Article Highlights:

• Vice includes the traditional sin industries of gambling, tobacco and alcohol; defense companies are commonly included as well. Investing in vice is inclusive by seeking what companies to invest in.
• Virtue is often referred to as environmental, social and governance (ESG) and seeks to align a portfolio with an investor’s personal beliefs. There is no single universal standard, but investors can look to mutual fund and exchange-traded fund (ETF) holdings to use as a starting universe.
• Both vice and virtue stocks are screened based on value and growth characteristics to provide examples of how to identify stocks based on a thematic approach.

This article discusses building stock screens based on thematic approaches.

Thematic approaches focus on a particular topic of interest. It can be specific, such as a focus on a specific industry, or it can be broad, such as gender equality.

To narrow the scope down to a more definable universe, we focus on two themes: vice and virtue.

Vice refers to the so-called sin stocks: tobacco, alcohol, casinos, etc. We extend the universe to include other industries that some may object to investing in due to their personal beliefs, specifically weapons makers.

Virtue, in the investment industry, is often referred to by the moniker ESG. ESG is an acronym for environmental, social and governance. Its overarching purpose is to help investors do well by doing good. Though ESG is not specifically religious, we incorporate some religious aspects in our discussion to provide some insights about creating and following a religious-based approach to investing.

In reading this article, please realize that we are not promoting any specific personal beliefs, nor are we advocating for investing in certain industries over others. We are simply providing examples of investing strategies, along with the caveats an individual investor should consider when thinking about screening for stocks based on a thematic approach.

Why Vice?

Vice stocks may be mispriced to the extent that there are investors who have aversions to owning them.

From the standpoint of creating a stock screen based on a thematic approach, vice is an easier-to-define universe than ESG and it offers insights for those who desire to screen by industry.

When following a thematic approach to investing, there are three ways you can build an initial list of stocks to look at. The first is to select industries (or even sectors) to focus on. The second is to look at mutual funds and exchange-traded funds (ETFs) following a similar approach. A third is to seek out indexes based on those themes and see what stocks they include.

We are not aware of any specific vice stock indexes. There are such indexes for ESG, and we’ll discuss this third approach of using indexes when we discuss the virtue theme.

We can put together a list of industries, however, and we can look at what a handful of funds (both mutual and exchange-traded) are investing in. It is these former two approaches we follow for seeking vice stocks.

From an investing standpoint, the consensus sin industries are gaming (gambling), tobacco and alcohol. Some broader definitions include marijuana. Others include defense. Pure-play marijuana stocks mostly are not exchange-listed and remain highly risky due to varying state laws and the prevailing U.S. federal laws. [Two NYSE-listed marijuana stocks, Cronos Group Inc. (CRON) and Canopy Growth Corp. (CGC) are currently excluded from the data that Thomson Reuters provides for AAII’s Stock Investor Pro stock screening program and database. There are varying companies with partial exposure to marijuana, such as Constellation Brands Inc. (STZ), which invested in Canopy Growth a week before we went to print.] Defense companies are those involved in the manufacture of weapons and military equipment; they count as vice for those who are opposed to warfare.

In terms of vice funds, there aren’t many choices from a broad perspective. The oldest ongoing fund we’re aware of is the Vice Fund (VICEX). Offered by USA Mutuals and started in August 2002, this mutual fund invests in tobacco, alcoholic beverages, gaming and aerospace & defense companies. A complete listing of its holdings can be found on the SEC’s EDGAR database (www.sec.gov/edgar/searchedgar/mutualsearch.htm). For any mutual fund, type in the ticker’s name and then look for either form N-Q or N-CSR to see its current holdings.

The other broad alternative is the AdvisorShares Vice ETF (ACT). Started in December 2017, this exchange-traded fund invests in alcohol and tobacco stocks. It also can invest in cannabis-related companies “conducting federally legal business per the United States government.” A spreadsheet with the fund’s holdings can be downloaded from its website (www.advisorshares.com/fund/act). As of early August 2018, the fund considered BJ’s Restaurants Inc. (BJRI) and Darden Restaurants Inc. (DRI) to be vice stocks. We presume this is because both serve alcohol at their restaurants. The AdvisorShares Vice fund also held Scotts Miracle-Gro Co. (SMG), which has a cannabis subsidiary. These holdings show how seemingly targeted funds can wade into gray territory when trying to implement a thematic portfolio strategy.

