Ethical investing, avoiding blow ups, and salacious indictments $RICK

My personal belief is that there are no ethics in investing.

I don’t mean that in a “you can lie, cheat, steal, and murder as long as you generate alpha” type of way. I wouldn’t want to do any of those, and I’m sure the authorities would want a word or two if I did!

I mean that, historically, I personally would be comfortable making any investment that I thought was a positive risk/reward no matter the industry or the ethics¹ behind the company.

That’s my personal point of view / belief. But there are plenty of people who believe otherwise. The classic example is sin stocks like alcohol, tobacco, and gambling. Plenty of people won’t invest in sin stocks!

One of the reasons I don’t like to use ethics to limit my investments is because I don’t know where the line ends. For example, say you won’t invest in alcohol; obviously that means you won’t be buying Budweiser stock any time soon…. but what about adjacent industries? Most restaurants sell alcohol; for example, about 5% of Olive Garden’s sales come from alcohol… could you buy Darden’s stock (Darden owns Olive Garden)? Grocery stores sell alcohol; could you buy Kroger? Delivery services will deliver alcohol to you as part of your grocery order; could you buy Instacart or DoorDash? It feels like every other advertisement during a football game is a beer commercial; could you buy a media company that broadcasts alcohol advertisements?

To me, it’s an impossible distinction, and I know firms that have ethical limits on alcohol investments that have different answers to each of those questions. So while I personally don’t drink² I’d be happy to buy any of those companies / I’m not sure why my ethics should prevent me from an investment (though, again, I have no ethical problems with drinking!).

But honestly, saying that “I’ll invest in anything, ethics be damned!” is kind of a trite point. Why do I bring it up?

Because I’m actually interested in the potential wisdom of having ethical limits. I wonder if having “ethical passes” on stocks is actually a way of identifying and passing on stocks with tail risks.

Let me return to alcohol for a high level example. Say I was writing this article just over a hundred years ago in ~1915. I could say “hey, I’ll buy anything that can generate alpha; alcohol stocks are cheap” while my friend had ethical concerns around alcohol stocks and refused to buy them. Two years later, prohibition hits, and my alcohol stocks would be decimated while my friend’s portfolio would be chugging along.

Is that an extreme example? Sure! But I think it illustrates my point nicely! Things with ethical concerns often have unique tail risks, particularly regulatory / legislative risks. Alcohol in prohibition was obviously a regulatory / legislative issue, but there are plenty of places where ethical concerns bring other issues / tail risks upon themselves. For example, in the mid-2010s, Valeant was an unstoppable acquisition machine. The business model was truly incredible: Valeant acquired underpriced drugs and brought their pricing in line with what the market would bear. Often that pricing was 10x what the old company was charging. Valeant had kind of discovered the holy grail in pharma: they did no risky R&D, every acquisition was insanely and instantly accrettive, returns on investment were astronomical, the company gushed cash, etc.

Of course, what Valeant was really doing was price gouging. In 2015, Charlie Munger called Valeant “deeply immoral”. Valeant was a hedge fund darling at the time, and Munger’s comments raised a lot of eyebrows. I remember a ton of investors who said Munger had lost it, and some hedge funders³ came out swinging pretty hard against Munger.

Within months of Munger’s comments, Valeant was in deep distress (which continues to this day!). Much like raisins mixed with turds are still turds, when a business is a turd no amount of accrettive acquisitions or clever financial engineering can save it. It’s still a turd and, true to form, Munger called a turd a turd.

Why do I mention all of this?

Last night, RICK’s got hit with a pretty salacious indictment from the NY AG (the company denies all wrong doing). And it has me questioning my “no ethics in investing” rule.

