hard to say exactly, but assuming VICEX lost most on its portfolio holdings of December 31, 2007, A/D fell 52%, Alcohol was down 50%, tobacco off 40%, and gambling fell 83%[4]. These numbers are consistent with the research reported on earlier: tobacco investments are quite stable while at least US casinos and gambling behave like a discretionary consumption item.
On November 11th, VICEX stood 22% below its price on January 2, 2008, while the S&P 500 was 16% lower. In short, VICEX went down as much as the S&P 500 in the crash and has not recovered as much as the S&P 500. That is the bad news.
What is the good news?
- The research finding cited earlier that sin/vice stocks outperform the market in the long run is correct at least insofar as VICEX is concerned: since inception in 2002, VICEX is up 85%, or more than twice the growth in the S&P 500.
- Middleswart took over as fund manager in February, and the holdings have changed dramatically: according to the SEC report of June, 6 of 11 Aerospace and Defense stocks have been liquidated and replaced as have half of the alcohol stocks; in the gambling sector only 2 of 9 the gambling holdings remain with a new emphasis on the booming casino market of Asia; and 2 of 4 tobacco companies have been replaced. In short, there is a much heavier reliance on equities that will benefit from the growth of emerging market countries. Middleswart has also cut out short sales and operates with lower cash balances.
So what do we have in VICEX? Three sectors with much lower risk than the overall market, with a heavy international exposure, and one sector – gambling, now growing rapidly in Asia and likely to recover once the recession ends in the developed world.
VICEX could be a useful hedge against my long emerging market positions.
I am not an investment adviser and nothing I say should be taken as a recommendation to buy or sell an asset.
[1] See F.J. Fabozzi, K.C. Ma, and B.J. Oliphant, “Sin Stock Returns”, Journal of Portfolio Management, Fall, 2008, and H. Hong and M. Kacperczyk, “The Price of Sin: The Effects of Social Norms on Markets”, Journal of Financial Economics, April, 2009 [2] The estimated percent change in the price of gambling stocks for any percent change in the S&P 500. A beta greater than 1 means gambling stocks are more volatile than the S&P 500. [3] Prostitution is legal in Nevada, but do you ever hear about this in Las Vegas marketing? [4] Jeff pointed out that because A/D, alcohol, and tobacco were so stable, they were sold off as redemption orders poured in during the financial panic.