Why 'Sin' Stocks Pay in a Down Market

Booze, guns, smokes, and slots tend to hold up during slumps.

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When the market heads south, investors usually flock to the safety of treasury securities, hard assets, buoyant sectors like healthcare, and big-brand companies, like Procter & Gamble, that sell consumer necessities. But there are also lesser-known pockets of the economy that tend to hold up in down markets like these. So-called "sin" stocks—of companies focused on alcohol, tobacco, gambling, and defense—fall into that category.

Think about it this way: Consumers don't give up necessities like toothpaste and laundry detergent in tough economic times. And they don't kick their habits, either. That's one idea behind the $143 million Vice Fund. Ironically, comanager Charles Norton doesn't think of the four pillars of his investment focus in terms of "vices," and certainly not as "sin stocks." Here's how he puts it: "We just focus on four sectors that deliver long-term gains in a variety of different market environments. Consumers enjoy alcohol and tobacco regardless of what's going on in the economy." Here's the scoop on Norton's outlook for each of the fund's four sectors, along with stock picks:

Booze. Emerging markets are the key driver for brewers, says Norton. Accordingly, he targets companies with the most exposure to these fast-growing countries. Brewers have suffered somewhat from higher input costs for things like barley and aluminum. "Pricing power remains strong, though, and the brewers have been successful in recovering most cost increases by hiking prices," he says. Relatively, distillers have been less affected by the same cost pressures, and spirits growth remains robust. In this space, Norton likes industry leader Diageo (symbol DEO), which has a large international distribution network and is gaining market share in many key spirits categories. "It's the 800-pound gorilla in categories like vodka and tequila that are growing even faster than the overall spirits market," Norton says. The stock, at $74, has held steady this week.

Smokes. Since tobacco companies have strong pricing power, they're relatively insulated from inflationary cost pressures, Norton says: "Many cigarette-makers have pristine balance sheets with little or no leverage and are buying back stock." Internationally, emerging-market consumers continue to trade up to higher-priced, international brands, like Marlboro. Although cigarette volumes in the United States have been in a steady decline for years, the menthol segment is gaining share. To that end, one of Norton's top picks is Lorillard (LO), the maker of Newport brand cigarettes, which has a "pristine balance sheet." The company is an attractive takeover candidate in this consolidating industry, Norton says. Lorillard also has plenty of room for geographic expansion. Its shares have had ups and downs over the past few months, but the stock, at $73, is down less than 5 percent from mid-June.

Slots. Gaming's had a tough time. Challenges facing casino operators include highly leveraged balanced sheets and declining cash flow as consumers curtail discretionary spending. Norton doesn't see a near-term turnaround in casino gaming (the fund's holdings in that category have dragged down the fund's returns over the past year, although its three- and five-year performance is ahead of the S&P 500). "We've been pretty lean for a while, but we're still finding some opportunities," he says. Lately, opportunity in the gaming sector has been in the makers of slot machines. That includes WMS Industries (WMS), which "longer term...should be a huge beneficiary of server-based gaming, the next significant technological development in the slot industry," according to Norton. WMS also is gaining market share in its niche and expanding overseas. Although shares, which recently traded at $31, took a dive mid-summer, they're now up $1 over the past year.

Defense. Historically, defense stocks have performed well in election years. These companies tend to benefit "when budget authority on procurement and development is on the rise, and we expect it to increase for at least a year, regardless of the election," says Norton. He favors Lockheed Martin (LMT), which is riding high on the strong defense budget. "The aging U.S. military aircraft desperately needs to be recapitalized," he says. Lockheed's aeronautics unit, which currently makes up about 30 percent of sales—and its F-35 program in particular—should drive growth in the coming years. The company's stock, which has been on a steady rise in this decade, is up nearly 15 percent over the past year.