When times are tough, the theory goes, “sin” stocks outperform because smokers and drinkers seek solace in vice. But another theory maintains these stocks fall, because discretionary items get crossed off shopping lists as purse strings tighten.

Neither theory holds water, however, says Charles Norton, a portfolio manager at GNI Capital Inc. in Dallas, who invests exclusively in tobacco, alcohol, military and gambling stocks as a subadvisor for Dallas-based USA Mutuals Vice Fund (VICEX). In fact, there’s little correlation between smoking, drinking and defence spending and the ups and downs of the economy. Vice goes on, whether it’s affordable or not.

“People around the world smoke and drink and gamble,” Norton says, “and nations around the world continue to defend themselves.”

So, if you can get past backing butts and booze, there is much to recommend sin stocks. There can be high barriers to entry; for example, licences for gaming facilities are highly restricted, curtailing competition. And consolidation in the tobacco industry in recent years has boosted profits in that sector.

Indeed, tobacco is one sector in which stock prices have held up fairly well. “Tobacco companies have been a good place to hide in this market environment,” says Richard Nield, Austin, Tex.-based co-manager of Invesco Trimark Ltd.’ s AIM Canadian Premier Fund. There are now several international tobacco powerhouses that have benefited enormously from economies of scale, he says, and London-based British American Tobacco PLC is one example.

In the nine months ended Sept. 30, 2008, BAT reported net income of £1.9 billion, a 13.5% increase from the same period the year before. “Although there is general concern about the prospects for the world economy and consumer behaviour over the next couple of years,” BAT chairman Jan du Plessis remarked, “these results demonstrate that there has been no discernable effect on BAT.”

Since stock prices plunged this fall, not one tobacco company has cut dividends, adds Norton. For instance, Marlboro maker Philip Morris International Inc., the world’s biggest cigarette company, with a market cap of US$78.4 billion, has a dividend yield of 5.8%.

But not all parts of the sin sector can boast such results, the gambling sector being a case in point. “We’ve definitely noticed that on gaming, things have slowed,” Nield says. “Casinos in the U.S. are just getting destroyed.”

Some declining sales of sin products are not related to the recession at all, but instead are a result of the growing concern among consumers about health. In addition, increased taxes, lawsuits and government regulation of smoking have had an impact on profits although, Norton believes, they won’t make or break the bottom line.

Canadians who want exposure to the sin sector can’t buy the Vice Fund, as it isn’t available in Canada. But they can match the international stocks held by the fund, or look for similar ones in Canada. It does take some digging, however, to find similar stocks on the Toronto Stock Exchange. Most of Canada’s alcohol producers and all of Canada’s tobacco companies are now part of multinational corporations. Only two major companies can be found on the TSX: Toronto-based Corby Distilleries Ltd., and Molson Coors Brewing Co., based in Denver, Colo., and Montreal.

Molson Coors is the parent company of Molson Canada Inc. and owns 42% of Denver-based MillerCoors Inc. (a joint venture with SAB Miller PLC). Although Molson Coors is controlled equally by Canada’s Molson family and the American Coors family, the source of its profits are very much Canadian: about 55%-60% of its net income is generated by its Canadian business unit. However, profits from the MillerCoors venture are expected to increase once cost savings realized by the merger of the U.S. operations with SAB Miller takes effect.

Brewers, including the Belgian beer behemoth Anheuser-Busch InBev SA have been struggling lately with a loss of market share, as Western consumers switch to liquor, spirits and wine. The Russian market for beer has been growing, says Nield, but was recently hurt by a decline in the ruble.

The trend toward increased consumption of mixed drinks, spirits and wine can only be beneficial for Corby, Canada’s biggest publicly traded liquor distributor, which celebrated 40 years on the TSX in February. Corby has been going strong for 150 years, says Con Constandis, the company’s CEO, and provides regular returns and long-term growth.

@page_break@“Our brands have seen a lot more than you and I ever will,” he says. “They’ve survived previous recessions, wars and, believe me, they will survive the next 150 years.”

Corby reported revenue of $93.8 million in the six months ended Dec. 31, 2008, a 3.5% gain from the same period a year earlier. But its bottom line was affected by the weak Canadian dollar and low interest rates on the company’s deposits. Net income in the six months was $17.9 million vs $19.9 million a year earlier.

