Are Vice Stocks Losing Their Allure?

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"unprecedented" Consumer weakening

There are several theories as to why sinful stocks haven't held up. Many companies were hurt by high debt levels while investors worried about exposure by others to troubled emerging markets.

A key concern is the suspicion that consumers are cutting spending far more than in past slowdowns. "The recession itself is different in its nature," says Keith Hembre, chief economist at First American Funds. Consumers are permanently altering spending patterns amid job shrinkage and vast losses in the markets for stocks and residential real estate. "We've had an unprecedented weakening in the household balance sheet," he says.

In fact, consumers are even cutting back small purchases like lottery tickets, notes Morningstar (MORN) fund analyst David Kathman. "This recession is pretty different from the last couple that we've had," he says.

The fundamentals of Vice: Ignored?

The effect on casino revenues has been striking. In October, gaming revenue at Las Vegas Strip casinos dropped a record 26% from the year before, according to the Nevada Gaming Control Board. In addition to the weak economy, an aggravating factor was the high price of gas, which discouraged drives from California to Sin City.

The USA Mutuals Vice Fund (VICEX) is one of the few mutual funds that specialize in the more disreputable part of the stock market. It focuses on tobacco, beverages, gaming, and aerospace and defense. In the past year, the fund is down almost 42%, about three percentage points worse than the S&P 500 benchmark. Charles Norton, Vice Fund manager, admits gambling operators have not performed well. However, he argues that the stock market is missing the resilience of fundamentals at tobacco, beverage, and defense companies. "The fundamentals don't really matter in this current market," Norton laments.

Some investors might be worried that alcohol and tobacco makers will see a slowdown in a key growth area: emerging markets. But despite the global recession, newly affluent consumers continue to upgrade to premium cigarette or alcohol brands, Norton says. "Even though these are premium brands, they're still highly affordable compared to other consumer products," he says.

Is this recession more "moral?"

In the beverage industry, consumer tastes may shift a bit, but sales and balance sheets will remain strong, Norton says. Last month, UBS (UBS) analyst Kaumil Gajrawala named Molson Coors a top pick, noting that the company is benefiting from a shift away from more expensive wine and spirits. "In tough economic times, we expect consumers to shift alcoholic consumption to the 'tried and true,' or what we would refer to as premium or sub-premium American beers like Coors Light, Miller Lite and Bud Light," Gajrawala wrote.

It's wise to bear in mind that, on average, alcohol, tobacco, and gambling earnings have held up in recessions. During downturns since 1970, as the Merrill Lynch study recently found, earnings growth for the group was 25% greater than for the market as a whole.

Because of the shocks to the global economy in the last few months of 2008, investors are still waiting to learn their impact on end-of-the-year results. Looking ahead, few economists foresee much improvement until at least the middle of 2009, with Hembre predicting "a fairly meager pace" of growth in the second half of the year.

So it remains to be seen if alcohol, tobacco, and other vices continue to prosper as affordable luxuries for many people. Or if, desperate to cut costs, consumers decide to clean up their act.

Steverman is a reporter for BusinessWeek's Investing channel.