This article was originally published on May 17, 2004.
One of the more obvious -- but perhaps underpracticed -- rules of investing is: Know what you're buying. With interest rates hovering at generational lows, many income seekers have been chasing yield over the past few years. That's led some to so-called Sin Stocks, which is a fancy name for makers of everything from tobacco to liquor.
If you're considering an investment in sin, be sure that you're aware of just how much sin you're taking on. You see, sin has evolved over the years, and the companies that sell sin have evolved right along with it. There was a time when sin was being watered down. But we've now entered a period where drafts of sin are as pure -- and as potent -- as ever.
OK, at this point you may be wondering just what in the H-E-Double-Hockey-Sticks I'm talking about. Allow me to use an example. Once upon a time, there was a company called Philip Morris. Young Philip was in the business of selling tobacco. Everyone loved Philip and his product, and all was good for a time. However, Philip was a bad boy, and it seems that everyone loved his product in part because it was nearly as addictive as crack rock.
Philip was probably aware of this pearl of information for a little while before he chose to officially disclose it, and that's when Philip got into trouble. No one loved Philip anymore. In fact, everyone started to sue Philip, and it was feared that this might just put Philip out of business.
From sin to safety, and back again
At this point, Philip said to himself, "Self, we've been running an extremely profitable business, and we have an awful lot of cash on our hands. So, maybe we should offset some of our litigation exposure related to the tobacco business by purchasing a nice, safe, stable, non-sued company in another business line."
Philip Morris then purchased Kraft Foods (NYSE: KFT ) and later renamed itself Altria (NYSE: MO ) . It was a good idea. After all, what could be safer than selling little squares of pasteurized cheese wrapped in cellophane? The company also purchased Miller Brewing Company, maker of the beer that bears its name.
All was well in Altria-Land as its investments paid off and society began to lean back toward the attitude that people should actually be responsible for their own decisions. Legal woes diminished.
But as Altria has averted legally induced bankruptcy time and again and negative sentiment has eased, the company has grown somewhat weary of the lower margins associated with its food and beer businesses. For this reason -- and to unlock the value of Kraft shares by removing the cloud of legal risk from the unit -- Altria brought Kraft shares to the market via an initial public offering. It also merged Miller Brewing with a South African company to form SABMiller.
The company still owns 84.6% of Kraft, but there is speculation that it will spin its ownership off to Altria shareholders in the coming years. Likewise, Altria maintains a 36% ownership in SABMiller for now.
Purity, not piety
The point here is that Altria is morphing back into a pure play in tobacco, and it's not alone in its journey. Other sin stocks such as R.J. Reynolds (NYSE: RJR ) , Diageo (NYSE: DEO ) , and Allied Domecq (NYSE: AED ) have taken similar roads.
You may recall the days when R.J. Reynolds was called RJR Nabisco. Nabisco, which is now a unit of Kraft Foods, is the maker of many consumer food products, including the beloved Nutter Butter cookie. These days, however, R.J. Reynolds is once again a pure tobacco company.
In darker times for booze, British spirits maker Diageo diversified its exposure to sin and put its large cash flows to work by picking up Burger King in 1988 as part of its purchase of Pillsbury. The company has since sold Pillsbury to General Mills (NYSE: GIS ) , and more recently dropped Burger King to once again become a pure play in the spirits industry.
If you've ever eaten a Dunkin' Donut or taken down a double scoop at Baskin-Robbins, you've transacted with liquor giant Allied Domecq. The company still owns these subsidiaries -- as well as the Togo's sandwich shop chain -- and has announced no plans to part with them. However, I believe there's a distinct possibility that a change in ownership structure of these units is coming in one form or another at some point.
Not that there's anything wrong with that
Don't get me wrong here. I'm not saying I take issue with the strategies that these companies are employing, and I'm certainly not saying there's anything wrong with owning sin stocks. I have nothing against these firms. Indeed, I've liked Altria enough to own the stock for the past several years.
However, investors need to realize that most of these firms are not the same companies they were just a few years ago. You have to know what you're getting with these stocks, and what you're getting has changed dramatically.
Now, the wages of sin can be high wages indeed. As such, the core businesses of these companies can be very profitable. Selling tobacco and booze will generate some of the best operating margins available, and investing in these companies now means that you get the benefit of non-watered-down margins from largely recession-proof businesses.
However, the flip side of that coin is that you'll be an owner of what is now a pure play, and you'll bear the full risk of that core business. The future of these stocks will depend on the success of booze and tobacco, not on ice cream, cookies, and hamburgers.
Again, I'm not saying that there's anything wrong with that. Just know what you're getting yourself into, and act accordingly.
The Foolish bottom line
Generating reliable income from your portfolio requires diversity and prudent decision making. It's OK to spice things up, but you should also have a base of companies that aren't likely to go bankrupt because of a single legal ruling.
Taking a risk is part of investing, but if you choose to tread heavily in the sin sector, it would be wise not to bear such high levels of political and litigation risk in the remainder of your portfolio.
If you're still looking for the elusive dividend -- from sin or elsewhere -- consider a subscription to Motley Fool Income Investor. Try itfor free.