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Financial Times: Weapons and dice, and all things vice

Financial Times
June 1st, 2006

Green is the new black. Gordon Brown and David Cameron are tussling over who has the 'greenest' policies, multi-national companies liberally splash about words like 'corporate social responsibility' and, to date, UK investors have ploughed AGBP5.5bn into around 75 different ethical vehicles.

It is an era where the last strongholds of nicotine addicts are soon to be vanquished, online gambling is regulated and excessive alcohol use is on the Government's hit list.

It seems the vices of humanity are getting squeezed from all directions. Yet, in a wicked twist of fate, companies that deal in all things morally suspect and debaucherous are proving sure-fire winners for investors.

It is an unpalatable truth that in recent years 'sin' or 'vice' stocks (stocks from companies associated or directly involved in activities considered to be unethical or immoral, such as gambling, tobacco, alcohol and defence) have been outperforming their more ethical counterparts.

reveals the performance of the FTSE All-Share versus the FTSE4Good (established in 2001 to house companies with the strongest records of corporate, social and environmental performance) over five years. Over this period the FTSE All-Share rose 9.1% while the FTSE4Good UK index only gained 1.49%. It is clear from this chart that the FTSE4Good tracked the All-Share until around August 2003 when the FTSE All-Share broke away, four months after the 2003 invasion of Iraq by US and Britain.

It is axiomatic that the defence sector will outperform in times of conflict. In a sinister play on the old saying, 'every cloud has a silver lining', defence stocks have benefited from the 11 September 2001, terrorist attacks and the war in Iraq. This is clear in , which shows that the FTSE All-Share Defence and FTSE Tobacco indices have accelerated over the past three years to outperform both the All-Share and the FTSE4Good. The FTSE All-Share Aero/Defence has experienced extraordinary growth, gaining 184.3% in the past three years.

Recession proof

Historically, sin stocks have been considered to be recession proof, less prone to the cyclical downturns of the economy. Gambling, tobacco and alcohol are all habit-forming activities, thus there is an ever-ready pool of customers ready to purchase such goods and services, regardless of the economic conditions.

For instance, when the S&P 500 fell 20% between June 2001 and June 2002, tobacco stocks rose 8% and gambling stocks gained 20% over the same period. Despite all its good intentions and the strength of the ethical investment trend, the FTSE4Good has not come close to matching the FTSE All-Share in its four and half year life. The closest that it has ever come was over the three years to December 2005 when it achieved 38%, which the All-Share trumped with 50.3%.

Throw in a climate of global conflict and a bull market in commodities and you have an environment of declining returns for socially responsible investment (SRI) funds.

In the UK there are now around 470,000 investors who have chosen to invest ethically, evidence that SRI investing has captured the minds and wallets of a new generation of investors. As highlighted earlier there is AGBP5.5bn invested into ethical funds in the UK, up from just AGBP800m in 1995. In the US, where the investment trend is more prevalent, SRI funds make up 10% of all managed funds and are worth $2.9 trillion.

Yet for every SRI fund taking the high road and shunning vice stocks there are 100 conventional funds happily dipping into the 'sin' bin to select stocks.

One of the few funds to publicly raise the flag for unethical investing is the US based Vice Fund. Launched three years ago, this fund invests only in industries such as gambling, tobacco, alcohol and defence. So far this fund is doing a great job at being the nemesis of any self-respecting, do-gooder ethical fund. Over its three-year life it has delivered an average annual return of 20%, and is ranked 22nd out of more than 700 funds in its classified sector.

Unlike the attention seeking Vice Fund, most UK mutual funds are more publicity shy when it comes to the inclusion of such stocks in their portfolios.

For instance, Rio Tinto, which is referred to by global corporate watchdog, Corpwatch as the "poster child for corporate malfeasance", is held in 74 UK listed mutual funds. Of these, First State Global Resources fund has a portfolio weighting of 9.01% and Insight Investment's Monthly Income and Equity High Income funds hold 3.14% and 3.13% respectively. Gartmore, Old Mutual, Societe Generale, Standard Life, Halifax and Jupiter are among the well-known asset managers that have funds with holdings in Rio Tinto.

