You Hate These Companies... Until You Invest In Them

By David Sterman
May 24, 2013

Editor's note: This article was updated November 6, 2013

More than a decade ago, major tobacco companies faced a possibly lethal headache.

The U.S. government wanted to make life a lot tougher for them in a bid to reduce the incidence of lung cancer. A "Tobacco Master Settlement Agreement" was signed in 1998, which entailed billions of dollars in fines, tighter restrictions on the sale of tobacco and very high excise taxes. Predictably, U.S. tobacco sales have been falling ever since.

Yet here's the rub: Tobacco stocks went on to become great investments.

The major industry players such as Philip Morris (NYSE: PM) and Lorillard (NYSE: LO) simply decided to stop making new investments in their businesses, and instead have been squeezing out as much cash as possible from their slowly dying businesses. And investors have been handsomely rewarded: Lorillard, which owns tobacco brands such as Kent, Newport and True has managed to boost its dividend a whopping 27% annually over the past three years.

(In fact, Lorillard is a favorite of my colleague, Amy Calistri, who runs the Stock of the Month newsletter. Each month, she actually buys and sells a pick each month in a real brokerage account, which my company funded with $100,000. She explains her strategy in picking out great stocks like Lorillard in her report, "How to Beat the Stock Market... In Just 12 Minutes per Month." Go here to learn more.)

That growth is why it's unwise to simply shun tobacco, alcohol, firearms and gaming companies, known collectively as "sin stocks." You may not be a consumer of their products, but they can become impressive investments.

The key when it comes to sin investing is determining your personal line in the sand. For example, I consume alcohol, I don't smoke but have friends who do, and I have a personal bias against firearms. So for me, alcohol and tobacco stocks are just fine, though I steer clear of gunmakers such as Sturm Ruger (NYSE: RGR) and Smith & Wesson (Nasdaq: SWHC). A friend of mine who is active in her church is a supporter of gun rights and owns shares of those gunmakers, but her religious views lead her to shun alcohol stocks.

To each their own.

Where To Invest

Which kind of sin stock is the best investment? There really is no simple answer. Yet it's abundantly clear that when the crowd is shunning a specific type of sin stock, opportunity can emerge. A decade ago, few would have thought about buying tobacco stocks, but the intrepid few that saw the great dividend streams ahead proved to be quite prescient.

Investors have been wagering on sin for more than a decade. In 2002, the Vice Fund (Nasdaq: VICEX) was launched, and it has risen roughly 200% since (compared to a roughly 100% gain for the S&P 500 in that timeframe). Nearly one-fifth of the portfolio is invested in tobacco stocks, while casino operators, liquor producers and other companies flesh out the holdings. The 1.76% annual expense ratio is about average for mutual funds.

There aren't many options for ETF investors. One of the few choices -- the Market Vectors Gaming ETF (NYSE: BJK), which focuses on casino stocks -- has handily outperformed the S&P 500 over the past few years, thanks to hefty exposure to the robust casino growth in Macau. Morningstar's analysts think that investors need to understand that gaming is now a global phenomenon "with governments worldwide beginning to allow it as a way to generate additional tax revenues and spur economic development."

The Investing Answer: Sin stocks may not appeal to everyone. Indeed, some feel strongly that it's best to align your personal social views with your investing philosophy. Still, to build the strongest long-term portfolio possible, it's OK to loosen your tie a bit.