Profiting from “Vice” Industries

In this article, we talk strategy with Charles Norton, of the “USA Mutuals Vice Fund”, an investment fund with c.USD100m under management, and a focus on Tobacco, Alcohol, Gaming and Aerospace/Defence.

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Vikas Shah, Thought Economics, December 10th 2008

In recent history, the financial community has put a great deal of emphasis on the ethics and morality of its activities and investments. Many argue that funding certain industries may be undesirable for social or environmental reasons, and many shy away from other markets fearful of the “taboo” associated with investing in them.

The fact, though, remains that where humanity exists, so does vice, and whether we consider smoking, drinking, gambling, the sex industry or even war, humanity will continue with these activities, almost regardless of economic conditions. In many cases, these industries flourish at the extremes of economic activity as humans seek to indulge in vices to celebrate or forget, and as economic growth creates war to expand civilisations, or as depressions create wars of economy.

History also shows us that vices (in all their forms) have become the gambit for many successes, whether we consider bond markets funding (and often determining the outcome of) war, or the immense wealth of families and firms involved in tobacco, defence, and more.

Investing, in its most basic form, can be defined as “…laying out money or capital in an enterprise with the expectation of profit”. This is a simple but effective definition, and is the tenet which has driven the investment markets for centuries. The shrewdest managers, though, seek not only to generate a “profit” but to generate a profit which is in excess of what one would normally expect in the market if investing their money in an “index” like fashion. This process of seeking returns in excess of market has spawned a whole generation of individuals who apply intellectual and mathematical principles to find that, “additional return above the expected return of the beta adjusted return of the market”…. Or Alpha.

Charles Norton is an experienced fund manager, and currently advises the “USA Mutuals Vice Fund” (NYSE:VICEX) which, “…invests primarily in equity securities of small, medium and large capitalization companies” and, “…normally invests at least 80% of its net assets in equity securities of companies that derive a significant portion of their revenues from alcohol, tobacco, gaming and defence/aerospace.”. Mr. Norton is also a Principal of GNI Capital, responsible for portfolio management and investment research for all of the company’s managed assets. He is a regular contributor to CNBC, Bloomberg and many other respected media outlets, and in this privileged interview, talks to us about investments in vice.As at November 2008, the fund’s portfolio has holdings in:

Philip Morris International Inc (Tobacco), Lorillard, Inc. (Tobacco), Diageo PLC (Alcoholic Beverages), Raytheon Company (Aerospace/Defence), Lockheed Martin Corporation (Aerospace/Defence), British American Tobacco (Tobacco), Boeing Company (Aerospace/Defence), Pernod Ricard (Alcoholic Beverages) and WMS Industries Inc (Gaming)


Q: "Vice" (derived from the Latin "Vitium") is defined as, "immoral or wicked behaviour" how do you define "Vice"?

[Charles Norton] "We simply focus on four sectors, Tobacco, gaming, aerospace and defence. We are ‘laser focussed’ on those four sectors, and do not have judgement about whether they are good, bad or in the middle, and instead look at companies from an investment perspective. We have believed, and seen, for a long time, that these sectors deliver long term gains regardless of economic conditions."

Q: Why are 'vice' sectors so lucrative?

[Charles Norton] "Regardless of economic activity, consumers consistently enjoy alcohol, gaming, and tobacco. In many cases, the cost of producing these products is very low, and the companies involved have strong pricing power. This, when combined with the degree of demand resilience experienced in these markets, gives you a very strong investment proposition.

Defence is usually not economically sensitive, instead tied to budgetary cycles. Aerospace, though, does depend more on global air traffic which, in turn is dependent on economic growth [it is important to note, though, that the fund’s holdings in aerospace are focussed on firms where a significant proportion of their income comes from defence aerospace, not just civilian]

The fund was incepted in 2002, and the thought process was that these sectors have been overlooked, and not for investment reasons. They also tend to be under-followed by investors, and analysts, giving opportunities due to inefficiencies which we can then, in turn, exploit."


