Vice fund stocks have outperformed the MSCI World Index for approximately 15 years since 2002. This changed in 2017, with vice stocks trailing behind the index by 17% over the last two years – an unprecedented situation that suggests a tipping point in favour of responsible investments.
Isn’t it surprising that investors are so divided over the issue of sin stocks? These have been established over many decades into industries that are as profitable as they are attractive in yield terms. From 2002 to 2017, the Vitium Global Fund (or “Vice Fund”), rose by an average 13% per annum, versus 11% for the MSCI World. An honourable track record for a fund that invests in casino companies, alcohol giants, and arms manufacturers. So why do we now seem to avoid these types of investments and focus solely on irreproachable ethical stocks? Society is gradually adopting a more responsible world view, which leaves less and less room for controversial businesses. There are growing expectations of the greater benefit of investments and, inevitably, yesterday’s winners are starting to look like tomorrow’s losers.
A profitable business model, at what cost?
Not all cultures perceive vice in the same way. To illustrate, the US tends to consider armaments as patriotic rather than unethical, whilst Canada chose to legalise the cannabis industry rather than leave it at the mercy of the black market. Despite these cultural nuances, sin stocks generally cluster around controversial industries such as tobacco, alcohol and gambling, comprised of ‘egotistical’ companies seeking profits regardless of the moral cost.
The business model of a vast majority of these stocks is inherently profitable, especially owing to the limited number of players. Also, addiction-related stocks are built on established brands with strong consumer recognition. The resulting high pricing power ranks industries such as tobacco and alcohol among the most profitable of all, with operating margins of 33% and 29%, respectively. With regards to the arms industry, its importance is very often strategic: whether to maintain military supremacy or to ensure homeland security, countries have no alternative but to invest considerable sums in their defence systems. Ultimately, the strong performance of sin stocks is attributable to predictable revenue streams and profitable business models – until now.
Assets under management in SRI funds reached $31bn at the end of 2018, an increase of 34% compared to 2016. In contrast, the Vice Fund lost close to 40% of its assets under management over the same period.
Whilst they remain profitable, controversial sectors today are at the mercy of both legal and governmental action, with gambling, smoking, junk food and certain kinds of alcohol under regulatory pressure. As a case in point, the proportion of smokers in the US fell from 42% in 1965 to 14% in 2017, resulting in the slow death of the tobacco industry. This is affecting investor behaviour. According to the Global Sustainable Investment Alliance, the proportion of assets under management in ‘socially responsible’ investment funds reached $31bn at the end of 2018, an increase of 34% compared to 2016. In contrast, the Vice Fund lost close to 40% of its assets under management over the same period.
Responsible finance is the only direction
Today, the first step in determining the potential risk level associated with an investment consists in assessing a company’s commitment towards ethics and responsible business. There has been a notable shift in how vice stocks are viewed within investment portfolios, with some investors now preferring to avoid controversial sectors and activities.
In a second stage, assessing the reputational risk of any investment is essential, as incidents can be extremely costly. Case studies include Bayer’s loss of close to 40% of its market capitalisation in the year following its controversial purchase of Monsanto, or Volkswagen’s painful experience following the outbreak of the ‘dieselgate’ scandal. A reputation can take decades to build, but it can be destroyed in mere minutes.
Ultimately, we can see that this new perception of risk and investors’ concern about the larger impact of their investment on society and our planet has an impact on valuations. Sustainable, fair and ethical companies benefit from higher valuations, whilst businesses perceived as irresponsible now trade at a discount. Given the strong growth in SRI assets under management, it seems inevitable that investors will demand an ever higher risk premium for this latter group. There is no doubt responsible investment will become the gold standard for investors in the future and this trend clearly spells an uncertain future for vice stocks.
Timothée Au Duong is an Equity Portfolio Manager for the Edmond de Rothschild Group.