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Margin of Safety
Margin of Safety
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The Sinful Portfolio

December 05, 2011 | About:

In troubled times, with a struggling economy at home and the rest of the world on fire, it seems especially tactless to bet on the weakness of mankind. But, if you’re an investor who has suffered through the pain of anemic stock market returns, it may be time to strongly consider the virtues of vice. “Sin” stocks, while not exactly fodder for water cooler talk, have always performed well in times of economic distress, and these last few years have seen them outperform the S&P 500 by a wide margin. Although there isn’t an index that tracks a sin portfolio, the Vice Fund (VICEX) which invests in tobacco, alcohol, gambling and defense stocks, has more than doubled the return of the S&P 500 since 2002. Over the last five decades, the sector has outperformed the S&P 500 by double digits and its average dividend yield is triple that of the average yield of the S&P 500. Sin stocks are generally shunned by socially conscious institutional investors, pension funds and endowment funds, so investors who are able to come to terms with their own political incorrectness can benefit from their under-valued stock prices.

Herewith are four stocks representing the four pillars of a sin portfolio worthy of virtuous consideration:

Altria Group (NYSE:MO)

If you like to win bar bets, ask someone to name the most profitable stock of the last 50 years. If they’re not astounded when you tell them that it is Altria Group, one of the largest producers of tobacco products in the world, they will be when you tell them that it has returned an average of 21% versus the S&P 500’s 10% over that time. Equally impressive is its 45-year history of increasing dividends.

After spinning off its brand namesake, Phillip Morris, in early 2011, Altria continues to dominate U.S. tobacco sales, which, in a period of declining usage and heavy regulatory attacks, remains its most profitable line of business. Its diversification into wine sales (Columbia Crest), beer sales (SABMiller), and real estate helps to secure its revenue and, in turn, protects its healthy dividend yielding nearly 6%. In the face of revenue and regulatory challenges it still manages to deliver a healthy return on equity (71% for the year ending September 2011) and it continues to reward its shareholders by paying out 80% of the earnings in dividends.

Diageo Plc (NYSE:DEO)

One of the largest producers of premium spirits in the world, Diageo has a strong foothold in the U.S. with its brand favorites, Johnnie Walker, Tanqueray and Smirnoff, as well as the fast-growing emerging markets where it generates 34% of its revenue. Although its revenue growth has tailed off in recent years, it blows away its competition on the margins posting a hefty 60% gross and 20% net in 2010. Future earnings growth is expected as a result of its dominant position in emerging markets, planned cost restructurings and anticipated acquisitions (newly spun off Jim Beam is a target), which means investors should continue to enjoy increasing dividends that currently yield 3.20%.

Las Vegas Sands Corp. (NYSE:LVS)

Throughout economic cycles there are few constants, but one of them is that people will gamble in good times or bad. Although the gambling industry was hit hard during the financial meltdown, it has since recovered thanks in large part to an Asian growth spurt. And now, several companies offer tremendous opportunities for earnings growth over the next several years. The ones offering the greatest potential currently have forward price earnings ratios well below the industry avenue. Las Vegas Sands Corp., the big daddy of the industry, has the added appeal of having demonstrated steady growth in its returns on invested capital over the last three years. And, with its dominant footprint in the new gambling Mecca of Macau, it has the luxury of waiting for domestic gamblers to make their way back to Las Vega and its other American casinos as discretionary spending picks up.

General Dynamics (NYSE:GD)

The fourth pillar of the sin portfolio has historically been built on firearms stocks, but more recently, political correctness has forged a sub-category comprised of defense contractors for their role in making war and not love. Both firearms manufacturers and defense contractors are facing financial and regulatory pressures, and defense contractors in particular are under the gun (sorry) due to the deficit cutting mandate given to Congress. The political reality, however, points to U.S. interests increasingly under siege from abroad, and a Congress that is more likely to buckle than make unpopular defense cuts.

General Dynamics (NYSE:GD) has emerged as a value play (Warren Buffet has recently bought 3.1 million shares) trading at less than nine times earnings while paying a solid dividend yielding 2.9%. Defense stocks have been battered recently over defense cuts concerns, and will likely remain under pressure through the next election. General Dynamics is a more diversified defense play for its emphasis in areas that aren’t like to come under the budget knife. Its profitable Gulf Stream jet division is still a winner and its lucrative submarine division would seem to be untouchable. Even if there is an across the board defense cut, GD has less exposure and reliance on government contracts than their competitors. Only 70% of its revenue comes from the government compared with 85% and 92% for Lockheed and Northrop.

As the market continues to vacillate over uncertain earnings growth, investors looking to stabilize their portfolios with more certain ROIC plays are well-advised to add solid performing non-cyclical stocks, and few have performed better over time than sin stocks. If there is ever going to be a time when vice becomes a virtue, this may be it. If you are conflicted over investing in these companies, you can always donate to your favorite charities once they make you wealthy!

About the author:

Margin of Safety
Margin of Safety Equity Research is a value-investing focused company providing equity research services, the Securities Analysis System investment software, stock valuation models, and other financial resources for value investors. Members of our subscription services have access to the Margin of Safety value-oriented portfolio and discounted access to our software.

We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:

1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins

2. We understand the business

3. They are run by competent management

4. They are available at bargain prices.

We require a 25-50% margin of safety, depending on the stability and economic moat for the company.

In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.

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