‘Vice stocks’, such as tobacco, gambling and alcohol, are often seen as a good defensive bet. The devil has the best tunes, they say – but does he have the best investments too? Traditionally, ‘vice stocks’ have been viewed as the classic defensive sector. It’s no surprise: vice is a constant feature of human life, despite continued attempts by societies and governments across the ages to suppress it in all its various forms. Civilisations come and go, but our bad habits, it seems, endure forever.
Contrast that with investing in wind power, or buying into the ethanol bubble. Many ‘ethical’ investments involve taking a punt on faddish trends or unproven new technologies – the rewards may be great when you get it right, but the chances of getting it wrong are far higher. But vice never goes out of fashion – technology is unlikely to render alcohol or tobacco obsolete any time soon.
These all seem like compelling reasons to buy into the sectors. And with the threat of a US slowdown hanging over the global economy, it’s certainly wise to be adopting a more defensive frame of mind. But the bad news is that everybody knows vice pays. Ethical investing might be growing in popularity, but there are more than enough investors out there whose main principle when it comes to buying stocks is to make money.
This has seen vice sectors such as tobacco, alcohol and gambling driven up far in advance of markets in recent years. In the US, the Vice Fund, which invests only in gambling, tobacco, alcohol and defence-related stocks, has produced annual returns of more than 20% since it was launched in 2002 (for more on the fund, see page 32). Those sorts of numbers should put contrarian investors on their guard; as we all know, yesterday’s star performer has a tendency to become tomorrow’s biggest loser. That’s not to say that there aren’t some decent opportunities in the vice sector – but it does mean that you have to be picky.
Taking a punt on gambling
The rise of online betting is the biggest story to hit gambling in recent years. There are thought to be around 2,500 gaming websites worldwide and the global industry is now worth an estimated $12bn to $13bn. But all bets are off following the arrest in July of David Carruthers, former chief executive of BetOnSports.com, as part of a US crackdown on online betting.
The US generates about half of the industry’s revenue, but online gambling is illegal in the country, which means providers are based offshore. How far the US authorities are planning to go is as yet unknown, but the prospect of the US becoming a no-go area has forced online casinos to seek new markets in Europe and Asia via costly takeovers.
Away from the US, research group Screen Digest is bullish on the prospects for the UK, where online gaming is regulated. The group’s recent report on the sector predicts that the number of active gambling accounts in Britain will nearly double by 2010 from 1.1 million to 2.1 million, as online betting goes mainstream. Gross margin – the portion of stakes retained by operators after winnings have been paid out – is predicted to grow over the same period from £660m to £1.56bn.
The anticipated boom in online gaming may owe more than a little to the Government’s retreat over Vegas-style ‘supercasinos’. At first, 40 were to be built across the UK – each at least 5,000 square metres in area, with up to 1,250 unlimited jackpot slot machines.
Media outrage saw plans cut back to just one supercasino, but licences to build eight large casinos and eight smaller ones are also up for grabs. “The prospect of new casino licences and increased freedom to advertise make the UK an attractive destination for foreign operators in markets like the US where growth is harder to come by. And for now, the only way in is through a tie-up with a UK operator,” says John Foley on Breakingviews.com.
The scramble has already begun. A bidding war is brewing over casino operators London Clubs International and Stanley Leisure, with Las Vegas-based Harrah’s Entertainment, owner of Caesars Palace and Malaysian gaming group Genting both making bids. The FT’s Lex column says: “No listed UK casino operator is likely to remain in UK hands.”
But despite deregulation, the UK is hardly looking to displace Las Vegas as the world’s premier gaming centre. For that, you have to look at “the Monte Carlo of Asia” – former Portuguese territory Macau. Macau returned to Chinese rule in 1999 and is the only place in China to permit casino gambling. The industry was controlled for 40 years by local tycoon Stanley Ho, whose monopoly was abruptly ended in 2002 by the Beijing government, which invited competitors from Las Vegas to tender for licenses.
Growth has been rapid. In 2004 alone, gaming revenues were up 43.4% to just under $5.3bn. That compares to $6.8bn turnover for Las Vegas. Las Vegas Sands Corp, which opened Macau’s first supercasino in May 2004, has already extended it. The Sands Macau, which has had more than 20 million customers, now offers a 229,000 sq foot gaming floor with 740 tables and 1,254 slot machines.
