The Sin Stock Never Mentioned

Professor William Dukes, a WWII soldier that survived combat and later became a distinguished tenured professor at Texas Tech, passed away in June 2015. One of his special side projects at Texas Tech involved studying “sin stocks” and examining (1) whether they generated superior returns; (2) why they generated superior returns; and (3) what type of investors owned these stocks.

Professor Dukes concluded that yes, sin stocks generated 2.8% extra annual returns per year since 1973. And these stocks tended to be owned by private investors that remained outside the limelight and institutional funds that are run by small committees. According to Professor Dukes’ survey of money managers that declined to make investments in tobacco, gaming, and alcohol, the most cited reason was “It wouldn’t look good to clients and the media.”

Dukes speculated that small committees of institutional money would feel comfortable putting money in Altria or Philip Morris International because the investment decision isn’t tied to one person, and large committees refrain from ownership in sin stocks because members do not want their signature contribution to the committee to be about the fight for inclusion of sin stocks in the portfolio (and the larger number of participants raises the likelihood that some member would object on moral grounds.)

In one of the exhibits at the end of Professor Dukes’ work titled “Personal Values and Stock Values: A Survey”, the Texas Tech academic notes that another category of sin stocks is associated with abnormally large returns–prisons that are run in a for-profit manner. He points out that the sector is so undercovered, and the morality of whether for-profit prisons should even exist in the first place is so controversial, that many financial analysts decline to even inform their clients that these potential investments exist.

I don’t like that approach–if something has been a successful investment for decades and an analyst thinks that it will make money in the future, then he should disclose that information to investors. This aura of paternalism is fine when you’re dealing with kids–but when you’re dealing with adults putting their own money at risk, you should disclose all relevant information and then let them make the choice with the information.

Take something like The Geo Group (GEO). It is a real estate investment trust that owns, leases, and manages correctional facilities in the United States, United Kingdom, Australia, and South Africa.

You won’t have to look too far to find moral reasons not to own it.

In 2007, the Texas Youth Commission found that the inmates at the Coke County Justice Center living in extraordinarily unsanitary living conditions, and responded by firing seven GEO Group employees, terminating Coke County’s relationship with the GEO Group, and then eventually shutting down the facility and transferring the inmates elsewhere because the status of the overall environment had fallen into such disrepair.

In December 2008, GEO Group closed down its operations at the George W. Hill Correctional Facility in Delaware County, Pennsylvania because eight inmates died prompting lawsuits that the GEO Group did not provide adequate medical care.

In 2009, GEO Group finally paid a $42 million judgment for negligently supervising two inmates that killed another at the Rio Grande Detention Center in Texas. During the trial, evidence came to light that the local Geo Group supervisors destroyed standard record entries that would have implicated the supervising team for negligence that night.

There are several dozen other examples like this that have occurred over the past fifteen years, but these three examples cover the flavors of immoral conduct that is associated with the for-profit prison industry: poor living conditions, poor medical care, poor policing of fights between inmates, and then deliberate cover-ups of these actions.

What is also true is that the valuation of these for-profit prison operatives is perpetually low: the number of investors that don’t want to touch the stock mixed with those dissuaded by the political and legal risks is reminiscent of the tobacco sector. I have written before that tobacco investors have gotten outsized returns because these concerns created a cheap valuation that mixed with high dividends and growing overall profits.

That is what is going on at GEO Group. The prison REIT pays out $2.49 in dividends against annual cash flow of $3.30 that has the stock trading at 9.95x annual cash flow. The dividend yield is 7.55%. Profits grow around 7% annually.

It has been publicly traded since July 1994–back then it was known as the Wackenhut Corrections Corporation (the original ticker symbol was WCC, and then it rebranded as Geo Group in 2003 after repurchasing the stock of a large private investor.) If you got in on the IPO, you would have received almost 18% annual returns through the present time. With dividends reinvested, every dollar invested in the original GEO Group through a tax shelter that existed in 1994 would be paying out $2.50 in dividends today. You invested $100,000 in Wackenhut in July 1994? You’d be collecting $250,000 in GEO Group dividends today.

This isn’t a situation where success came as a result of buying in at an IPO either–the past ten years have given GEO Group shareholders 21% annual returns. Even if you’re morally opposed to holding a for-profit prison, there is a good chance that you may own it through one of your index funds. It’s not a member of the S&P 500, but it is a member of the Wilshire 5000 and some actively managed funds at Vanguard. In fact, Vanguard is the largest shareholder of GEO Group stock as Vanguard investors own 14.7% of the overall company.

The profit motive that drives business in general creates moral problems when applied to prisons. GEO Group shareholders benefit when prisoners are denied decent-quality food or amenities. The lower cost the treatment for human beings in jail, the more money that GEO Group makes. And GEO Group does not have a clean history of handling this moral dilemma well–the past fifteen years have been filled with legal judgments against the firm, and I would not bet that the last of the litigation has come.

Yet, I do feel an obligation to inform investors of where the high returns come from. People that have owned Lockheed Martin and participated in bomb creation have earned 16% returns since 1977. Investment researchers Iroy Dimson, Paul Marsh, and Mike Staunton of the London Business School have shown that, since 1900, American tobacco stocks have outperformed the rest of the market by over five percentage points annually. The original Anheuser-Busch or the current Brown-Forman have been legacy holdings that would any family generationally wealthy if they bought a modest amount and held for decades. I’m not as familiar with the casino industry, but casino stocks in general have outperformed the S&P 500 by almost two points annually.

Investment writers have no problems mentioning these stocks to investors, and then letting them decide whether these stock selections are consistent with their personal ethics. When comes to for-profit prisons, most writers turn into information gatekeepers. I think you should be trusted better than that. There are a lot of bad things that for-profit prisons have done, and it is also true that they have provided exceptional shareholder returns during periods that include litigation payments for these bad acts. To be a fully informed investor, you should know that the same elements which have historically given rise to superior tobacco returns exists in the for-profit prison sector at the present time.