Biblical bashing from the Sindex

The Money Observer Sindex – the UK stock market’s largest companies that are not members of the FTSE4Good index of more ethically sound companies – is roaring ahead, reports Heather Connon

The wages of sin is death, according to the Bible. For investors, however, the wages of sin could be a bit extra in the retirement nest egg. While we are all supposed to be paid-up members of the green squad – buying free-range products, recycling and reusing, and reducing our carbon footprint – the evidence is that companies that are banned from most ethical investment portfolios tend to deliver the best investment returns.

Saints and sinners
Over 10, five and three years as well as the last six months, our portfolio of 28 sinning companies – the Money Observer Sindex – has beaten the ‘saints’ hands down, according to statistics from Thomson Reuters. Indeed, over 10 years, anyone investing £100 in the Sindex would now have more than £258, while the same stake in the saints would have shrunk to just over £61. The only period when the saints came close to the sinners was over the past year, when they registered a 28 per cent loss compared with 33 per cent for the sinners. However, over the past six months the sinners have produced a 34 per cent increase – more than six times that of the saints.

This is not necessarily what you would expect: the amount of interest in, and legislation on, good ethical and environmental performance should mean companies with squeaky clean ethics will win out. Instead, investors seem to be backing the adage ‘where there’s muck there’s brass’.

To be fair, Money Observer’s saints are not necessarily typical of an ethical portfolio. The saints comprise the 72 members of the FTSE 100 index that also qualify for inclusion in the FTSE International’s FTSE4Good index. This index screens companies for compliance with ethical criteria in five areas: environmental management, climate change adaptation, observance of human and labour rights, countering bribery and monitoring the behaviour of suppliers.

The index includes pharmaceutical companies that are banned from some ethical portfolios because of their use of animals for research – although others like their efforts to alleviate common diseases in the developing world – and banks, which are often excluded because it is impossible to police who they are lending to.

And, because the index comprises only the giants of the FTSE 100 index, it excludes smaller companies that might be expected to benefit from the greening of the economy. Think of Ceres Power, which is developing fuel cells; RPS, which offers environmental consultancy; or wind company Ocean Power Technologies.

A question of conscience
But it is what FTSE4Good excludes that makes our Sindex so interesting. The largest category is commodities. Mining and oil companies account for 11 of the 28 companies and include established giants such as Anglo American and newer upstarts such as Kazakhmys and Eurasian Natural Resources. The two big cigarette makers: British American Tobacco (BAT) and Imperial Tobacco are included, as well as defence contractor Rolls-Royce and support business Serco, which provides services to the defence industry. Given the spectacular performance of the Sindex over the past decade, investors might be tempted to consider building a portfolio of these companies – provided, of course, their conscience allows them to.

The Sindex portfolio includes some reliably good performers. Many of them – ranging from BAT through BAE Systems to Serco and Intertek – have produced decent earnings increases for at least five years and, if analysts’ forecasts are to be believed, will continue to do so.

Most have also produced decent yields: BAT offers a generous 4.7 per cent, BAE 3.8 per cent and Imperial 3.5 per cent. Many look reasonable value – Balfour Beatty and Rolls-Royce shares stand at less than 10 times their earnings and Anglo American is on 5.8.

This reliability has been well rewarded: many of the components have done two or even three times as well as the rest of the market over the past five years.

Can this continue? The dramatic recovery in the stock market in recent weeks has been concentrated in the kind of bombed-out cyclical and consumer stocks that feature in the saints rather than the more defensive sinners – banks are the obvious example, but retailers and house-builders have also staged a dramatic recovery. If, as some economists are starting to hope, the concerted action by governments across the world has managed to engineer a V-shaped recession, with the recovery as sharp as the downturn was, then the staid sinners may be neglected.

But it is far too early to be certain that will happen. It is at least as likely that developed economies are in for a prolonged period of sluggish growth at best, as companies, governments and consumers gradually pay off their excessive debts and unemployment rises. In that kind of environment, stocks that are relatively immune to economic ups and downs should still be in demand.

Price worth paying
These would certainly include the two tobacco stocks, both of which are gaining more customers in fast-growing emerging markets than they are losing in developed ones. On multiples of around 14 times earnings, they are not that cheap, but the price could be worth paying for reliable earnings and generous – and increasing – dividends. Services companies such as Cobham, Serco and Intertek have also proved resilient in the face of recession, and their ratings are not too demanding. Our choice from the list would be Cobham or Serco.

Commodities companies have been more vulnerable to the economic downturn: having soared for much of the past decade, the prices of most basic commodities fell back sharply as recession spread around the globe, and company profits and share prices did the same. But the argument on which the commodities boom was based does still make sense. The likes of India, China and Brazil are growing rapidly – albeit a bit less rapidly than had been anticipated. Some of the increased wealth that growth is bringing will be spent on the basic staples and consumer goods that use commodities. In the long term, this increased demand should translate into higher prices and therefore increased profits.

But the link is not immutable. Commodity companies have a habit of expanding and contracting at exactly the wrong time – witness Rio Tinto’s expensive acquisition of Alcan in 2008 just before the commodity boom ended. And there can be political and governance risk – many companies in the sector are foreign companies, which do not necessarily comply with UK rules on disclosure and transparency in their dealings. But a company such as Tullow Oil, which has proved itself to be a shrewd oil explorer, could be worth adding to a portfolio.

While governments talk about cutting their spending, defence costs seem to rise inexorably, benefiting companies such as BAE Systems – which is also profiting from the growth in spending in Asia and the Middle East. That means the shares should live up to their status as defence stocks.

Fund option
It is possible to find funds that have large holdings in these kinds of companies. Neil Woodford, the investment guru behind Invesco Perpetual’s Income and High Income funds, is one of the longest-standing investors in BAT and Imperial.

His funds also include US tobacco company Reynolds, which put his exposure to tobacco companies at more than 14 per cent, while he has a similar proportion in AstraZeneca and GlaxoSmithKline. Holdings of defensive companies such as these have helped Woodford become one of the most consistent fund managers of the decade.

Many of management group Newton’s funds are also big investors in drugs and cigarettes – Tineke Frikkee’s Newton Income fund, for example, has 4 per cent in BAT and a further 10 per cent split between Astra and Glaxo.

In the US, it is possible to buy into the Vice Fund, which is run by USA Mutuals. It invests in industries such as tobacco, alcohol and pornography. Its recent performance has been disappointing: according to its latest fact sheet, it has lagged its benchmark over one and three years, although it remains ahead over five years.

Tim Cockerill, head of research at Rowan, says defensive companies of the type in the Sindex have lagged in recent months as investors have rediscovered their appetite for risk. But he cautions that this may not last: ‘If we move to a phase where the market pulls back, these sectors could look attractive again.’