Do you help a company when you buy its stock?

I read a lot about investing. I read blogs, newspapers, magazines, and mainstream media webpages. I enjoy the discussions about the relative merits of various individual investments. Reading other investors’ thoughts have helped sharpen and focus my investing plan. Some investors are looking for safe and steady investments and others want to get more aggressive. Some people invest for capital gains, some people invest for income. In general, people seem pretty tolerant towards other’s investment decisions with one major exception – investing in so-called “sin stocks”.

Sin stocks

Sin stocks are in industries that tend to either cause or profit from human misery. These include alcohol, cigarettes, gambling, and weapons/defense stocks. Investors tend to have very strong feelings about these industries and stocks in these industries – as I mentioned above, these stocks tend to generate some pretty strong feelings in investors, both for and against. Some people believe that owning shares in a tobacco company or an alcohol company is tantamount to profiting from human misery. Others disagree, believing that nobody forces smokers to smoke, and we shouldn’t take away their freedom to do something, even if it’s going to kill them.

There’s one thing nobody disagree about – these companies have performed incredibly well over the years and generated huge profits for their owners. Jeremy Siegel (Professor at University of Pennsylvania and author of multiple books on investing and the economy) did an analysis on the rate of return of stocks since 1968. What do you think the single best stock to purchase in that time was? Coke? Exxon? IBM? Walmart?

None of the above. The single best investment was Altria (formerly Philip Morris). It logged 20.6% annual returns for 50 years. That’s a 6,638x return over 50 years. If you’d invested just $1,000 in Philip Morris and reinvest the dividends you’d now have $6,638,000. That’s astounding.

What about other sin stocks? Well, in the UK, the highest returning sector since 1900 was alcohol stocks.

Overall, it appears that sin stocks have beat the broader market by 2.5%. Clearly sin stocks are a very profitable place to invest.

Why such high returns?

Why have sin stocks outperformed the market? As Warren Buffett said, “I’ll tell you why I like the cigarette business. … It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.” Let’s see – huge margins, addictive, and brand loyalty. That’s the recipe for a fantastic business. Sin stocks are usually in highly regulated industries.  Virtually all tobacco advertising is illegal in the US, which makes it harder for competitors to enter the market and hurt those high margins.

In addition, the fact that some people why away from sin stocks means they systematically underpriced. The price of any stock is set through the forces of supply and demand. In general, the more people want to buy a stock the higher the price goes. If you remove some buyers the price of the stock will move lower.

All other things being equal, the lower the stock valuation is today the higher the expected returns in the future, and vice versa. If a stock is continually undervalued then not only do buyers get to buy the stock at a low price, but the company itself can retire shares through buybacks at a lower price.

So why are sin stocks often underpriced?

“Supporting” sin stocks

Many investors shy away from sin stocks because they believe that buying stock in Altria means they are supporting the cigarette company. Similarly people believe that buying stocks in solar energy companies means they are supporting the solar industry. But are they?

When you buy a share of Altria you are purchasing a share of the company from another investor. Altria is not affected by that transfer, other than needing to send the quarterly rent checks to a different address. As an owner you have the right to your proportional share of future profits and dividends, and you have the right to vote in shareholder meetings on things like executive pay, shareholder propositions, and elections for the board. The company doesn’t care whether you are the owner or somebody else is the owner.

But what if everybody refused to buy the stock and the stock price dropped? Wouldn’t that hurt the company? The answer is simple – no, it wouldn’t. There is a slight advantage to a company to have a high stock price, as that allows the company to buy other companies with its highly valued stock. Conversely, having a low stock price makes the company vulnerable to being bought by other companies. But buying other companies or being acquired aren’t necessarily good or bad things. Otherwise, a low stock price doesn’t affect the company’s sales, profits, or anything else. There might be a SLIGHT effect on morale, as employees’ stock options would be worthless with very low stock prices. Otherwise, at a low enough stock price the company would just divert all excess cash flow to buying back stock at bargain basement prices. This would have the effect of stabilizing the stock price as well as improving all of the company’s per-share metrics (less shares means higher per share sales, profits, dividends, etc.) This would be a huge benefit to existing shareholders and employees/management with stock options.

Who benefits from a high stock price?

So if the company doesn’t benefit from a high stock price, why do companies care about their stock price? Simple – because the MANAGEMENT of a company benefits from a high stock price. Management is typically compensated with stock options and restricted stock grants that only have value if the price of the stock goes up. If the stock price goes up then management gets rich. If the stock price goes down their options are worthless and management might get fired.

If the stock goes too low the company is a potential takeover target.  Since buyouts happen at a premium to the current market price, you’d think management would jump at buyout opportunities, right? Wrong. The reality is that buyouts are usually opposed by management because a buyout means that management in the acquired company will likely be let go. C-level management is just like the rest of us – they want to keep their jobs.

There is some small benefit to the company from a high stock price. In addition to being able to purchase other companies with stock, a higher stock price allows companies to issue more shares to raise money. However, I’d argue that this is usually a bad idea anyway. A better way to raise money is to issue debt. Once the debt is repaid there’s no further impact on profits. By issuing shares a company is permanently diluting the existing shareholders. Regular corporations typically only issue stock when they have to, that is, when issuing debt isn’t a viable option anymore (this was what Bank of America did during the depths of the debt crisis). And when a company NEEDS money it usually means the company has a lot problems, which means the stock price is low, which means they have to issue a lot of stock (and dilute their existing shareholders a LOT) in order to raise capital. Issuing stock is rarely a good idea (except for REITS or MLPs which operate under different rules).

Is there a benefit to owning sin stocks?

So if owning or not owning the stock of a company doesn’t help or hurt the company, is there a reason to own sin stocks?

Well, there are actually 3 reasons:

• sin stocks have outperformed the market, as mentioned above
• you can use the income from the sin stocks to do good. That is, you could take your Altria dividends and donate them to charity or to anti-smoking foundations.
• you can use your partial ownership to push the company to behave more ethically. You can vote out management that sells to children, or vote for shareholder proposals to make the product less dangerous

Conclusion

I just don’t understand the strong moral position some people have against owning “sin stocks”. The reality is that owning or not owning the shares of a company has no effect on the company itself, and if you are truly against what a company does it’s easier to change it from the inside by being a shareholder. You can divert all of your share of the profits to a good cause, and you can use your ownership stake to make the company behave as ethically as possible. Similarly, owning shares of a solar company or other “good” company doesn’t help the company.

Make your investment decisions based on facts and numbers, not emotion.