This week, US billionaire Stephen Wynn opened the Wynn Macau, with the Venetian Macau due to follow next spring. We look at which stocks offer the best exposure to the boom below.
Investing in alcohol
There are plenty of ways to invest in alcohol: pubs, off-licences and drinks makers are obvious options. But if it’s a consumer downturn investors are worried about, then how defensive are any of these groups in reality? Pubs may have done well out of this year’s hot summer and the football World Cup, but plenty of headwinds face the sector.
A ban on smoking in enclosed public places in England and Wales comes into effect next year. In Scotland, where a ban has been in place since March, the Scottish Licensed Trade Association reckons sales have fallen more than 10%. The rising minimum wage and energy costs are putting pressure on profit margins, and a consumer downturn would see people cutting back on nights out. Given all this, the pubs sector looks undefensive.
So what about drinks makers? Investors have been paying a lot of attention to the sector recently, based largely on the cider revival. “Oh for the luck of the Irish,” declares the FT. “Just as Guinness sales are falling, Britain has developed an unquenchable thirst for Magner’s Irish cider.” Manufacturer C&C saw sales quadruple in the half-year as a clever marketing campaign made cider the latest trendy beverage.
But the British are a fickle bunch. Cider may be the booze du jour, but how long before it goes the way of the alcopop? And while UK consumers are drinking more than ever – boosted partly by the rise in women drinking – European markets are in decline. “Drink sales in France and Germany have dropped by 6% and 8% over the past five years,” says the FT.
The best prospects for the drinks sector are emerging markets, where growth remains strong. Many of the big drinks makers offer exposure to these economies, but their mature markets act as a drag on growth. Luckily, we’ve found a way investors can get pure exposure to one particularly heavy-drinking nation – look at our tip in the box on the previous page.
Tobacco is still a draw
Interestingly, one of the vice sectors least affected by the smoking bans taking effect across the UK and Europe is the tobacco sector. While bingo halls lose money across Scotland, and pubs shudder at the thought of smokers being unable to light up in their premises, it’s business as usual for tobacco companies.
It’s little wonder. Cigarette volumes throughout developed countries have been in decline for some time, but sales in emerging markets are more than making up for the fall, according to ABN Amro. Moves to slash costs by shifting manufacturing from expensive factories in the UK and western Europe to the Far East and eastern Europe, which are nearer their new markets, mean that tobacco firms have no need to fear the more health-conscious attitudes developing in the western world.
The main market in cigarette makers’ sights is, of course, China. The Chinese are prodigious smokers – about a third of the world’s nicotine addicts are Chinese. “If the Chinese market were to open, it would increase the foreign tobacco companies’ market by 40%-50% overnight,” says ABN Amro.
Just 3% of the near two trillion cigarettes smoked by the Chinese last year were foreign brands. But the market is dominated by the State Tobacco Monopoly Administration and there is no imminent sign of China’s markets opening up – unsurprising, as the state monopoly is the government’s “single biggest taxpayer”, according to the FT.
Yet it seems likely that it’s only a matter of time before foreign firms are able to make inroads into the region. In the meantime, the outlook regarding litigation is clearer than for some time. In July, a $145bn class-action lawsuit that had been hanging over the sector since 1994 was overturned by the Florida Supreme Court.
This month, a US judge found that, while tobacco firms had conspired to hide the dangers of smoking in the past, she could not order them to fund a ten-year $14bn anti-smoking campaign. Tim Ghriskey at Solaris Asset Management called it “a victory” for tobacco firms.
The fading allure of sex stocks
Way before gambling, alcohol or tobacco, there was sex – the oldest vice there is. You might think that would make it a sure-fire investment. But there are some key differences between the sex industry and other vices, availability for one.
If you want a drink or a smoke, you have to pay for it. The same goes for betting – you can gamble among friends, but casinos and bookies offer convenience and the chance to make – and lose – a lot more money. But when it comes to sex, there’s no need for a consumer actually to buy anything to fulfil their need.
Linked to this is another major difference – the virtual absence of barriers to entry. It would be tough, if not impossible, for a small upstart to challenge the dominance of a British American Tobacco, or a SAB Miller, for example. But anyone with a digital camera and someone willing to take their clothes off in front of it can get into the sex industry. Just as in traditional publishing, the internet is hurting adult magazines, which are also barely coping with the rise of ‘lads’ mags’ such as FHM.