In order to ascertain what funds are including vice stocks to drive up their portfolio performance, Money Management enlisted fund ratings agency Morningstar to screen UK mutual funds for tobacco, gambling, defence and alcohol stocks. is the result of this screening, and shows the 60 funds with the highest percentage invested for each vice sector.

Tobacco

Once the darling of the social scene, cigarettes are now considered public enemy number one by public health systems and Governments across much of the developed world. The industry may have been in duck and cover mode for the past decade but tobacco shares continue to thrive.

Since the dotcom crash tobacco shares have outperformed the wider market by 400%, with a winning combination of above average growth at below average earnings multiples, according to investment bank, ABN Amro.

Tobacco earnings are declining in Western Europe but the cigarette sales in emerging market's continue to outweigh this market decline, ABN Amro states.

The Chinese market is something of a Moby Dick for the industry and foreign tobacco companies have been eying it hungrily. The State Tobacco Monopoly Administration (STMA) dominates China's tobacco industry -" the world's largest by any measure. If the Chinese market were to open, it would increase the foreign tobacco companies' market by 40% to 50% overnight. The Chinese represent around one third of all the world's smokers and of the 1,947bn cigarettes they puffed through last year, only 3% were foreign brands. While foreign tobacco companies are attempting to erode the edges of STMA control of the tobacco industry, it is unlikely that China's central government will give up full control of its single biggest taxpayer.

Fund manager, Nick Purves holds British American Tobacco within the AGBP961m Schroder's Income fund. Purves said that the tobacco stock was selected purely on valuation grounds. Purves said that despite the low growth market, tobacco companies have been growing profits by taking out costs and valuations had significantly increased since stocks fell out of favour after the TMT crash.

"Sin areas like drinks and tobacco tend to have relatively defensive profit streams," he said.

Among the trends driving up tobacco earnings are consumers trading up to more expensive brands, the elastic quality of cigarette pricing (smokers will still buy a pack of cigarettes if the price goes up), exposure to parts of the world where smoking is on the rise rather than on the decline and efficient management of costs (to this end, the tobacco titans, BAT Industries, Altria, Gallaher and Imperial Tobacco, all have their brands manufactured in China).

A glance at Table 1 reveals that there is a plethora of UK fund managers who believe in the fundamentals underpinning a growing tobacco sector.

The AGBP5.51bn Invesco Perpetual High Income fund has a nearly 20% of its portfolio in tobacco stocks while its sister fund, the AGBP3.05bn Invesco Perpetual Income, has a 17.86% weighting. Neil Woodford, who manages both funds, said that tobacco consumption would continue to decline across developed markets. Woodford said that this was causing tobacco businesses to focus on margin rather than volume, protecting earnings growth through a mix of pricing and making efficiency gains in the manufacturing and distribution.

"I believe that valuations continue to look attractive across the tobacco stocks that I own and so I continue to rate them highly as investment opportunities," he said.

Both Woodford's funds have been the top two performers in the IMA UK Equity Income sector over the past five years with the High Income fund returning 85.4% and the Income fund generating 84.6% in the five years to 24 April 2006.

Aerospace/defence

There is nothing like making money from the manufacture and sale of weapons to set ethical alarm bells ringing. War is good for business and if you need any further proof that the UK defence sector is booming, look no further than the UK's Ministry of Defence's (MOD) latest deal. In April, the MOD signed the largest ever private finance initiative (PFI) deal, a 35-year, AGBP8bn contract under which a private company will finance, build and maintain accommodation for 18,000 soldiers. Also at the time of writing, the MOD was haggling over a AGBP13bn aerial refuelling contract.

During 2003/04 the MOD's expenditure limit (DEL) rose 43% to a peak of AGBP37.4bn, according to MBD's February 2006 UK defence equipment market development report.

The rise in spending reflects the Government's commitment to fund its current military operations but also its preparation for future conflicts that could occur. The defence budget is tipped to increase 1.4% annually till 2007/08 and overall growth of 12% in real terms is expected between 2005 and 2009, taking defence expenditure to a peak level of AGBP35.1bn.

