The Peculiarity of Socially Responsible Investing

The Ave Maria Catholic Values Fund, which trades under the symbol AVEMX, is the best example of a socially responsible fund I have encountered. It has been a long-term owner of Lowe’s, which accounts for almost 4% of the overall portfolio, and Lowe’s has dragged the overall performance of the portfolio upward by delivering 17% annual returns over the course of its inclusion in the Ave Maria Funds.

The problem? It hasn’t been enough to keep the pace of a traditional benchmark like the collection of stocks in the S&P 500. In the past year, the S&P 500 has been up 7.4% while Ave Maria has been down 3%. In the past three years, Ave Maria is up 10.3% annually while the S&P 500 has advanced 17.3%. Over the past five years, Ave Maria is up 12% per year while the S&P 500 is up 17% per year, and the ten-year difference is two and a half percentage points: Ave Maria up 5.5% while the S&P 500 has been up almost 8.0% annualized.

And none of these performance returns include fees, which would have lopped 1.1% off your annual returns. Imagine that ten years ago you chose to put $100,000 into AVEMX. Today, you would have only $149,000 because you had to pay $14,000 in fees over the ten years. Someone who took the plain vanilla approach of sticking it all into the S&P 500 through VFINX at Vanguard would have $203,000 and would have only paid $2,300 in fees along the way. The difference was a little over 50,000.

And the performance of neither the Ave Maria Fund nor the S&P 500 comes all that close to what you’d get investing in the class of the economic called “sin stocks.” Owned Altria over the past 10 years? You got 19.5% annual returns. Owned Diageo, which is currently undervalued? You would have gotten a little over 10% returns. How about Brown Forman? Almost 16% annual returns. Reynolds American? Almost 22% annual returns. Boston Beer? 25% annual returns. Molson Coors? 11.5% annual returns. The Craft Brew Alliance? 13% annual returns. Vector Group? 15% annual returns.

Some of these results are a creature of the times–it’s hard to find income, so a lot of people own tobacco stocks right now that wouldn’t do so if thirty-year treasuries yielded 6%. That is why the dividend yield at something like Altria is at a generational low.

Why does this happen? How come tobacco indices have returned 17% over the past century, and alcoholic beverages have an eighty-year record of 13.5% returns? And why does the relatively new phenomenon of socially responsible funds fall significantly short (e.g. The Vanguard FTSE Social Index Fund has only turned $10,000 into $27,600 over the past fifteen years while the The Barrier Fund, formerly known as the Vice Fund and still trades under VICEX, has turned the same amount into $42,000 over that time frame)?

The most succinct explanation for the success of Vice Fund stocks comes in the 2004 Dan Ahrens book “Investing in Vice: The Recession-Proof Portfolio of Booze, Bets, Bombs & Butts” which theorizes that vice stocks benefit from both operational and valuation benefits that hold up well over time.

On the business side: Beer and alcohol companies benefit from stable demand, generate consistently high profit margins compared to capital deployed, and operate in an industry with barriers to entry once a significant brand name is established.

On the valuation side: The segment of the investor class that refuses to buy the company for ethical reasons depresses the price of the stock below what fundamentals would dictate, and this abstinence paradoxically boosts the long-term returns because these companies regularly repurchase stock and pay out high dividends so that the low share price increases earnings per share and raises the share count above what should be fairly expected.

When someone analyzes something like United Technologies, they are probably not getting bogged down by ethical considerations. Elevators don’t have that effect on people. That means the market of potential buyers for something like United Technologies is close to 100% of the investor population (there aren’t many investors removing themselves from the potential owners).

Tobacco and beer, meanwhile, have plenty of people that analyze the company and can recognize the investment merits of the industry, but voluntarily remove themselves from becoming a possible business owner because they do not morally endorse the business practices. The paradox is that this removal helps explain the long-term investment returns in the industry; the smaller pool means fewer buyers, a lower price than would be the case if there were no ethical considerations, and therefore the stock buybacks boost earnings per share by a little bit more than you’d expect and the reinvested dividends buy back a few more shares than you’d expect. Over twenty, thirty, fifty years, this kind of thing makes a difference.

Imagine if, in 1900, you had a choice: Invest $1,000 each into the original Philip Morris and Anheuser-Busch, or purchase $2,000 in the Dow Jones and reinvest every dividend and hold on to all the spinoffs along the way? The Dow Jones index route would have become $76,000,000. The Philip Morris and Anheuser-Busch route? $12 billion. Over one hundred fifteen years, the difference is beyond staggering. You got 157x as much riding the coattails of the pre-eminent tobacco and alcohol purveyor compared to the general market index. And, in case you’re wondering, Anheuser-Busch got through the 1920-1933 prohibition period by selling ice cream, soft drinks, soft drinks mixed with ice cream, and trucks and buses.

The underperformance of socially responsible funds can be explained by the reliance on the story. When people make a socially responsible investment, it is rarely driven by a desire to own something that pounds out cash. Instead, you become attached to the “story” of the stock, and the story and valuation is often higher than the cash-generating ability of the firm. Meanwhile, the only appeal of sin stocks is that they generate cash in a reliable way.

Everyone should make investments that are consistent with, or at least do not violate, their moral principles. But you should understand the cost of doing so. The track of socially responsible investing is not good, while vice stocks have a long record of making their owners rich. You should know exactly what you are sacrificing when making a socially responsible investment, because the lowered investment returns in socially responsible funds is a real phenomenon, and the disparity is even worse when you compare socially responsible funds to vice stocks.