Even defining what counts as vice is open for discussion. Investors who are focused on the environment and climate change might view profits realized from investing in petroleum companies [e.g., Exxon Mobil Corp. (XOM)] to be dirty money. From an ESG standpoint, they can be. But from the traditional view of sin stocks, they’re excluded. As you’ll see with virtue stocks, one person’s dirty money is a potential source of profit for someone else.

The process of investing in a vice theme is inclusive: We’re looking for companies to invest in. In contrast, investing in virtue is usually exclusive: It excludes companies not aligned with a person’s beliefs. An investor who is indifferent about vice can get exposure to such stocks by simply buying a broad market index fund.

The Vice Universe

For those who specifically want to invest in vice, we can construct a universe of vice stocks to screen. The Stock Investor Pro stock screening and database program contains a field under the Company Information category labeled industry. From it, we choose the sin industries of aerospace and defense, beverages (alcoholic), casinos & gaming and tobacco. Gun manufacturers are excluded from this list because they are classified under the recreational products industry by Thomson Reuters, which provides our data. (Industry classifications differ by data providers.)

By simply requiring stocks be exchange-listed, have a stock price above $4 and have a market capitalization of at least $30 million—the minimum required to be included in the Model Shadow Stock Portfolio—a total of 64 companies are identified.

Screening the Vice Universe

The next step is to narrow this list down to an investable universe. To do so, we overlay two different strategies: one value oriented and one growth oriented. In both cases, there is a broad set of parameters an investor can choose.

One option is to use absolute criteria, requiring stocks to have a specific set of characteristics in order to pass a screen. Such approaches can be overly restrictive when applied to a small universe of stocks. For instance, assume a maximum limit on a valuation is required [e.g., the price-earnings (P/E) ratio is no higher than X]. If most vice stocks are valued above this limit, then no stocks will pass the screen. The flip side is that a more restrictive screen can alert you when these stocks are trading at low valuations. The same issues and logic apply to other types of criteria too, including growth and momentum.

A second option is to use industry comparisons. Such approaches compare companies against their competitors and peers with the goal of finding the best of the breed. These types of strategies will always find stocks. The downside is that they do not consider the absolute level of the criterion used. If valuations for the given industries are high relative to an overvalued market, then even the valuations of the cheapest stocks within those industries may be high. Similarly, if growth rates are low (or even negative), then even the best stocks may lack strong growth when viewed on an absolute basis.

To provide you with a starting point for additional research, we use industry comparisons for the value screen and a combination of industry comparisons and absolute criteria for the growth screen. Industry comparisons allow us to find companies in all industries. The absolute values are used for projected growth to ensure a minimum amount of projected increase. In the results for both screens, pay attention to the absolute levels of the criteria used.

In creating screens, it’s worthwhile to have basic parameters set up initially to weed out stocks you otherwise wouldn’t invest in. As previously discussed, we require companies to be exchange-listed, have a minimum market capitalization of $30 million and a share price of more than $4. These basic requirements eliminate the riskiest and least-traded stocks.

For the value approach, we seek companies trading at a discount relative to their peers. A price-earnings ratio below or equal to the industry median is required. The price-earnings ratio is calculated by dividing the current share price by earnings per share. The simple inclusion of this ratio reduces the number of passing stocks down to 26. It’s a useful indicator for identifying those stocks that are inexpensive relative to their industry peers and for excluding companies that failed to achieve profitability over the past 12 months. To reduce the odds of a company with a historically high valuation appearing on the screen results, a current price-earnings ratio below each stock’s five-year average high price-earnings ratio is also required.

One additional criterion is included, return on equity (ROE). Return on equity is calculated by dividing net income by common equity (which excludes any preferred shares). A company’s ROE must be above the median for its industry group. Return on equity can be problematic when used across industries because of differing capital requirements. The ratio can be boosted by profitable companies that take on higher levels of debt relative to their equity. ROE is useful within industries because the relative levels of capital investment required are more similar. The ratio also shows which companies are more effective at generating profits off of shareholder equity than their peers.

A total of nine stocks were identified and are shown in Table 1.

