These sin stocks could be smoking hot bets

With products that keep consumers coming back for more, sin stocks could be a good way to get high returns.

Vikram Barhat 27 October, 2015 | 5:00PM

The so-called "sin" sector comprises companies operating in the liquor, tobacco and gambling industries.

Due to year-round demand for their products and services, and consumer loyalty based on human weakness, these companies generate heaps of cash, have high profit margins and pay hefty yields. In other words, there are substantial gains to be made by those not averse to investing in these sin-dustries.

According to Morningstar data, brewers as an industry have returned 8.12% for the year to date, and Tobacco stocks have gained a solid 8.32%, compared to a negative 1.94% returned by the S&P 500 Index (all figures as of Oct. 22).

The following four stocks represent the best in their industries and are trading at a sizeable discount to Morningstar analysts' estimates of their fair value.

Anheuser-Busch Inbev SA (ADR)
Ticker BUD
Current yield 2.94%
Forward P/E 23.0
Price US$118.73
Fair value US$126
Data as of Oct. 23, 2015

 Anheuser-Busch InBev (BUD) is the largest brewer in the world, with a portfolio that contains five of the top-10 best-selling beer brands including Beck's, Corona and Budweiser; 17 of its brands generate retail sales over US$1 billion. The company recently reached a deal to acquire SABMiller, the world's second-largest brewer. AB InBev also has a 62% economic interest in its Latin American subsidiary, Ambev.

The global behemoth has built a strong competitive advantage by guzzling rivals and keeping a sharp focus on cost control, which has helped generate excess returns on invested capital for many years, says a Morningstar report. "Return on invested capital has remained in the low-double-digit range over the past five years," said Morningstar equity analyst Philip Gorham who placed the fair value of the company's American Depository Receipt (ADR) at US$126, implying a juicy 5.2% free cash flow yield. "We believe its wide moat will sustain this level of returns for at least the next two decades."

Gorham forecasts 2% revenue growth for the brewer in 2015, but projects 4% organic revenue growth thereafter, and a 60% normalized gross margin boosted by falling commodity prices, particularly barley and aluminium.

Philip Morris International Inc.
Ticker PM
Current yield 4.49%
Forward P/E 19.1
Price US$89.63
Fair value US$92
Data as of Oct. 23, 2015

New York-based  Philip Morris International (PM) is the world's largest publicly traded tobacco company that owns leading brands such as Marlboro, Chesterfield, Parliament and Virginia Slims, among others. The firm holds 28% of the global market, excluding China.

According to a Morningstar report, the company leads the industry with more than 40% operating margins (forecast to grow to 44.3%), and maintain a robust competitive advantage through strong brand loyalty and lower costs.

The stock's US$92 fair value estimate by Morningstar equity analyst Philip Gorham implies a 4.4% dividend yield for 2015, driven by volume, pricing and margins. Gorham projects a long-term gross margin of 66% and expects "returns on invested capital to remain over 30% over the next decade."

The cigarette maker's profitability in emerging markets, particularly in Asia, is a key differentiator against its competitors. "Indonesia (where Philip Morris has about a 31% share), Turkey (about 45%) and the Philippines (about 90%) are all growing in volume at a low- to mid-single-digit rate," said Gorham, attributing this growth to a more lax regulatory environment in those regions leading to higher levels of smoking initiation.

Wynn Resorts Ltd.
Ticker WYNN
Current yield 5.92%
Forward P/E 16.2
Price US$67.60
Fair value US$145
Data as of Oct. 23, 2015

 Wynn Resorts (WYNN), the Las Vegas-based casino company, operates four megaresorts: Wynn Macau and Encore in China and Wynn Las Vegas and Encore in Las Vegas, with plans to open two more over the next few years: Cotai Palace in Macau and Everett in Boston.

Wynn gets 70% of its earnings before interest, taxes, depreciation and amortization (EBITDA) from Macau, where it runs one of only six gambling operations legally allowed, and 30% from Las Vegas.

According to a Morningstar forecast, Wynn's Macau revenue is expected to grow at a compound annual rate of 5.8% over the next decade, with a more modest revenue growth forecast of 1.5% for its Vegas business for the same period.

Wynn's stock is trading at less than half of its US$145 fair price value estimated by Morningstar equity analyst Dan Wasiolek, based on revenue growth and profit margins assumptions for 2015 through 2024.

The company's founder, Steve Wynn, is regarded as one of the most successful entrepreneurs in the history of the casino industry. "Wynn Resorts offers investors the rare opportunity to bet on both the jockey and the horse," said Wasiolek.

Diageo PLC (ADR)
Ticker DEO
Current yield 2.98%
Forward P/E 19.1
Price US$114.43
Fair value US$125
Data as of Oct. 23, 2015

The maker of Guinness stout and Johnnie Walker whisky,  Diageo (DEO) is the world's leading producer of branded premium spirits. The UK-based distiller's portfolio also includes Smirnoff vodka, Crown Royal Canadian whiskey, Captain Morgan rum and Baileys Irish Cream. It also produces and markets beer and wine, owns 34% of premium champagne and cognac maker Moet Hennessy, and a near-55% stake in India's United Spirits.

The firm's wide economic moat flows from strong intangible assets and low costs. It owns 14 of the top 100 global premium distilled spirits brands and seven of the top 20, something a new entrant will find hard to replicate. This makes Diageo an important partner for bars, restaurants and retailers.

Morningstar equity analyst Philip Gorham pegs the fair value estimate for Diageo's ADR at US$125, implying an earnings yield of 4.4% and a dividend yield of 2.6%.

The distiller's current 27% global volume market share, according to a Morningstar report, is set to grow following the acquisition of India's largest liquor company United Spirits, which provides access to a large base of middle-class consumers with a preference for premium brands.

Complete access to Morningstar's research on equities, mutual funds and exchange-traded funds is available to subscribers to Morningstar Canada Premium.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Anheuser-Busch InBev SA/NV ADR96.90 USD-0.07
Diageo PLC ADR163.21 USD-0.42
Philip Morris International Inc71.56 USD-0.64
Wynn Resorts Ltd112.90 USD-0.90

About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.