The ‘Sin Stock’ Premium: A Neat Illusion Dismantled

(c) 12-08-04 © Jim JuricaTwo scholars associated with the University of Reading’s ICMA Centre, in a new paper, take on the notion that the so-called “sin stocks” (chiefly: stocks of companies whose business plan is tied to highly addictive behaviors) outperform other stocks in an actionable alpha-generating way.

The theory behind talk of a ‘sin stock’ premium is straightforward. Reputational and political considerations lead to the withdrawal of large institutional investors from the market for stocks in casino, alcohol, or cigarette marketing corporations. That means that there are fewer claimants chasing those company’s income streams, and a premium is left for the hardier, devil-defying souls who remain in that chase.

The theory seemed to get empirical support from a 2009 working paper by Harrison Hong and Marcin Kacpercyk, “The Price of Sin.” Further, Hong’s data seemed to show that it was in fact reputational risk, the other side of the demand for socially responsible investing, which produced the neglect of these stocks and the corresponding premium. They considered and rejected the alternative hypothesis that it was litigational risk at work. Sin stock returns, they said, were not “systematically related to various proxies for litigation risk.”

But the new paper, by Hampus Adamsson and Andreas Hoepner, argues that the supposed sin premium disappears when various other pertinent factors are added to those Hong and Kacpercyk (HK) considered. The dismantling involves two distinct steps.

First Step: Account for Size

For example: HK compared an equal-weighted portfolio of sin stocks to a value weighted market benchmark. By definition, smaller firms have greater significance in an equal weighted portfolio than in their value weighted counterparts. So HK might simply have observed a smaller-firm premium.

What happens when the data is reviewed with a value-weighted portfolio of sin stocks? That depends on which sin is under consideration. Adamsson and Hoepner (AH) say that the premium of the gambling portfolio goes to zero once value weighting is applied. But the alcohol and tobacco portfolios continue to outperform even after this arithmetical re-jiggering is done.

Second Step: Account for Industrial Sector

Does that mean that AH have confirmed the sin premium and the theory behind it, albeit with the loss of one member of HK’s unholy trinity? No.

For their next step is to accept a conventional (ICB) division of the investable world into sectors. One sector, “consumer goods,” includes both alcohol and cigarettes, but also includes a lot of other not-so-sinful things like sneakers and chocolates. Another sector, “consumer services,” includes gambling but this too, of course, includes a lot of other not-so-sinful services. Do the sin stocks show a premium compared to their sector as a whole?

AH answer in the negative. “The previously reported outperform of alcohol and tobacco stocks could be driven by the characteristics of” the consumer goods sector in general. Not only “could it” be so but, they also say, the sector-wide analysis better explains the numbers than does a sin premium.

Final Thoughts: Are There Only Three Sins?

Much of the discussion of the sin premium focuses, as both the HK and AH papers did, on three highly addictive behaviors and he industries that profit from them: alcohol, tobacco, and gambling.

But aren’t there other sins? Other sorts of business whence socially responsible investors shy? Toward the end of their discussion, AH address this point. Adult entertainment, the defense sector, biotech, and the nuclear industry are all considered sinful by some, and investment funds that are subject to outside political pressure (such as pension funds for public employees) can be pressed to divest from any or all of those.

Faith-based investors may also want to shy away from businesses that charge interest, sell pork, or provide abortions or contraception. AH construct various portfolios designed to include virtually all stocks that might be considered sinful by anybody. Their tentative conclusion is that an investor’s best shot at earning sin-based alpha is investing in biotech, contraceptives, hotels and restaurants and bars.

 

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