Table 1. Vice Companies Passing the Value Screen

Company Name (Ticker)	Price-Earnings Ratio (X)			Return on Equity (%)		Stock Price (8/14) ($)	Price Change 52-Wk (%)	Market Cap ($ Mil)	Industry
	Current	5-Yr Avg High	Indus Avg
				Firm	Indus
Altria Group Inc. (MO)	15.4	18.4	20.9	72.1	23.3	59.21	-8.68	111,320	Tobacco
British American Tobacco PLC (BTI)	3.3	19.3	20.9	109.1	23.3	53.35	-15.06	121,661	Tobacco
Compania Cervecerias Unidas (CCU)	10.9	27.5	23.0	26.6	9.7	26.63	0.60	4,869	Beverages (Alcoholic)
Constellation Brands, Inc. (STZ)	21.5	23.7	23.0	30.9	9.7	221.81	12.49	40,804	Beverages (Alcoholic)
Las Vegas Sands Corp. (LVS)	16.1	26.7	28.5	56.4	8.3	66.72	9.76	53,466	Casinos & Gaming
Lockheed Martin Corp. (LMT)	20.8	21.2	27.6	706.3	8.4	318.59	3.58	89,171	Aerospace/ Defense
Melco Resorts & Entertainment (MLCO)	26.8	64.0	28.5	14.1	8.3	22.30	6.14	11,128	Casinos & Gaming
Molson Coors Brewing Co. (TAP)	12.6	25.4	23.0	12.1	9.7	67.39	-25.84	14,243	Beverages (Alcoholic)
United Technologies (UTX)	18.2	20.6	27.6	16.7	8.4	132.42	13.04	106,492	Aerospace/ Defense
Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 8/14/2018.

For growth, stocks must have realized higher revenue growth than their industry peers over both the past five years and the past 12 months. This narrows the results to the companies with the highest growth rates within their respective industries. We then require the I/B/E/S consensus forecast among analysts to project annualized earnings per share growth rates of at least 5% for the current year and the next two years. A minimum growth rate of 5% was chosen to ensure that projected growth is in excess of the rate of inflation. An alternative measure would be the long-term estimated growth rate. We chose not to use the projected long-term growth rate because it is not available for all companies. In the case of many mid-sized and smaller companies, only one or two analysts make their long-term forecasts available.

The 10 companies passing the growth screen are shown in Table 2.

Table 2. Vice Companies Passing the Growth Screen

More than half of the companies passing the growth screen are in the aerospace and defense industry, while no single industry accounts for the majority of the passing companies in the value screen. The difference shows the impact of requiring stocks to meet absolute minimum criteria instead of just looking more attractive than their peers. Companies from all industries are able to pass the value screen because it only uses industry comparisons. The growth screen’s use of a minimum estimated growth rate eliminates most alcohol companies.

The different results reflect the relative valuations of the vice stocks and the growth outlooks for each individual industry.

The Challenge of Defining Virtue

Defining what counts as virtue is far more difficult because of differences in personal beliefs. One way to narrow the universe is to simply eliminate all vice stocks. Doing so doesn’t work universally because a person could be against gambling but support a strong military (and even be a smoker).

An alternative is to look at funds. In our 2018 Guide to Exchange-Traded Funds (August 2018 AAII Journal), 74 funds were designated as “socially responsible.” Within this group, there are 30 broad domestic stock funds (as opposed to sector/industry funds or bond funds). Only six have accumulated more than $100 million in assets under management (AUM) and just two have more than $500 million in AUM. Those two ETFs are the iShares MSCI KLD 400 Social ETF (DSI) and the iShares MSCI USA ESG Select ETF (SUSA).

The former, iShares MSCI KLD 400 Social, is based on one of the first socially responsible investing indexes. It invests in large-, mid- and small-cap companies with high ESG ratings. The latter, iShares MSCI USA ESG Select, seeks to track a broader market index while factoring in a company’s ESG ratings. This index purposely excludes tobacco and controversial weapons companies, as well as major producers of alcohol, gambling, firearms, military weapons and nuclear power.

On the mutual fund side, TIAA-CREF Social Choice Equity Fund (TICRX) starts with the Russell 3000 index and then favors companies meeting certain environmental, social and governance criteria. The Vanguard FTSE Social Index Fund Investor Shares (VFTSX) invests in large- and mid-cap stocks chosen, at least in part, based on certain social, human rights and environmental criteria. A broader discussion of these funds’ ESG strategies, as well as alternatives, can be found in the March 2017 AAII Journal article, “The Next Generation of Socially Responsible Investing.”

There are a few mutual funds that invest based on religious values. An example is the Ave Maria family of funds, which uses moral screens established by the firm’s Catholic advisory board. The fund family avoids companies that are not considered to be pro-life or pro-family.

As you can see just from this summary of ESG funds, there isn’t any single universal standard an investor can rely on to screen for ESG stocks. Some funds and ESG indexes seek out stocks with certain ESG characteristics, while others purposely seek to exclude certain industries. A case can be made for both approaches, depending on what a person desires for their portfolio.