These strong fundamentals have sent the market rushing to aerospace/defence stocks as a result the FTSE All-Share Aero/Defence has gained 184.3% over the past three years and 56.4% over the past five years.

Stocks such as BAE Systems, have experienced a 70% jump in share price in the past 12 months, in part assisted by a near completed AGBP10bn deal to construct fighter jets for Saudi Arabia government. Credit Suisse, in particular, has significant exposure to BAE Systems with its Alpha Income, Income and Alpha Growth funds possessing 5.11%, 4.07% and 3.46% weightings respectively, according to Morningstar data.

Table 1 shows that the fund with the highest exposure to the overall aerospace/defence sector is the AGBP301m New Star UK Alpha fund, which has a portfolio weighting of 15.32% to defence stocks. Fund manager Tim Steer is a strong proponent of investment in anti-terrorist technology and defence applications. Among the companies that he backs are Detica and VT Group, both of which make high-tech products for the military and intelligence services, and transport security firm TRL as well as defence industry stalwarts, BAE Systems, Meggitt, and Smiths Group, all suppliers to aviation and defence industry.

Steer's UK Alpha fund has returned 129.3% in the three years to 24 April 2006, ranking it 23rd among the 259 funds in the IMA UK Equity sector.

The AGBP797m Framlington UK Select Opportunities has the next highest exposure to aerospace/defence sector with 13.29% of its portfolio in defence stocks. This fund too has enjoyed solid performance, returning 143.7% over five years, ranking it 12th within the same IMA sector.

Gambling

Gambling may be the sure way of getting nothing from something but investing into the gambling industry is a whole other story.

The size of the industry just in the UK is staggering. The total value of stakes placed at UK betting shops was AGBP32.3bn in 2004, a 72% increase on the previous year, according to Mintel's Betting Shops UK, July 2005 report.

Internet and telephone gaming is rapidly growing but is yet to overtake the traditional betting shop as the most popular way of betting, the Mintel report states. Nevertheless, hordes of investors have descended on the relatively new phenomenon of online gambling industry.

The sector is growing voraciously, with revenues swelling to AGBP5.25bn in 2004 and revenues are tipped to double by 2008, according to investment bank Dresdner Kleinwort Wasserstein and Global Betting and Gaming Consultants.

During 2005, online gaming entities Party Gaming, Sportingbet and 888 all grew their earnings per share by 50% or more.

Dresdner Kleinwort Wasserstein is optimistic about the future of all three companies and predicts that they will achieve at least 20% growth during 2006.

There are a number of domestic headwinds building in the UK. In 2005, the UK became the first industrialised nation to introduce a regulatory framework for online gambling and this year it will host the first international summit on online gaming to address growing concerns about protection of minors and the potential for criminal infiltration by rogue operators.

Given that Party Gaming, Sporting Bet and 888 are based offshore and generate most of their profits in the US, any anti online gaming sentiment or regulatory changes in the UK has little impact. What has been more worrisome for the industry has been the Internet Gambling Prohibition Act that is being debated in the US Congress. The Act attempts to outlaw certain forms of online gambling and is accompanied by two other Bills, which aim to stop the use of credit cards to pay for online wagers on sites based overseas. To date, the Internet Gambling Prohibition Act has stalled, but the Kyl Bill and Leach Bill is yet to come. While these regulatory risks are adding to the sector's volatility, most market analysts believe that an adverse regulatory outcome is unlikely. However, in Morgan Stanley's February 2006 report Online gaming- regulation or prohibition, the analyst group points out that if the issues of online gaming industry continue to be entwined with morality and ethical issues, it will increase the chance of a bill succeeding.

The funds that are gambling on online gambling being legalised in the US include Fidelity Funds European Smaller Companies, M&G Pan European and New Star UK Growth fund, which respectively have a 3.57%, 2.84% and 2.44% weighting in Sporting Bet.

According to Table 1, the rather obscure AGBP233m Nordea North American Value fund has the highest exposure to the gambling sector with hefty 15.56% weighting in its portfolio. The more prominent funds to be playing gambling stocks include M&G Pan European with 4.95%, Jupiter European Special Situations with 4.69% and Baring Australia with 4.36%.