Q: What is your opinion of the negative publicity about the ethics of ‘vice’ sectors as investments? And what is your view on the potential social and environmental issues arising from them?

[Charles Norton] "I am, fundamentally, an investor, and so any sort of opinions which relate to outside ‘making money’ only go against the development of a sound investment decision. We do not consider the outside noise, and maintain focus on our sectors from an investment perspective with anything else coming into the fray serving only as a distraction. Our view is not to analyse the ‘ethics’ outside the investment side. We focus on the merit of our four sectors and apply our deep knowledge, globally.

We also find a lot of people connect with our message, a lot of individuals do drink, gamble, or smoke and so many investors will understand those businesses (through their own participation) more than, say, the latest semi-conductor firm."


Q: What do you think are the vice-sectors to watch in coming years?

[Charles Norton] "Our four sectors (Tobacco, Alcohol, Gaming and Aerospace/Defence) give ample opportunities short and long. Our approach is global, and this gives us untold opportunities worldwide and as consumers continue to enjoy beverages and tobacco in western and emerging markets, we will see more opportunities. For firms involved in these industries, trade is certainly up, and as international brands, they attract attention, giving exposure to mature and fast growing economies. In an environment where earnings and pricing is volatile, cash flow and earnings stability are really of increasing importance, which is where our sectors come in, and vice fund exists as the only exclusive fund for these sectors."

Eric Lansky, the president of USA Mutuals (who represent the vice fund) also added, of the Vice Fund, “What we are seeing and really what providing is the opportunity for investors to invest in something they understand and believe in. What USA Mutuals offer is the opportunity for Investors to Invest Their Knowledge--a person may feel individuals drink or smoke more in hard times and hence this would make sense from an investment perspective, or perhaps unfortunately with continued global unrest, military expenditures will continue to increase--this too becomes perhaps a reason to invest in such companies. The bottom line is that seemingly over last few years funds have become so complex and investors so removed from understanding what they are actually investing in, despite having so much info readily available. Today it seems investors are not fully understanding what they are investing in and/or don't believe in what they are investing -and this is unfortunate as investing is all about buying”

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These are tremendously difficult times for global economies, and investors are now, more than ever in our recent history, presented with fewer opportunities to generate return in the markets with considered risk.

Modern Portfolio Theory “….assumes that investors are risk averse, meaning that given two assets that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher returns must accept more risk.” The problem occurs that in our current market, there is an incredibly high degree of perceived risk, leading to a “flight to safety” as capital flows out of equity markets, and into treasury bonds and comparable products. On December 10th 2008 Bloomberg reported that due to this overwhelming capital outflow into ‘safety’, three month “T-Bill” rates have become negative for the first time amid the worst financial crisis since the Great Depression.

One of the bi-products of this capital outflow has been that many equities have been punished unfairly, leading to lower than necessary valuations of well-performing stocks in many sectors. Andrew Lo (Harris & Harris group professor at the MIT school of management) proposed, in 2004, the “Adaptive Market Hypothesis” (an evolution from ‘efficient market’ thinking) in which he argues that, “….much of what behaviouralists cite as counterexamples to economic rationality – loss aversion, overconfidence, overreaction and other behavioural biases – are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment using simple heuristics”. His theories, while relatively ‘new’ are being seen played out in our current economic crisis where rationality and efficiency seem to be making way for behaviour, specifically the aversion towards risk, otherwise manifested as fear.

It is therefore, perhaps, a prudent time for the investment market to remove some emotion from its views, and take a lesson from Warren Buffet himself who states of Berkshire Hathaway’s investment principles, “…We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

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For more information on the vice fund, visit their website at: http://www.usamutuals.com

Other Resources:

- Morningstar Vice Fund Report
- "The Adaptive Markets Hypothesis" Research Paper by Professor Lo
- "Treasury Bills Go Negative" - Bloomberg