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Does sin pay? Yes, according to a new study published last month in the Journal of Financial Economics that looked at the returns of so-called sin stocks - tobacco, alcohol and gambling - from 1965 to 2006.

The study found that over those 41 years, sin shares on average returned about 3.5 percentage points a year more than other stocks. It also found that sin shares were cheaper, by about 15 to 20 per cent, based on valuation ratios. And because of the stigma of these stocks, pension funds and other institutional investors were more likely to avoid the shares and analysts were less likely to follow the companies.

"Our explanation was based on social norms," says New York University's Marcin Kacperczyk, who with Harrison Hong of Princeton University wrote the study.

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Because so many investors choose not to invest in sin stocks, Mr. Kacperczyk says, share prices are lower and "people who are staying in sin, because there are fewer of them, have to bear proportionately more risk than otherwise." Those investors will expect higher compensation, seeking out stocks that have been steadily rising and boosting dividends.

But Mr. Kacperczyk warns that investors still need to be cautious when picking their vice. During this recession, many sin stocks have taken a hit, he says, despite the conventional wisdom that they are virtually recession-proof.

Casinos, in particular, "have had big trouble," he says. "Alcohol has been hit a little, too - but tobacco has done really well."

In fact, consumer researcher Mintel International Group Ltd. has looked at the tobacco market in the United States and found that sales increased 44 per cent between 2003 and 2007 (to $103-billion U.S.) and, in its 2009 forecast, predicts that sales will increase a further 5.1 per cent by 2011.

It's a trend that Charles Norton, co-manager of Dallas-based USA Mutuals Vice Fund (VICEX), also points to. Like his fund's name suggests, it concentrates on "vice" - alcohol, gambling, defence and tobacco. But look at its top 10 holdings by percentage as of June 30, and tobacco places No. 1 and 2 - Philip Morris International Inc. at 15.4 per cent and Lorillard Inc. at 8.9 per cent.

"From a business standpoint," Mr. Norton says, "the tobacco sector is doing best. But I still think that's not fully appreciated in the stock prices. So we still think there's significant upside in tobacco and have the greatest piece of our portfolio allocated to the sector."

Mr. Kacperczyk and Mr. Norton say that tobacco's strength lies outside of North America, in emerging markets like Eastern Europe and Asia.

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"If you sort of slice and dice the world," Mr. Norton says, "over the past decade or so there's actually been volume increases in the amount of cigarettes that are consumed globally. But the way that breaks down, in the mature developed world there's significant declines, and all the growth is coming from the emerging markets."

In the United States, tobacco companies have been hit recently by a major excise tax increase, and "we're entering into a more regulated environment," Mr. Norton says. "Broadly speaking, globally, excise tax risk is pretty benign and the regulatory environment is pretty stable as well."

Philip Gorham, a tobacco analyst with Chicago-based Morningstar Inc., says that not only is consumption rising in emerging markets, but the long-term trend is that consumers have been "uptrading" - switching to more expensive products from cheaper ones. "That's another way companies can grow - by offering more premium products," he says.

Mr. Gorham says Philip Morris International - the company that makes Marlboro - has "been on a good run … but we think it's fairly priced at the moment." Morningstar's target price for Philip Morris is $53; it closed yesterday at $46.27, down 41 cents.

In fact, "the whole market has been on a good run recently" but Altria Group Inc. is "the cheapest at the moment," he says. Morningstar's target for Altria is $24, and it closed yesterday at $18.27, up 10 cents.

"The dividend is yielding about 8 per cent," Mr. Gorham says of Altria. "We think it has the least to lose from the [U.S. Food and Drug Administration]regulation in the U.S. - so its market share will be set in stone. It owns about half of the U.S. market - we think it's quite well placed."

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Mr. Gorham says he expects Reynolds American Inc. , whose flagship brand is Camel, to underperform the market because the company's brands are small, and they plan to discontinue some. Morningstar's price target for Reynolds is $82 and it closed yesterday at $45.82, down 18 cents.

As for Lorillard, the Vice Fund's No. 2 holding, Mr. Gorham says Morningstar isn't recommending it, although he says the company's Newport brand is "incredibly strong - it's kind of defied all logic."

The problem with Lorillard, Mr. Gorham says, is that "it's really a one-trick pony."

Newport is also a menthol brand, and the FDA is planning an inquiry into whether menthol tobacco is more harmful than regular tobacco.

For now, menthol is under fire, Mr. Gorham says, so "there's too much of a risk to recommend Lorillard right now."

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