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Are 'vice' stocks actually recession-proof? Experts explain

Alcohol, gambling, and tobacco stocks usually hang tough. They've underperformed of late.

Twenty/20

If you're invested in a broadly diversified portfolio, chances are you hold at least some stock in a company that provides a product or service that you think is, well, questionable.

Some investors see owning stock in firms they don't like as the cost of doing business. But others intentionally invest in the market's bad boys. After all, like that guy with the motorcycle you dated in college, "vice" stocks hold a certain appeal. Firms that make their money from sales of alcohol, tobacco, or gambling typically generate ample cash that they distribute to shareholders in the form of dividends.

They're also thought to hold up better than other firms during difficult economies because their customers tend to be brand-loyal and often dependent consumers regardless of their economic circumstances. In other words, you might argue that they're recession-proof.

Lately, though, during this topsy-turvy economic time, vice stocks haven't held up their end of the bargain. "I'd be careful to use the term 'recession-proof'" when discussing vice stocks, says Morningstar analyst Nick Johnson. "It very much depends on the recession."

So far this year, alcohol, tobacco, and gambling stocks in the S&P 500 have posted an average return of -21%, compared with a 7% gain in the broad index. That should make vice stock investors wonder whether any perceived moral trade-off for holding these firms is actually worth it, or if they should settle down with that sensible boy who drives a Volvo.

Vice stocks face ongoing challenges

There's no single definition for what a vice stock is. Alcohol, gambling, and tobacco firms seem to be undisputed members of the category, but there are others, too, depending on who you ask. Exchange-traded funds and mutual funds with vice-stock mandates, such as the AdvisorShares Vice ETF (ACT) and USA Mutuals Vitium Global Investor (VICEX), may invest in gun-makers, defense contractors, online gaming firms, drug manufacturers, and cannabis growers.

Whether you use a narrow or broad definition, vice stocks of all stripes face a similar set of challenges. For one, they're subject to more government interference than the typical firm. Major gun control legislation would likely spike the volatility of gun manufacturers' stocks, for instance. And excise taxes meant to curb a particular vice could make life difficult for companies in that industry, says Vivien Azer, a senior analyst and managing director at investment research firm Cowen.

Should Democrats take control of Congress and the White House, expect a bump in the federal excise tax on tobacco, she says.

What's more, so-called ESG investing — investing in companies that score high marks for environmental, social, and governance practices — is on the rise, with investor assets in sustainable index funds having quadrupled, to $250 billion, in the last three years alone. Many ESG strategies exclude vice stocks, which presents a major problem, says Azer.

"A certain subset of institutional investors can't invest in tobacco because of ESG considerations," she says. "You need money to go into stocks for stocks to go up. If the pool of investable capital in tobacco is shrinking, that makes it hard for the sector."

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Some vice stocks still hold appeal, but be choosy

Until recently, vice stocks had posted a pretty good track record during tough times. The USA Mutuals Vitium Global Investor fund, which invests in a broad basket of vice stocks, for instance, posted positive returns in 2011 and 2015 — both tough years for the broad stock market.

But as investors recently found out, not all down markets and tough economies are created equal. The pandemic-induced recession of 2020 has been unique, Johnson says, due not only to the forced closures, but the unevenness of who has been affected. While millions of Americans have taken hits to their income, he says, "white collar jobs are still around. Plenty of people have the same if not more disposable income."

I'd be careful to use the term 'recession-proof.' It very much depends on the recession.
Nick Johnson
Equity analyst, Morningstar

This recession has affected vice industries in different ways, but in each case, it has clobbered some firms while leaving others relatively unscathed. Here's what the landscape looks like for the three major vice industries.

Alcohol

Revenues from so-called on-premises consumption (drinking in bars) is markedly down across the board, as bars have been forced to close during the pandemic, and companies have been able to make up the difference, to varying degrees, from an uptick in home consumption. The shift away from public drinking has accelerated an existing trend of companies offering premium alcohol offerings, such as spirits, wine, and imported beer, outperforming those with lower-end offerings, such as domestic light beer.

Brown-Forman, which manufactures and markets Jack Daniel's whiskey, has returned 11% on the year, while global brewer Molson-Coors has surrendered 35%. The biggest growth story among booze stocks? Hard seltzer. Boston Beer Company, which owns popular seltzer brand Truly, has returned an eye-popping 142% in 2020.

Johnson expects the sector to hold up well through the remainder of the pandemic and to perform well coming out of it. "Overall, we have a favorable view of these companies," he says. "Even the ones that haven't performed well, we think are undervalued. They'll pay nice dividends and should provide a mix of income and capital appreciation."

Gambling

It's easy to see why Las Vegas was hit hard by the pandemic, but it actually held up better than you might think. As of August, Nevada gaming revenue was down 22% year-over-year, compared with a 47% decline in revenue across the broad hotel industry. Things have been tougher in Macau. The Chinese enclave, usually a gambling mecca, "has been smashed," says Morningstar senior equity analyst Dan Wasiolek, due to Chinese travel restrictions. Casinos there have reported revenue losses of as much as 90%.

That's hurt U.S. casino operators, such as MGM Resorts International, Las Vegas Sands, and Wynn Resorts with major presences in Macau. Shares of all three have declined by at least 30% on the year.

Encouraging news for investors interested in gambling: the rise of legal sports betting. As more states legalize gambling on games, Morningstar expects the money to pour in to the tune of $6.2 billion in revenue for gaming operators by 2024, up from $900 million reported in 2019. Morningstar expects Caesars Entertainment, MGM, and online sports betting company DraftKings to be among the main beneficiaries. As for Macau, Wasiolek says things will eventually pick back up, and that growth in gambling there represents a long-term opportunity for patient investors willing to withstand some volatility.

Tobacco

Cowen's Azer isn't bullish on much of the tobacco market, which faces pressure from regulators and competition from upstarts such as e-cig company Juul. Although smokers don't typically drop the habit during tough economic times, users, many of whom are low-income, can switch up their habits, Azer says, gravitating toward cheaper tobacco products, such as dip, which not all tobacco firms sell.

Tobacco giants Altria and Philip Morris International have lost 17% and 10% on the year, respectively.

Philip Morris International's stock holds promise, says Azer. Thanks to its popular Iqos e-cigarette, the firm is among the global leaders in "reduced-risk" tobacco products and should be able to boost earnings faster than peer firms as a result, Azer says. Another potential winner: Turning Point Brands, which produces, among other things, rolling papers and smokeless tobacco products, such as dip. "For many of the other companies, expect low- to mid-single digits earnings growth," Azer says.

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