Why are sin stocks like tobacco performing so well?

For some investors, being good is essential, but for others, a big part of the appeal of sustainable funds is that they have far outperformed the market in recent years.

With portfolios brimming with growth stocks, sustainable funds followed the wave during periods of low interest rates.

Now they are going through a period of dismal performance as interest rates continue to climb and investors move from growth to value.

By contrast, some of the FTSE’s major players selling tobacco and fossil fuels, which are largely excluded from sustainable portfolios due to their “sin stock” status, have held out.

Tobacco stocks are heading for their best year in a decade and it’s a similar story for oil and gas stocks.

The oil and gas sector has been boosted by increased demand after the pandemic, and the Russian invasion of Ukraine has pushed the price of oil even higher.

Meanwhile, tobacco has benefited from investors’ shift to defensive stocks that offer more reliable cash flows.

We look at why investors have switched to sin stocks and what this means for sustainable investing.

Why have ‘sin stocks’ done well?

The sin stocks label has traditionally referred to gambling, alcohol, tobacco and weapons companies, although it also includes other sectors such as fossil fuels. These sectors are usually shielded by ESG funds.

The shift to defensive stocks as the threat of a recession looms means sinful stocks are starting to enjoy their time in the sun.

Oil and gas companies in the FTSE 350 were, unsurprisingly, the strongest performers this year.

Analysis by AJ Bell shows that the oil and gas producers of the FTSE 350 have reached an increase of 38.7 percent in the year to date, up from 26.6 percent in the previous year and -43.9 percent in the year to date. 2020.

Tobacco companies in the FTSE 350 are up 19 percent from 1.76 percent in 2021 to 20.7 percent in 2022 so far.

Tertius Bonnin, assistant portfolio manager at EQ Investors said: “The new economic environment we are in is characterized by higher inflation, higher interest rates and greater uncertainty.

“This environment has led investors to favor companies with short-term cash returns (for example, companies that pay high dividends). Companies with these characteristics are often more mature companies, such as Oil & Gas or Tobacco.

Indeed, both Oil & Gas and Tobacco are two areas where sustainable investors have had little to no exposure, but have performed very well so far. This has undoubtedly hurt relative performance (the performance of investors versus global equities, for example) for some sustainable funds.’

Despite relative demand for more sustainable funds, 13 of the 20 largest UK-based equity funds have tobacco and/or oil stocks in their top 10, according to data from Morningstar Direct.

This is largely because tobacco and oil and gas make up a significant portion of the FTSE 100 and have historically paid dividends even during downturns.

Indeed, in the third quarter, oil and gas dividends rose a fifth (18.9 percent) year-over-year, according to Link Group’s Dividend Monitor.

It is precisely for this reason that BP and Shell have proved to be the mainstays of British equity funds. This year, the two companies announced massive share buybacks after making huge gains thanks to rising oil and gas prices.

Tobacco company Imperial Brands has also announced a buyback of up to $1 billion and is a lucrative earnings stock with a seven percent dividend yield and a strong payout history.

Source: Link Group Dividend Monitor

How sustainable is this period of strong performance?

Investors have flocked to the oil and tobacco sectors as they have proven to be safe havens for investors seeking income and a little more security – but how long can this continue?

As the world grapples with the transition from fossil fuels to alternative and renewable energy sources, investors are looking to oil companies’ huge profits as a way to protect themselves from the recession.

However, they face increasing criticism over their shareholder rewards during the cost of living crisis, which could make it more difficult to increase dividends in the coming months.

“Global commodity prices are very difficult – it’s a very volatile market and very difficult to predict,” said Laith Khalaf, chief of investment analysis at AJ Bell.

“There comes a point where the global economy, when faced with very high energy prices, starts to collapse on its own.

“What’s happening is that energy demand is stifled and prices are falling. But there’s an unpredictable geopolitical situation at the root of all of this, so it’s hard to predict.

‘I don’t see anything to indicate that energy prices are going down or that we are getting more security in the world. There is a case where things are actually getting more uncertain, so I see oil and tobacco continue to do well for now.’

Although the tobacco industry has relatively reliable cash flows – as it sells an addictive product – its future is far from certain.

Bonnin says: ‘Although the energy space is more nuanced, we see tobacco as a clear example of an industry in decline and whose prospects are seriously challenged. Cigarette sales volume growth has continued to decline in developed markets, as governments tightened the screw on both higher taxes and stricter regulations.

“This is driving some of the major players in the market to take over other companies that are far from their core competence. As a result, there is a risk that these management teams misallocate shareholder capital.’

Khalaf adds: ‘In the longer term, both sectors are concerned with the transition to greater sustainability – broadly in terms of sustainable energy for the energy companies and the abandonment of tobacco products for tobacco companies.

‘With such a huge wholesale transition, there is a big risk of repeating the successes you have had in the past with a completely different business line.’

Bonnin adds, “So while these sin stocks are enjoying their moment in the sun, our conviction rests in those companies that provide solutions rather than problems.”

What does this mean for ESG investing?

Exclusion-based ESG funds have had a difficult year, as the areas they tend to avoid were among the best-performing sectors in the UK market, while the areas in which they typically invest, such as technology, were weaker.

Could sin’s outperformance show we’ve reached the pinnacle of ethical investing?

Investors have certainly become more skeptical and pessimistic about ESG investing than even a year ago.

According to fund network Calastone, ESG funds saw their first total outflow in more than three years ago in September.

And a recent study by the Association of Investment Companies (AIC) also found that the proportion of investors who believe ESG investing is more likely to improve performance has shrunk from 33 percent to 22 percent.

Khalaf notes that much of the growth in the ESG fund markets hasn’t just come from ESG investors: “[There were] people looking for returns because they could see that this was going to be a pretty big growth area. Perhaps there has been some fuss about that.’

Dominic Rowles, chief ESG analyst at Hargreaves Lansdown added: “Many who invest in exclusion-based funds do so for moral or religious reasons, so the recent period of underperformance is unlikely to cause them to change their approach significantly. change.

“Many exclusion-based funds have the potential to perform well over the long term, but it is important that investors understand and are prepared to endure the inevitable ups and downs associated with these types of approaches.

“As always, when investing in funds, it is important to invest with fund managers who have a proven track record of adding value for investors.”