Since much of Corby’s business is based on brand distribution — it represents its 51% shareholder, liquor giant Pernod Ricard SA in Canada — it is bolstered by the fact that it offers a range of brands and price points. “We have something for every consumer in the country,” Constandis says. Corby owns Wiser’s whisky, Lamb’s rum and Polar Ice vodka, and distributes Pernod Ricard brands Kahlua, Chivas Regal, Beefeater and Jameson.

While these latter brands have cachet, investing in Pernod Ricard may be a more risky venture, says Nield, as the France-based company is saddled with debt from acquisitions. A more popular bet is London-based Diageo PLC, which owns brands Guinness, Bailey’s, Crown Royal and Seagram’s. Since September, Diageo’s stock has outperformed the S&P 500 composite index. In its Feb. 12 earnings report, Diageo forecast that profits would drop slightly because of the weakening economy, but says it continues to seek acquisitions in emerging markets.

Companies that supply the military are also expected to do well. The U.S. is expected to spend US$650 billion on its basic and supplemental defence budget in fiscal 2009, not including the cost of items such as veterans’ funding and nuclear research.

That means steady business for contractors such as Raytheon Co., the missile manufacturer based in Waltham, Mass., which makes air-to-air, strike, naval weapon systems, land combat missiles, guided projectiles, exoatmospheric kill vehicles and directed energy weapons; Lockheed Martin Corp., based in Bethesda, Md.; and Northrop Grumman Corp., a top U.S. military contractor and security company headquartered in Los Angeles.

Canada’s top publicly traded defence company is Montreal-based CAE Inc., which manufactures both civilian and military flight simulators and offers training to hundreds of companies around the world. CAE was recently awarded a $330-million contract by the Canadian Forces for aircrew training for Canada’s new fleet of 17 C-130J Hercules tactical airlift aircraft.

CAE reported net income of $148.1 million in the nine months ended Sept. 30, 2008, vs $117.1 million in the same period a year earlier. The results were better than expected, but the company warns that the economy will probably dampen future performance as a slowdown in global growth has hurt the civilian aviation industry.

“The year ahead will be more difficult for civil aviation,” says CAE CEO Robert Brown. “Our outlook for CAE’s role in the defence markets continues to be positive. Overall, we believe that our actions and our diversification will help us as we go through the next period.”

Despite the possible challenges, David Tyerman, an analyst with Toronto-based Scotia Capital Inc. , calls the company’s share price attractive. The company has “robust” and “strong” military prospects, he says, which should partially offset any drop in civilian business.

Investors who cringe at sin should take a close look at their portfolios. Sin stocks can be found in the majority of index funds, which, by their very nature, don’t screen stocks, as well as in actively managed funds run by mainstream companies such as Toronto’s CI Investments Inc., Invesco Trimark and AGF Funds Ltd.

And even if you hold only so-called “ethical” funds, you still have a stake in sin if you plan to draw on the Canada Pension Plan. The CPP Investment Board, which had assets under management of $117.4 billion as of Nov. 12, 2008, has a wide range of holdings in tobacco, booze and defence companies. Many other public and private pensions hold these stocks, too. For instance, Quebecers own Japan Tobacco through the Caisse de dépôt et placement de Québec.

The CPPIB holdings don’t bother Michael Jantzi, president of Toronto-based Jantzi Research Inc. , which analyzes companies for their behaviour on environmental, social and governance fronts. First, Jantzi says, alcohol isn’t a red flag for most of his firm’s clients, who don’t view it the way they view tobacco sales. The CPPIB has recently taken an interest in company performance on carbon emissions and climate change, which, to Jantzi, is the most pressing issue of concern to future generations. Also, Jantzi says, the CPPIB has a fiduciary duty to obtain the best return on investment it can. In other words, it is obliged by law to look at investment returns before ethics.

For the client who likewise puts a priority on strong returns but, unlike the CPPIB or big mutual funds, may have trouble analyzing the financial statements of high-tech companies with complex wireless devices, the business of spirits and smokes is easy to understand, says Eric Lansky, president of Dallas-based USA Mutuals.

“Sin stocks,” says Lansky, “may be for that investor who visits a local pub and notices it is busier now, more then ever before, and wants to invest with that knowledge.” IE