While socially responsible investing (SRI) and the broader category of environmental, socially responsible and governance (ESG) continue to gain in popularity, economic theory suggests the share prices of “sin” businesses will become depressed if a large enough proportion of investors choose to avoid them.
Such stocks would have a higher cost of capital because they would trade at a lower price-to-earnings (P/E) ratio, thus providing investors with higher expected returns. (Some investors may view those higher expected returns as compensation for the emotional “cost” of exposure to offensive companies. However, it’s important to point out that SRI and ESG—sometimes referred to as “double-bottom-line” investing—encompass many personal beliefs, not just one set of values.)
Thus, an investment strategy that focuses on the violation of social norms has developed in the form of “vice investing” or “sin investing.” This strategy creates a portfolio of firms from industries typically screened out by SRI and ESG funds, pension funds and investment managers.
Vice investors focus primarily on the “sin triumvirate”: tobacco, alcohol and gaming (gambling) stocks. Historical evidence on the performance of these stocks supports the theory—sin stocks have provided significantly higher returns than stocks in general.
Harrison Hong and Marcin Kacperczyk, authors of the study “The Price of Sin: The Effects of Social Norms on Markets,” published in the July 2009 issue of the Journal of Financial Economics, found that for the period 1965 through 2006, a U.S. portfolio long sin stocks and short their comparables posted a return of 0.29% per month after adjusting for the Carhart four-factor (beta, size, value and momentum) model. As out-of-sample support, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a year.
The authors concluded that the abnormal risk-adjusted returns of vice stocks are due to neglect by institutional investors, who lean toward the side of SRI.
As further evidence that avoiding sin stocks comes at a price, Elroy Dimson, Paul Marsh and Mike Staunton found that, when using their own industry indexes that covered the 115-year period 1900 through 2014, tobacco firms beat the overall equity market by an annualized 4.5% in the U.S. and by 2.6% in the U.K. (but over the slightly shorter 85-year period 1920 through 2014). Their study was published in the 2015 Credit Suisse Global Investment Handbook.
They also examined the impact of screening out countries based on their degree of corruption. Countries were evaluated using the Worldwide Governance Indicators from a 2010 World Bank policy research working paper from Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues.” The indicators comprise annual scores on six broad dimensions of governance.
Dimson, Marsh and Staunton found 14 countries that posted a poor score, 12 that were acceptable, 12 that were good and 11 with excellent scores. Post-2000 returns for the last three groups were between 5.3% and 7.7%. In contrast, the markets with poor control of corruption had an average return of 11.0%.
Interestingly, realized returns were higher for equity investments in jurisdictions that were more likely to be characterized by corrupt behaviors. As the authors note, the time period is short and the result might just be a lucky outcome.
On the other hand, it’s also logical to consider that investors will price for corruption risk and demand a premium for taking it. But it may also be a result of the same exclusionary factors found with sin stocks (investors boycott countries with high corruption scores, driving prices down, raising forward-looking return expectations).