Alcohol

Drink sales in France and Germany have drooped by 6% and 8% over the past five years. Meanwhile, in Britain sales of alcohol have risen by 5% -" in part boosted by the rise in women drinkers. In 2004, the consumption of alcoholic drinks in the UK exceeded 8bn litres and the alcohol market was worth AGBP38 bn.

Following the publication of a number of scientific reports detailing the health and financial impacts of alcohol misuse, the sector has come under greater pressure to promote responsible drinking. One report estimates that alcohol causes as many deaths and disabilities globally as smoking or high blood pressure. This year medical journal, The Lancet, published a study that revealed increasing alcohol consumption had led to a big rise in deaths from liver cirrhosis in the UK. Between the periods 1987 to1991, and 1997 to 2001, male deaths from cirrhosis in Scotland more than doubled, and in England and Wales they rose by over 66%. For women, rates increased by a half in the same period.

Given this research it is interesting that a number of ethical funds do not screen out the alcoholic drinks sector. The Axa Ethical fund has an 8.13% exposure to the sector and Legal & General Ethical Tracker fund has 4.16% weighting.

"We exclude everything evil you can imagine but one thing we don't exclude is drink," says Stuart Fowler, manager of the Axa Ethical fund.

In an example of the often muddled ethics of the SRI industry, Fowler was unable to explain why alcohol was permitted in the Axa Ethical fund. He was able to say that the ethical screen was established when the fund launched in the late 1990s and he was reluctant to change it.

The alcohol stocks that are included in the Axa Ethical portfolio are Diageo and SAB Miller, two companies that Fowler describes as having strong brand portfolio, premium yield and representing good long-term investment.

Despite concerns about the impact of excessive alcohol use in society, the growth in value in the alcoholic drinks sector is not driven by growth in volume sales, which on the whole are stagnant. Rather, the major trend supporting the sector is 'premiumisation' according to Mintel's Drinking habits, UK, March 2005 report. If consumers cannot be persuaded to drink substantially more, they can be coaxed into drinking more expensively. According to the Mintel report, the strategy has been a success with standard lagers being replaced by premium alternatives, malt whiskeys outperforming blends and sales of champagne and expensive wine soaring.

Virtues of vice

There have been numerous studies that disclose the shortcomings of investing with ethical screens.

Analysis of the performance of the Domino 400 Social Index (a US index which excludes stocks of companies that operate in alcoholic beverages, defence-related, gaming and tobacco sectors) versus the S&P 500 over multi-year periods showed that excluding these vices areas resulted in some amount of relative return deficiency over one, three, five and 10 years.

Early this year, the UK SRI industry received a setback by research conducted closer to home, which revealed that companies that have socially responsible investment policies deliver poorer investment returns than companies that have not screened for their practices.

The study of 451 companies in the FTSE All-Share index , carried out by Cass Business School, University of Bath and University of Reading, showed that the average return for the least socially responsible firms was some 24% higher than for the most socially responsible firms and 17% higher than the average for the whole market. As Chris Brooks, professor of finance for Cass Business School, bluntly puts it, "If the sole objective is to maximise returns, its is still worth looking at corporate social responsibility indicators, but in a negative way -" invest in firms with the lowest scores because they will generate the highest returns."

The report concludes that: "It may be the case that altruistic private or institutional shareholders are willing to forego returns in order to feel morally at ease with stocks that they hold so that required returns on the stocks of socially responsible firms are lower."

It is true that in the past three years the odds have not been in favour of ethical companies. Tobacco, mining, oil and gas, gambling and defence have been the shining stars on the FTSE 100. But markets change and a correction in mining stocks and resolution to the Iraq war would produce a more level playing field.

A valid point that has been raised in defence of ethical investing is that these investors may be picking tomorrow's stock market winners. For instance, boutique broker Dawnay Day suggests that fuel cell designer ITM Power should be regarded as the next BP, Royal Dutch Shell or Exxon such is the power of its technology.

It may be that over a 20-year view there will be little difference in the performance of an ethical and conventional fund. And it must always be remembered that, no matter how successful a 'sin' stock is, there are many people for whom investing in such stocks is anathema and will opt for the ethical fund as a matter of principle.



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