A challenge with either approach is the exclusion of stocks. By excluding certain stocks—either purposely or by giving emphasis to a company’s ESG rating—the universe of stocks to select from is narrowed. This will, in turn, lead to more concentrated portfolios and potentially cause an investor to miss out on the best-performing stocks. For some people, this trade-off may be a worthwhile cost to pay in exchange for investing based on their personal values.

If one were to simply exclude the vice industry groups of alcohol, casino & gaming, aerospace & defense and tobacco, 64 companies would be excluded out of 4,031. It’s not a big number but using the same screen criteria we applied for vice stocks, it would knock out all of the stocks listed in Tables 1 and 2.

An inclusionary approach would be to seek out stocks scoring well, or at least higher, on ESG metrics. This would again reduce the universe because some otherwise desirable stocks would be excluded or least see their allocation in a portfolio diminished to where their impact on returns would be minor. With either method, an investor is making a conscious choice to ignore or purposely underweight certain stocks for reasons beyond their return and financial-related characteristics.

Screening the Virtue Universe

Any screen can be modified to exclude vice stocks by adding criteria to exclude alcohol, casino, defense and tobacco companies. Screening to find ESG companies with attractive investment candidates is much more difficult. Most stock screeners that are currently and widely available to individual investors lack the ability to incorporate ESG characteristics into a screen.

One workaround is to screen an existing list of ESG companies. This can be accomplished by downloading the holdings of a mutual fund or ETF whose definition of virtue is similar to the personal values you want your portfolio to reflect. ETFs work better for this because their holdings are updated daily and can often be downloaded in a CSV (comma-separated values) format. As noted previously, mutual funds update their holdings less frequently and their holdings must be copied from U.S. Securities and Exchange Commission (SEC) filings.

To illustrate how a fund’s holdings can be screened, we used the iShares MSCI KLD 400 Social ETF. The fund’s holdings can be downloaded from the iShares website (www.ishares.com/us/products/239667/); look for a link labeled Detailed Holdings and Analytics. After downloading the CSV file—which can be found in the Holdings section—we copied and pasted the tickers into a plain text file. We then opened Stock Investor Pro and created a new portfolio by importing the text file with the portfolio editor tool.

Keep in mind that this process will not alert us if a stock has been dropped from the fund or the index. To find out if a stock has been dropped from an ETF, you will have to periodically download its holdings and check. It’s an imperfect process, but if your goal is to incorporate virtue into your portfolio and you want to invest in individual stocks, this is an option available to you as an individual investor.

Now that the universe is defined, we can screen on the portfolio within Stock Investor Pro. We use the same value and growth screens that were used for vice.

The value screen, as a reminder, requires a price-earnings ratio below or equal to the industry median. It also requires a stock’s current price-earnings ratio to be below its five-year average high price-earnings ratio and the company’s ROE to be above the median for its industry group. The value screen identified 105 stocks possessing these characteristics and being exchange-listed, having a minimum market capitalization of $30 million and a share price of more than $4.

Table 3 shows the 10 virtue stocks with the lowest price-earnings ratios.

Table 3. Virtue Companies Passing the Value Screen

The growth screen requires stocks to have realized higher revenue growth than their industry peers over both the past five years and the past 12 months. They must also have estimated earnings per share growth rates of at least 5% for the current year and the next two years. The growth screen identified 87 stocks.

Table 4 shows the 10 virtue stocks with the highest expected growth rates for their current fiscal year with the aforementioned stock exchange listing, market capitalization and share price requirements.

Table 4. Virtue Companies Passing the Growth Screen

Vice Versus Virtue

Far more virtue stocks pass the screens than vice stocks. The reason is the respective size of the universes. The vice stock universe was limited to a few industry groups, most of which are small in terms of the number of companies they encompass (e.g., there are only nine exchange-listed tobacco companies). The virtue universe covers a far broader range of industries.

Investing directly in vice companies requires making a purposeful effort to target such industries. An investor who is indifferent as to whether their portfolio includes vice stocks can screen the entire universe of stocks.

Had we run the value and growth screens without purposely seeking out vice or virtue, we would have found 520 value stocks and 551 growth stocks. Some of these stocks would have fallen into either the vice or virtue realm.

Virtue investing requires either excluding certain industries or favoring companies with specific environmental, social or governance traits. It purposely omits certain companies from a portfolio, which can cause an investor to sacrifice potential upside, a cost some may find justifiable given the desire to adhere to personal values.

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