BAT Stock Purchase – Why Sin Stocks Outperform The Markets Over The Long Term

Sin stocks are profitable for investors. There is no two ways about it. Whether you are talking tobacco, alcohol, sugar, gambling or defence, all these categories have comfortably outperformed markets over the long term.

Just look at the most profitable stock over the past 50 years, Phillip Morris, a Tobacco stock.

The top 3 sectors over the past 82 years were cigarettes at 8.34% real annualised return, beer at 7.51%, and oil at 6.84%. Investors in “ethical” funds that avoid these sectors are virtually guaranteeing drastic underperformance.

It is no surprise to see Tobacco topping the list. I have already written about the fantastic economics around cigarette manufactures so I won’t elaborate here. If you haven’t already, go and read the article before continuing this.

Apart from the fantastic financial and business performance of tobacco companies, one of the reasons why investors in Phillip Morris, British American Tobacco and Imperial Brands have outperformed markets over the years is due to their low historical valuations. Most investors simply do not want to own shares in immoral companies. This leaves them to trade at low P/E ratios and high dividend yields which is great for those investors that want to own shares in these types of companies. Non ethical companies have share prices that are artificially lowered due to lessened demand, thus shares will return higher than otherwise anticipated returns

Have a look at the following excerpt from a note from Cliss Asness of AQR:

” What happens when one group of investors, call them the virtuous, simply won’t own a segment of the market (the sin stocks)? Well, in economist terms the market still has to “clear.” In English, everything still gets owned by someone. So, clearly the group without such qualms, call them the sinners, have to own more than they otherwise would of the sin stocks. How does a market get anyone, perhaps particularly a sinner, to own more of something? Well it pays them! In this case through a higher expected return on the segment in question. This may be unpleasant but it is just math (like math could ever be unpleasant). In the absence of extra expected return the sinners would own X of the market segment in question. The only way to get them to own X+Y is to pay them something more. Now, assuming nothing else changed, how does the market assign this sinful segment a higher expected return? Well by according it a lower price. That is, if the virtuous decide they won’t own something, the sinners then have to, and they have to be induced to through getting a higher expected return than otherwise. This in turn is achieved through a lower than otherwise price. ” 

It is that simple. It is pure maths. If a whole group of investors are averse to a particular sector, they won’t touch a stock in that sector even if it offers them 10%-15% returns a year! This is exactly what is happening to tobacco today. It seems that all the large investors – sovereign wealth funds like the Norwegian one worth over $1 trillion, large pension funds such as Californian Teachers Fund (CalSTRS) and insurers such as AXA – don’t want to hold tobacco stocks for moral reasons. So there is this very large pool of money that not going to touch tobacco. This is brilliant for you and I as we do not need to compete with these large pools of capital. We can buy Tobacco shares on the cheap. Additionally, tobacco companies who conduct buy backs can also reduce their share counts on the cheap and this has the effect of really juicing returns over time.

British American Tobacco (LON:BAT) Stock Purchase

The recent decline in tobacco stocks has to do with threats of increased regulation in the US and slightly disappointing results from Phillip Morris. Sure they are declining trends in the market such as reduced cigarette volumes and high debt by the likes of BAT as a result of the Reynold acquisition. But to me, this fickle selling has provided a buying opportunity. BAT is at levels now that is has not been in a very long time.

I bought 28 shares at £36.17 a piece. With BAT having recently bumped up its dividend by 15% to £1.95, my annual dividend income from this share is £54.60. With the company having good exposure to the emerging world where smoking rates are increasing, and with the dividend well covered by Free Cash Flow, I expect BAT to keep increasing the dividend by high single digits to low double digits over time. Even a 10% increase per year for the next 5 years would see me collect, £54 , 60, 66, 73 and £80. This is why I love investing in companies that increase their earnings and dividends over time.

Looking at my portfolio as whole, my dividend income now stands at £2,150. This is money I’ll receive for simply owning shares in wonderful companies. I expect the organic rate of growth to be 5% – 7% over the short and medium term. This means that if I don’t invest a penny more in the markets, my dividends will naturally grow to £2,279 next year from companies simply earning more profits. And if I were to re-invest those dividends of £2,150 expected this year, my annual dividend will be bolstered even further to £2,365. My dividends are truly buying more dividends.

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