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Companies selling alcohol or cigarettes among other human vices have historically enjoyed higher returns than the stock market indices to which they belong. Ironically, the stocks of tobacco companies have at times performed better than the pharma companies making cancer drugs to combat smoking-related illnesses.
Since all active fund managers chase alpha – seeking to make higher returns than the benchmark – this in theory makes them ideal holdings. However, investors holding them can face reputational risk, particularly as lobbyists become increasingly vocal against industries known to harm human health such as alcohol or weapons.
So how come sin stocks outperform, making them irresistible but shunned at the same time? Their returns were investigated by David Blitz, co-head of quantitative research at Robeco, and Frank Fabozzi, Professor of Finance at EDHEC Business School, in their article ‘Sin Stocks Revisited: Resolving the Sin Stock Anomaly’ published in the Journal of Portfolio Management.
Blitz and Fabozzi define sin stocks as companies directly involved in the alcohol, tobacco, gambling or weapons industries. Many are barred from portfolios on ethical grounds.
“Various studies have investigated the historical performance of sin stocks and observed that they have delivered significantly positive abnormal returns,” says Blitz. “Despite this, many investors have composed an exclusion list of sin stocks that they do not wish to invest in because they do not want to be associated with the activities of these firms.”
“A popular explanation for the observed abnormal returns of sin stocks is that they are systematically underpriced because so many investors shun them. This enables investors who are willing to invest in sin stocks, going against social norms, to earn a reputation risk premium. Other explanations are that sin industries could benefit from monopolistic returns, or that these stocks face increased litigation risk for which investors are rewarded.”
In fact, the outperformance of sin stocks can be explained by the two new quality factors in the recently introduced five-factor model by renowned economists Eugene Fama and Kenneth French, says Blitz. Their previous three-factor model used ‘market risk’, ‘size’ and ‘value’ to explain why some stocks performed better than others. The 2015 update added two quality factors, ‘profitability’ and ‘investment’.
The profitability factor maintains that stocks with a high operating profitability perform better, while the investment factor suggests that companies with high total asset growth perform worse. Sin stocks tend to have high exposure to both factors; cigarette makers, for example, enjoy high margins due to relative price inelasticity, and are restricted in how they can grow their assets.
Blitz and Fabozzi re-examined the performance of sin stocks using global data right up until the end of 2016, focusing on the question of how their performance holds up in light of these latest factor theory insights.
“We find that, consistent with the existing literature, sin stocks exhibit a significant outperformance in the US, European, and global samples,” says Blitz. “However, this premium disappears completely when accounting not only for classic factors such as size, value, and momentum, but also for exposures to the two new Fama-French quality factors – profitability and investment.”
“For Japan, sin stocks also exhibit significant exposures to the profitability and investment factors. In sum, the performance of sin stocks is fully in line with their exposures to factors included in current asset pricing models, and there is no evidence of a specific sin premium next to that.”
It means that investors who are uncomfortable holding sin stocks but don’t want to miss out on outperformance can proxy them by weighting their portfolios towards the Fama-French factors including profitability and investment.