Are Sin Stocks Paying the Price for their Accounting Sins?

Abstract

A recent study by Hong and Kazperczyk (2005) finds that sin stocks - publicly-traded stocks in the gaming, tobacco, and alcohol industries are neglected by the stock market despite generating abnormal stock returns. We examine a rational explanation for their findings. Are the excess returns and investor neglect of sin stocks attributable to higher levels of information risk arising from poor financial reporting quality? Contrary to expectations, we find that sin firms exhibit better financial reporting quality along three dimensions: earnings and accrual persistence, predictability of earnings for future cash flows, and timely loss recognition. Our results are more consistent with a supply-side argument, whereby sin firms have high financial reporting quality to attract a wider investment and analyst base. Despite superior returns and financial reporting quality, investors are willing to bear a financial cost in order to comply with societal norms and reflect non financial tastes in their portfolio by neglecting sin stocks.