VALUE INVESTING
The Ethics Of High Yield

By Stephen Bland (TMFPyad)
June 25, 2004

In the latest edition of my Value Investor newsletter, I suggested British American Tobacco (LSE: BATS) as the sixth addition to the sector-diversified high yield portfolio (HYP)  I am constructing there by instalments. When writing about this company as a long term yield play, I guessed that it might generate some controversy amongst those who favour ethical investing and so it has turned out. I've had this debate on several occasions in the past with various people but ultimately there is not a lot to argue about really because it is a question of individual beliefs. Long experience has taught that arguing with a person's personal beliefs very rarely changes them and anyway in this case there is little purpose in even attempting to do so, it's not as if ethical investing is likely to be harmful.

I personally have no interest in ethical investing, the only unethical share is one that eventually fails to make money, but for those who do, probably a small minority of investors, then that is fine, don't buy shares with which you have a problem. Ethical investors are unlikely to convince the rest of us "unethical" investors of their view and vice versa. Ethical investing obviously restricts the range of shares available but that apart there's little downside to it. But there may be a bit.

The amount of downside as far as HYPs are concerned depends on how ethical is ethical. Ethical investing is not clearly defined with the consequence that individual views vary on whether a particular share or sector contravenes ethical concepts. BAT is perhaps an obvious ethical pariah but what of Shell (LSE: SHEL), an earlier selection in my series? Some ethical investors may see oils as particularly nasty, others not so. Similarly problematic considerations might apply to miners or breweries and pub groups or weapons manufacturers as further examples of potential ethical dilemmas. Some might even have a problem with banks, the largest sector in the market by value.

If an ethical HYP investor is too ethical then they will cut out a lot of attractive sectors. Given that the choice of decent HYP candidates is not very wide anyway, particularly if investors stick to large caps, then the available choice could become too restricted if sectors like tobacco, alcohol, oil, mining, weapons and so on are omitted.

You could probably find something unethical in almost any sector if you really wanted to. Clothing retailers have been criticised for supporting third world sweatshops, supermarkets for their policies towards farmers and denuding inner city areas of small local shops. Utilities almost certainly do something wrong somewhere to the environment, phone companies stick up ugly aerial masts for mobiles, chemical producers doubtless have horrible but necessary products in their repertoire and so on. You get the picture.

Looking at the demo high yield portfolios that I run on TMF, the best performer by far in the oldest, HYP1 started in 2000, is presently tobacco share Gallaher (LSE: GLH). It's now up about 64%. For HYP2 started in 2003, BAT is the fourth best performer, up 50%. In addition, both have been increasing their dividends at a decent rate. Had I been ethically inclined when I set up the portfolios these companies would not have appeared. This does not mean though that whatever other ethically approved companies, had I gone for those, that I picked instead of  these ciggy shares would not also have done well. I can't of course know but the fact remains that tobacco shares have been exceptionally attractive investments amongst large caps, both for capital gains and increasing dividends, the latter point being critically important for HYPs.

I am not trying to convince ethical investors to change their stance, merely showing that two particularly unethical shares have done well. I cannot though attribute that success purely to their unethicalness, it may well be just chance.

Perhaps in the future with the newsletter, once I have completed the present and completely; ethicless HYP I am constructing which will be in about a year or so, I might give some thought to designing an ethical one, provided I can agree guidelines as to exactly which types of share qualify.

It's all in the newsletter.