Similar problems arise in retail. With the ascent of the sex shop from back street dens for the dirty-mac brigade, to fragrant boutiques popular with glossy women’s magazines, the erosion of sexual taboos has made the market much more attractive to competitors.
A recent proposal by high-street chemist Boots to stock sex toys alongside the aspirin and hair dye raised a few choice puns in the press, but the reaction otherwise was muted. As goods that would once have been considered beyond the pale make it into high-street shops with the support of consumers, the rising supply will inevitably squeeze margins by forcing quality improvements and price cutting, just as it does with every other consumer good.
Sex shops are also exposed to the vagaries of consumer demand, like any other retailer. German chain Beate Uhse was forced to issue a profit warning recently, blaming the hot summer and the World Cup for poor second-quarter sales – excuses familiar to investors in any number of high-street retail chains.
All of this means that we’re not convinced that the oldest vice actually converts into a decent investment proposition – though we’ve had a brief look on the previous page at one option for investors who may disagree.
Which vices are nicest?
Of the four vice sectors we’ve covered, the most exciting in terms of investment – appropriately enough – is the gambling sector.
Although the overseas rush to tie up with UK casino operators could lead to a takeover bid for leisure group Rank (RNK), analysts are not convinced this will happen soon, particularly after half-year results disappointed and contained little by way of news on selling its Hard Rock Cafe unit. With shares trading at a forward p/e of 19, the company seems too expensive and its future too uncertain to take a punt on a bid materialising.
The real action is in Macau. One way to buy into Macau’s gambling boom would be through a US casino operator active there, such as Wynn Resorts (NASDAQ: WYNN), says the Profit Hunter newsletter. But with a market capitalisation of more than $7bn, it’s “quite a ponderous proposition”.
Instead, Profit Hunter tips Melco International Development (HK: 200), a smaller company originally founded in 1910 as The Macau Electric Company. Now focused on leisure, gaming and entertainment, it teamed up two years ago with Australian media and gambling group PBL to build “The City of Dreams”, a 2,000-room hotel due to open its doors in the second half of 2008. Mocha Slots, Melco’s very lucrative slot machines unit, has more than 1,000 machines in operation, and the City of Dreams opening will more than quadruple that figure.
Profit Hunter reckons there is a “realistic chance that Macau will soon be bigger than even Las Vegas” and that buying Melco now “could almost make you feel as if you were back in the 1940s when Bugsy Siegel took the lead in Las Vegas”.
Within the alcohol sector, large drinks manufacturers such as Diageo are unattractive for the reasons outlined above – indeed MoneyWeek’s Paul Hill urged investors to sell the stock in a recent issue, citing overvaluation. As for the cider boom, C&C (CCR), manufacturer of Magners, trades on a forward p/e of around 25, which doesn’t leave much room for slip-ups if consumers decide they’ve had enough of alcoholic apple juice.
But the Profit Hunter newsletter has uncovered an interesting play on emerging markets – in Poland. Central European Distribution (NASDAQ:CEDC) sells, distributes and imports alcohol in Poland and “has a stranglehold on the Polish market”. The Poles have some of the highest alcohol consumption rates in the world, at about nine litres a head each year, so it’s a great place to be selling alcohol.
The group is the country’s largest vodka producer and has a 32% share of the market. Net sales rose from $178m in 2001, to $749.4m last year, with net income soaring from $2.5m to $20.2m in the same period. It should have no trouble posting double-digit annual growth over the next five years, and Profit Hunter reckons the share price could “easily go to $64”. It currently trades at around $24.
Tobacco is less exciting for those hunting for multi-bagger stocks – but as a genuinely defensive sector in a downturn, it’s worth investors taking a look. Broker Charles Stanley is keen on both British American Tobacco (BATS) and Gallaher (GLH). BAT, the world’s second-largest tobacco firm, trades on a forward p/e of 13 for 2007, while Gallaher trades on a p/e of 13.9 for 2006, which “looks excellent value given the quality of the business” and does not take into account the “possibility of it becoming a bid target, given the probability of industry consolidation”.
The sex sector takes the wooden spoon when it comes to our vice recommendations. One stock of potential interest is Rick’s Cabaret International (NASDAQCM:RICK), which owns 11 strip clubs across the US and is set to expand further. Its latest club in New York turned profitable within three months of opening. But we would point out that, like many of its peers, it relies heavily on high-rolling Wall Street-types to support its business – if a US recession does hit home, Rick’s is unlikely to be immune