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How To Invest In Addiction

August 17th, 2012 Leave a comment Go to comments

One of the easiest ways to pick individual investments (as opposed to diversified mutual funds, ETFs, or index funds) is to invest in addiction. Addiction is a strong word that correctly applies to certain situations but I would expand this investing style to include other kinds of products and services that are bought and used consistently. These investments can be categorized using the following descriptions:

1. Addictive – products or services that really create a chemical dependency, such as tobacco or alcohol.

2. Dependency – products or services that may have a mild addictive component that either isn’t very harmful or the product is used in a responsible way. For example, a physician might call your consistent use of coffee “dependency”.

3. Habitual – for some products, a habit is formed because the need is consistent and there may be barriers to seeking alternatives. If you heat your home with natural gas, you are in a sense forming a habit. It’s possible to switch to some other form of energy, but it comes with a switching cost.

In this article I will talk about these kinds of investments as well as serving up a sample portfolio.

Wall Street’s Take

Wall Street has for a long time categorized stocks that have characteristics of addiction as Consumer Staples or sometimes as Secular Growth stocks. This definition is fairly narrow, it refers to a subset of companies that sell products that are staples of everyday life, such as drinks, paper products or razor blades. These companies are in contrast to so-called Consumer Cyclical and other kinds of stocks that are more sensitive to macro economic factors.

If you are a new investor, this is really a great place to get started. Consumer Staples provide a lot of downside risk protection due to low beta (beta is a measure of how well a stock correlates with the market – a lower beta implies that the stock will drop less when the overall market drops).

Wall Street has some logic here when it comes to pricing different kinds of stocks. The biggest mistake that new investors make is to buy Cyclical, or economically sensitive stocks at the wrong time. Because the earnings, or the expectations of earnings, can vary to a larger degree for these kinds of companies they can just as easily get clobbered as well as shoot up in price.

In order to come up with companies that have qualities like Consumer Staples, we need to look at the qualitative aspects of companies, not only the specific financial figures, such as P/E, earnings, or earnings growth. We could ask questions, such as:

  • Does the business have high margins?
  • Does the company maintain a high level of consistent earnings and cash flow that is stable?
  • Does the product or service have limited competition and qualify as a ‘staple’?

Expanding The Definition

For traditional staples kinds of stocks it’s easy to find them. Look no further than tobacco, alcohol, beverage companies and food companies. These kinds of companies certainly qualify to be put into our basket.

For our purposes, we don’t have to stick to this strict Wall Street definition of companies with addictive properties. Pretty much any type of product or service wherever we find it that has addictive characteristics will potentially be a great area to invest. You just need to think outside of the box to find businesses that have the same qualities.

Here are a few examples that I have:

  • Energy Pipelines – Energy is typically put into the cyclical category not staples, even though people certainly need to buy energy consistently and continuously. Energy is cyclical because of commodity price risk. The way to play this is to invest in energy pipelines that make money simply transporting the energy. There is limited commodity price risk here.
  • Restaurants – Eating out of the home is very discretionary and has a large correlation with economic growth. But there are some businesses (such as McDonalds (MCD)) that have addictive properties because the food is highly processed, low quality and tasty. Also, the low price point makes the food more attractive when the economy goes south.
  • Financials – When we think of financials, we might think of banks which make their money with loans made during good economies. But, there are some financial companies that don’t make any financial bets, they simply are toll takers in the economy: payroll processors, investment firms and wealth managers. These companies make money in good and bad economies.

Sample Portfolio

I’ve assembled here a portfolio of great companies that could be a basis for you to start investing in individual stocks, or at the very least a starting point for your analysis. All of these companies have properties that make them candidates for an addiction portfolio.

Company Description
Diageo (DEO) Alcoholic Beverages
Lorillard (LO) Tobacco products
McDonalds (MCD) Restaurant
Enterprise Product Partners (EPD) Energy pipeline
Paychex (PAYX) Payroll processor
Kraft Foods (KFT) Food processor
Coca-Cola (KO) Beverages
Colgate-Palmolive (CL) Consumer products
Staples (SPLS) Office supplies
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