By LARRY SWEDROE
Investing in the shares of firms with morally questionable business models (“sin” stocks, such as tobacco, alcohol and gambling) raises ethical concerns for investors who seek to align their investments with their values. Investing in tobacco stocks is perhaps the best example because smoking leads to millions of premature deaths. The Tobacco-Free Finance Pledge is a recent global initiative whose mission is to inform, prioritize and advance tobacco-free finance and ultimately lead to a tobacco-free world. At the start of 2021, the pledge was signed by 160 investors representing $11 trillion in assets under management.
David Blitz and Laurens Swinkels, authors of the May 2021 study Who Owns Tobacco Stocks?, examined the ownership of tobacco stocks — which investors hold tobacco stocks and which do not. Their ownership data was from Refinitiv (previously Thomson Reuters) Share Ownership and Profile data as of December 2019 and covered the Australian, New Zealand, U.S., U.K., Japanese and European markets.
The authors began by noting that there are at least five arguments made by the group of investors who exclude tobacco from their portfolio:
There are clear adverse health effects and there is no safe level of tobacco consumption.
It is morally objectionable to earn money from providing smoking products.
Tobacco investments may turn out to be “stranded assets” if governments discourage smoking further and perhaps eventually prohibit it altogether.
Investors can earn the equity premium without investing in sin stocks. Although sin stocks have historically outperformed the market, research shows that the outperformance can be explained by their factor characteristics, which may also be obtained with other, more sustainable stocks.
Engagement with the tobacco industry is often considered to be futile.
Blitz and Swinkels offered arguments that favour investment in tobacco firms:
Tobacco firms operate within democratically established laws and provide jobs and consumption goods that people value, at least in the short run.
Systematically excluding any investment based on subjective moral considerations would conflict with the fiduciary duty to obtain the best financial results for clients.
Investors may choose to stay invested in tobacco shares because they believe that changes for the better are more likely to be realised by exercising their voting rights as shareholders and through engagement instead of divesting from controversial firms and ending up on the sideline.
Investors in tobacco shares have not financed the expansion of the tobacco industry over the past two decades. And in the future, providing fresh capital to tobacco firms could be beneficial to society if those firms wish to invest in developing less harmful alternatives to smoking.
Tobacco investments have been lucrative financial investments historically, and with high barriers to entry and high dividend yields, they may well remain an attractive investment going forward.
Following is a summary of their findings:
Investors that do not need to disclose their positions are larger owners of these sin stocks — hedge funds, which are often regarded as the least norm-constrained institutional investors, invest heavily in tobacco stocks.
Norm-constrained investors, such as sovereign wealth funds and pension funds, underweight tobacco stocks.
U.S. and U.K. asset managers collectively overweight tobacco stocks. Conversely, Dutch institutional investors largely avoid investing (near zero weighting) in the tobacco industry. Investors from Australia and New Zealand also have relatively low ownership of tobacco stocks. These pronounced geographic differences in tobacco share ownership indicate that societal norms vary substantially across countries.
U.S. passive managers have large stakes in tobacco stocks that are in line with the weights of these stocks in broad capitalisation-weighted indices — passive replication of ethically screened indices is still a niche. Passive investors outside the U.S. underweight tobacco stocks, possibly due to different reporting requirements. In addition, passive investors typically track free-float adjusted indexes — strategic owners are excluded from the total share count, leading to lower ownership of companies with higher strategic ownership.
Since the total ownership of passive investors has increased from 20 percent in 2010 to almost 30 percent in 2019, passive investors have been large net buyers of tobacco stocks during the past decade.
Given that many investors exclude from their portfolios companies that engage in what they view are objectionable activities, an interesting question is what impact the exclusions have on a portfolio. Norway’s Sovereign wealth fund, the $1 trillion Government Pension Fund, is one of the largest socially responsible investors. According to a 2017 article in Pensions & Investments, the fund divested companies from its investment portfolio based on two types of exclusions: product-based (including weapons, thermal coal, and tobacco producers and suppliers) and conduct-based (those companies with a track record of human rights violations, severe environmental damage and corruption). According to their analysis, Norges Bank Investment Management, which manages the sovereign wealth fund’s assets, found that the fund had missed out on 1.1 percentage points of cumulative additional gain due to the exclusion of stocks on ethical grounds over the prior 11 years. Specifically, they found that divesting from tobacco manufacturers reduced the portfolio return by 1.2 percentage points.