I understand RICK is a contentious stock, and I’m not trying to grave dance on the longs or point fingers here. I’m only writing about this from my personal interest in the stock; I’ve never been long RICK, but I’ve always been very intrigued by the story as a long. It’s the type of stock I very easily could see myself owning: an asset heavy business (RICK tends to own the real estate under their clubs) operating a sin business with a founder CEO who owned a ton of stock and was openly talking about running an “Outsiders” playbook / was planning to buyback tons of stock when it was cheap while also pursuing extremely accrettive (and low multiple) acquisitions? Honestly, the only way a stock could be more up my alley is if instead of strip clubs (which I personally abhor) they were operating something I liked that for some reason was considered a “sin” business (an illicit escape room? an underground fantasy book speakeasy?).

In the wake of the indictment and the after hours stock drop, I saw a poster who said “Ask yourself if Buffett would ever own something like this, especially after today.”

I’ve always thought that type of thinking is misguided. I can near guarantee that early stage Buffett would have owned anything that made him money, ethics be damned. The man was a pure shark; some of his earlier wins involved buying and liquidating the largest businesses in small towns (Dempster Mills)…. it’s not until Berkshire got really big that he started bringing ethics into investing because he had to weigh the profits from individual investments versus the downside of hurting Berkshire overall.

So, a few years ago, I would have thought that “would Buffett own it” was a silly way to invest, a dumb reason to avoid a stock, and honestly pretty ignorant of Buffett’s early career and the calculated methodology of his shift.

But I’m rethinking that stance. There were/are a lot of issues at Rick’s that you had to get comfortable with to be long to the stock⁴; in general, the way you could get comfortable with the issues was something like “it’s a strip club business; the whole industry is shady so you kind of just need to accept that and realize ultimately the cash flow of the business + stock ownership of the CEO pushes this higher.” Given the upside here, I think there was a reasonable chance you could talk yourself into that if you were ignoring all ethics…. but, if you used an ethics based screen, then you wouldn’t have even been tempted by the cash flows / alignment issue. You would have seen the shadiness and instantly passed.

So I’m increasingly wondering if I’ve been too tough on ethics based off limit stocks. Sure, you’ll miss some great stocks if your ethics preclude them (the tobacco stocks in general are famously some of the best performing stocks of all time)…. but if you’ve tuned your ethics correctly, it seems like there are a heck of a lot of blow ups and regulatory disasters you can dodge.

As with all things, perhaps judgement and discretion is the key here. I like things to be all or nothing, so I kind of want to say either “these are the things I absolutely will not invest in based on ethical standards” or “I will invest in anything, ethical standards be damned” with no in between. As my friend Artem Fokin likes to remind me (sometimes publicly!), there is no one rule that works all the time in investing⁵; perhaps the answer is simply you just need to use judgement and be willing to pass or dig into something based on if it fits what you’re personally comfortable with.

PS- In the second to lass paragraph, I casually noted “you’ll miss some great stocks if your ethics preclude them.” That is a big negative! The way compounding works is that one grand slam investment more than makes up for a lot of negative investment. Phillip Morris stock famously was one of the best performing stocks in the world for decades; it compounded at ~20%/year from the mid-70s until the early 2000s. If you had bought and held the whole time, you did insanely well. What if you had bought a basket of Philipp Morris and two other “sin stocks” in equal size in the 70s, but the other two went to zero while PM compounded at 20%/year? At the end of thirty years, your IRR would have been ~15.7%/year…. still an absolutely world beating return despite two of the three sin stocks being complete zeroes! So, again, the risk of missing world beating stocks from an ethics screen needs to be weighed against the upside of missing blow ups, and I’m still torn on if the risks outweigh the rewards. Investing is hard!

1. Note: ethics and legality are obviously very different things! I’d be pretty quick to pass on a company that was somehow turning a profit murdering puppies for a million reasons.

2. For health reasons; absolutely no ethical issues with drinking for me personally!

3. To not throw stones from glass houses, I’ll put my hand up and admit that as a young ex-McKinsey-ite at the time, I was aware of the concerns around Valeant but generally thought they were the smartest guys in the room and had cracked the pharma machine.

4. This is a small one, but I thought their IR strategy alone was a big red flag!

5. To bring my nerdiness back into it, I feel like “only a sith deals in absolutes” would slot in nicely here!