The wages of sin are…

“Sin stocks” have grabbed investors’ attention over the past few years. Research showed that companies selling stuff like fags, booze, gambling or guns, tended to outperform the market significantly over time. Why is that?

“Sin stocks” have grabbed investors’ attention over the past few years.

Study suggests “sin stocks” will always outperform the market – Seeking Alpha
“Sin-vestors” can reap smoking hot returns – Wall Street Journal
Can you profit from the sin stock anomaly? – Stockopedia

Research showed that “sin stocks”, ie companies selling stuff like fags, booze, gambling or guns, tended to outperform the market significantly over time. Why is that? Well it was speculated that upright and ethical investors shunned those stocks, which pushed down their price and up their returns. For example the yield in US tobacco and casino stocks has stayed steady at about 4% for a century, which is above the average yield in the market.

After the research was published, sin stocks got hot. Opportunist investors bought into sin businesses, hoping to profit from the “anomaly”. New ETFs and funds such as the FocusShares ISE SINdex funds sprung up to fulfil the demand. The secret was out.

So is that it – should we sell the stocks and the house and cash in the pension and load up on fags and booze?

Er, no. It turns out the sin stocks “anomaly” was a mirage. And the story about how ethical investors lower the demand for sin stocks and raise their price was a load of nonsense. New research shows what’s really going on with the extraordinary returns from sin stocks.

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Scientific-sounding nonsense

I’m sure this isn’t the first time you’ve heard a story like this – stocks in XXX industry have been proven to outperform! When the price of copper goes down, stocks in YYY have been shown to go up! Or, when the price of ZZZ falls, the price of XXX tends to follow!

You should be very careful with stories like this. Reason one: there’s masses of data on stock prices, going back to 1900 and earlier. And there are thousands of financial economists prodding, poking and testing that data. Given enough regressions, the economists will eventually find some statistically significant relationships by pure chance. For example, did you know that Coca –Cola is tightly correlated with a water utility from southern Brazil?

Reason two: every individual company has a thousand different characteristics. It’ll have distinctive value, growth, capital structure, industry, governance, momentum, and on and on and on. But in the 50 years or so that financial economists have been crunching the data, they only find a handful of characteristics that persistently outperform the overall market. They are:

  1. Size. Investments in the stocks of companies dramatically outperform investments in the stocks of big ones
  2. Value. Investments in companies that are cheap relative to their assets outperform
  3. Momentum. The shares in certain companies seem to have “momentum” – they keep moving in whatever direction they’re going

Very often, weird new stock price “anomalies” are just one of the above three characteristics in disguise.

And that’s exactly what’s happened with sin stocks. Sin stocks tend to be smaller than most stocks in the market, and small companies strongly outperform the market.

New research from Andreas Hopener at Henley Business School shows that when you control for their size, sin stocks show no tendency to outperform. Mystery solved.

I’ve built my investing strategy on what academic economists call “the small company effect” – the tendency of small companies to outperform the wider market. And I’ve stolen a smart strategy from the world of academic economics to help my readers capitalise on it. To learn about my strategy, click here.

That’s it for today. I’m off to Northern Ireland, the home of Halloween apparently. Have a great weekend!

The Penny Share Letter is a regulated product issued by Fleet Street Publications Ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Seek independent financial advice if necessary. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234 www.fsa.gov.uk/register/home.do.

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