As further evidence, in their study published in the 2015 Credit Suisse Global Investment Returns Yearbook, Elroy Dimson, Paul Marsh and Mike Staunton found that over the 115-year period 1900 through 2014, tobacco companies beat the overall equity market by an annualised 4.5 percent in the U.S. and 2.6 percent in the UK (over the slightly shorter 85-year period 1920 through 2014).
Results such as these have led to the development of an investment strategy that focuses on the violation of social norms: “vice investing” or “sin investing”.
Sin investing: the evidence
This strategy creates a portfolio of firms from industries that are typically screened out by sustainable mutual funds and ETFs, pension funds and investment managers. Vice investors focus primarily on the “sin triumvirate”: tobacco, alcohol and gaming (gambling) stocks. The historical evidence on the performance of these stocks supports the theory.
In his 2017 study, Fewer Reasons to Sin: A Five-Factor Investigation of Vice Stocks, covering the period October 1996 to October 2016, Greg Richey employed several factor models to determine whether a portfolio of vice stocks outperformed the S&P 500 on a risk-adjusted basis. Richey measured the performance of vice stocks using the single-factor CAPM model (market beta), the original Fama-French three-factor model (adding size and value), the Carhart four-factor model (adding momentum) and the newer Fama-French five-factor model (market beta, size, value, profitability and investment). His dataset included 61 corporations from vice-related industries. Following is a summary of his findings:
While the S&P 500 returned 7.8 percent per annum, the “Vice Fund” returned 11.5 percent.
The annual alphas (return above the risk-adjusted benchmark) on the CAPM, three-factor and four-factor models were 2.9 percent, 2.8 percent and 2.5 percent, respectively. All were significant at the 1 percent level. These findings suggest that vice stocks outperform on a risk-adjusted basis. However, in the five-factor model, the alpha virtually disappeared, falling to just 0.1 percent per year. This result helps explain the performance of vice stocks relative to the market portfolio that previous models failed to capture. Richey concluded that the reason for the higher returns to vice stocks is that they are more profitable and less wasteful with investments than the average corporation.
Richey’s findings are consistent with those of Harrison Hong and Marcin Kacperczyk, authors of the 2009 study The Price of Sin: The Effects of Social Norms on Markets, who found that for the period 1965 through 2006, a U.S. portfolio long sin stocks and short their comparables had a return of 0.29 percent per month after adjusting for the four-factor model. As out-of-sample support, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5 percentage points a year. They concluded that the abnormal risk-adjusted returns of vice stocks were due to neglect by institutional investors.
The findings of higher returns to sin stocks should not be surprising. Let’s look at what economic theory has to say on the subject.
Economic theory
While sustainable investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors choose to favour companies with high sustainability ratings and avoid those with low sustainability ratings (sin businesses), the favoured company’s share prices will be elevated and the sin stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ tastes should lead to a return premium on the screened assets.
The result is that the favoured companies will have a lower cost of capital because they will trade at a higher price-to-earnings (P/E) ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). And the sin companies will have a higher cost of capital because they will trade at a lower P/E ratio. The flip side of a company’s higher cost of capital is a higher expected return to the providers of that capital. The hypothesis is that the higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the cost of expressing their values.
There is also a risk-based hypothesis for the sin premium. It is logical to hypothesise that companies that neglect to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. The stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to lowest-scoring firms. The greater tail risk creates the sin premium. However, returns are not all that matters. Investors also care about risk and thus risk-adjusted returns.
The research, including the 2019 study Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance, has found that companies with high sustainability (environmental, social and governance) scores exhibit less risk, typically having above-average risk control and compliance standards across the company and within their supply chain management. Because of better risk-control standards, high ESG-rated companies suffer less frequently from severe incidents such as fraud, embezzlement, corruption or litigation cases that can seriously impact the value of the company and therefore the company’s stock price. And less frequent risk incidents ultimately lead to less stock-specific downside or tail risk in the company’s stock price.
The good news
The gains in reduced risk provided by companies with high ESG scores offset their lower raw returns, producing similar risk-adjusted returns. In addition, the evidence from studies such as Richey’s shows that if ESG investors are willing to “tilt” their portfolios to those sustainable firms with higher costs of capital, they can “have their cake” (earn higher expected returns) and “eat it too” (express their social views).