Whether you like the sector or loathe it, you cannot argue with tobacco’s returns over the years. Tobacco stocks have produced some of the market's best returns over the past 100 years, with Altria Group (MO, Financial) outperforming even the likes of Apple (AAPL, Financial) when dividends are included.
It was not always this way, however. Before smoking became taboo, tobacco stocks actually matched or underperformed the market. Only after it became widely known that smoking is bad for your health did tobacco began to outperform. The figures supporting this statement are contained in a study published in the 2009 Journal of Financial Economics by H. Hong and M. Kacperczyk, entitled "The price of sin: The effects of social norms on markets." According to the researchers findings, the tobacco sector underperformed the market by 300 basis points or 3% per year between 1947 and 1965. During this period, the sector underperformed the market by around 40% on average. But after 1965, it seems investors flocked to tobacco despite the barrage of litigation faced by tobacco companies.
Tobacco rules
After 1965, Hong and Kacperczyk find that between 1985 and 2006, international sin companies outperformed the market by 21 basis points per month, around 2.5% per year. In this study, sin businesses include gambling, tobacco, defense and alcohol.
These sin stocks are interesting because despite the negative publicity surrounding them, they still attract more investor interest than the rest of the market.
A new sin sector?
Big Oil (Chevron (CVX, Financial), ExxonMobil (XOM, Financial), Royal Dutch Shell (RDS.B, Financial) and BP (BP, Financial)) is not yet considered a sin sector, but it is rapidly becoming one with institutional investors around the world divesting their positions under pressure from clients to reduce carbon exposure. This trend raises the question, will Big Oil become a sin sector and will investors benefit as a result?
To answer this question, we need to look at what makes a stock sinful. Apart from the questionable (addictive) nature of the product the company produces, sin companies usually have pricing power. And despite the regulations placed on these industries, the companies continue to thrive as there is always a demand for the product.
What’s more, regulation increases barriers to entry. It is almost impossible for new entrants to break into markets such as defense, alcohol and tobacco.
It is easy to argue Big Oil is going the same way. Even though there are thousands of small oil companies operating around the world, the regulatory burden on these companies is increasing, and with oil prices set to remain depressed for the foreseeable future, the capacity for these companies to deal with onerous regulations is decreasing. There is also Big Oil’s presence in refining and trading to consider. It is almost impossible to build a refinery from scratch today in most developed markets due to the enormous upfront costs, environmental considerations, regulations and planning laws. Yet the world still needs refined products and the demand for products like these is growing every day. Alternatives are gaining market share slowly, but it will take many decades for these alternative products to dominate the markets.
Trading is another area where Big Oil dominates thanks to its global presence and economies of scale. All of these traits point to the conclusion Big Oil has many of the qualities of a sin stock, but the one quality it lacks is pricing power.
Oil companies are price-takers, so they lack the ability to achieve steady, consistent profit margins. Regardless, what these companies lack in pricing power, they make up for in economies of scale.
Conclusion
Overall, it is clear that just like the tobacco sector in the late 1960s, public opinion is turning against Big Oil. The sector cannot just disappear overnight, however. The demand for oil and refined products is only increasing, and while alternatives are emerging, the sector will remain dominant for many decades. That being said, investors are exiting the sector for ethical reasons. This presents an opportunity similar to the one faced by big tobacco in the late 1960s.
Disclosure:Â The author owns shares of Royal Dutch Shell.
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