'Sin' Stocks Help Investors Escape Slump

BOSTON (TheStreet) -- Vice always comes at a price, but given the economic tumult, the historically defensive "sin" stocks of gambling, alcohol and cigarette companies are struggling, despite their well-earned reputation as recession-proof.

That's because consumers have cut back on discretionary spending as they fret over job security, and a slew of new taxes prices life's little pleasures out of the reach of many wage earners.

Even the stocks of defense contractors, lumped into the "vice" category by politically correct do-gooders, are under the gun because of Congress' avowed efforts to cut spending across the board to trim the deficit in a plan hashed out a week ago.

Gerald Sullivan, manager of USA Mutual's Vice Fund ( VICEX), a 42-company portfolio made up of the stocks of only four industries -- cigarettes, alcohol, gambling and aerospace/defense -- said his portfolio will weather the downturn better than the S&P 500 Index, as it has previously, and will then outdo them when prosperity returns.

Sullivan said the fund's portfolio mix is diverse enough to offset one another, providing a less-volatile and, therefore, more predictable performance.

The Vice fund has fallen 5.8% over the past three months, about half that of the S&P 500 Index in what is the longest losing streak in two years. But the fund is up 6.5% this year, while the S&P is down 3.5%.

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In an example of the challenges the cigarette industry faces, New York state recently raised excise taxes on a pack of cigarettes by $1.60. Marlboros now sell for $14.50 a pack in midtown Manhattan. Elsewhere in the U.S., it's half that.

But providing some sort of redemption for sin stocks is international demand. Growing middle classes in Russia, China and India have more money to spend, which has increased their appetite for cigarettes, alcohol and gambling. And they're also trading up from cheap, local brands to major international brands, which they perceive as being of higher quality and more prestigious.

The Vice fund's top beverage-industry pick is Diageo ( DEO), a London-based firm with eight of the world's top 20 brands and an unrivaled global distribution platform that spans 180 countries. It's expected to earn $5.09 per share in fiscal 2011 and $5.57 per share in 2012. The company's top brands include Smirnoff, Johnnie Walker, Jose Cuervo and Guinness.

Diageo's shares are up 5% this year through Aug. 4, and 11% over the past 12 months and has a three-year average return of 5.7%. It also has a 2.62% dividend yield.

The top cigarette stock pick of the Vice fund is Lorillard ( LO), at 5% of the portfolio, with a value of $4.3 billion. Its sales topped $4 billion in 2010, making it the nation's third-largest cigarette manufacturer. Its leading brand, Newport, claims a 13% share of cigarette industry sales.

Lorillard's shares have gained 29% this year and it has a three-year annualized return of 20%, while carrying a hefty 5% dividend yield.

The gambling industry is suffering domestically, thanks to reduced consumer-discretionary spending. But it's far from dead because of Asian gamblers, who are still flocking to casinos in Macau, a gambling-centric island resort off the coast of Hong Kong. Some are coming to Las Vegas as well, said Richard Wells, president of Wells Gaming Research, an industry-consulting firm that collects the daily visitor counts of most U.S. casinos.

Macau's booming growth has given a boost to U.S.-based firms such as Las Vegas Sands ( LVS), MGM Resorts International ( MGM) and Wynn Resorts ( WYNN), which all have casinos there.

Wynn appears to be the big winner, which is reflected in its share price, up 37% this year through Aug. 4, and up 63% over the past 12 months.

Wells said Macau's gambling revenue has ballooned from $1 billion a month at the end of 2009 to about $3 billion a month now. In other words, what economic slump?

But it's a different story in the U.S., where gamblers are cutting back, he said. "At this point, being able to hold on to customers and trying to get a modest increase in the number of customers during this recession is a real challenge," Wells said.

But at the same time, many cash-strapped U.S. states are doing all they can to promote gambling, as several are actively starting up various types of casinos or expanding existing gambling operations to boost revenue and keep gamblers' money at home.

The end winner as, always, is the house, meaning the companies that manage legalized gambling.

But Wells cautioned that if he were thinking about investing in the sector, "I would wait until the dust settles in this current market decline."

The $145 million gaming-industry exchange traded fund, Market Vectors Gaming ( BJK), has been holding its own in the downturn. It lost 11.8% last week through early Friday, resulting in a 1.7% return this year. The ETF has risen 23% over the past 12 months.

Even defense-industry stocks are under a cloud since Congress is conjuring up ways to lower the deficit. Military spending is in its crosshairs, but the defense industry is one of the largest manufacturing employers left in the U.S., so a cut to defense would erode an already evaporating job base, which means legislators with defense plants in their district are going to fight those cuts.

Plus, with international political tensions still on the rise, and the U.S. involved in conflicts in three countries, defense may end up escaping much of Congress' reductions.

That should protect high-tech defense companies such as Raytheon ( RTN), a defense electronics and missile manufacturer, and General Dynamics ( GD), which makes ships, armored vehicles, defense-oriented information-technology systems and business jets. General Dynamics gets 72% of its revenue from the Department of Defense.

Vice Fund manager Sullivan jokes that perhaps the ultimate defensive mutual fund would be his fund blended with one of the self-described "morally responsible" Ave Maria Mutual Funds, which subscribe to Catholic Church values in their stock selection. (The Ave Maria Catholic Values ( AVEMX) fund is little changed this year, easily outpacing the S&P 500.)

Although their investment focuses are diametrically opposed, they both exclude a wide swath of stocks from their portfolios that don't fit their strict criteria, and the end result has been that they both regularly beat the S&P 500 Index, Sullivan said.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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