Sin stocks operate in certain industries that are deemed bad for society and are actively clamped-down on by governments. The added regulatory burden raises the barriers to entry and makes these industries more concentrated. Meanwhile, sin products, such as gambling, tobacco, and alcohol, are often so addictive that customers are willing to pay exorbitant prices to get their fix. 

It’s a recipe for some truly robust profitability, which is why I dedicate a portion of my watch list to these sin industries. Here are some of my favourites from the sinner basket: 

Diageo

Drinks giant Diageo (LSE: DGE) is not only my favourite sin stocks, but it’s also one of my favourite British companies. Not only has the company delivered 21 consecutive dividend increases over the years, it has also doubled investor capital over the past five years. 

Diageo’s 2% dividend yield is nothing to boast about, but it might be the most robust payout on the FTSE 100 at the moment. The company’s payout ratio is a mere 54.5%, which means it has plenty of room left to reward shareholders in the future.

Speaking of the future, 20% of the company’s drink sales are already generated in Asia, which is the fastest growing market for alcoholic beverages in the world. I think Diageo’s underlying business model and portfolio of incredible brands is enough to cheer any long-term investor, which is why it’s the cornerstone of my investment watch list.  

British American Tobacco 

Smoking is notoriously addictive. Fortunately, the rate of smokers across the globe has plateaued in recent years. Unfortunately, a 2014 study found that over a billion people were still addicted to tobacco and were loyal to brands that were owned by a handful of multinational conglomerates. 

One of the largest is FTSE 100 constituent British American Tobacco (LSE: BATS). The £70bn tobacco giant offers a 7% dividend yield. While the stock has had a rough run over the past five years, the company’s underlying revenue, profits, and dividend payouts have steadily increased. 

Earnings per share cover the dividend by more than 30%, while net gearing remains relatively low at 68.63%. However, investors have punished the stock as younger smokers have turned to vaping and e-cigarette products in recent years. The stock’s price-to-earnings ratio has been sliced in half over the past five years. 

That presents an opportunity for long-term income-seeking investors like me.  

Other sins

Drink producers and tobacco giants aren’t the only sin stocks I’ve been watching. The potential legalisation of sports betting in the US has piqued my interest in gambling stocks like 888 Holdings, while the possibility of a sugar tax has me eyeing AG Barr.

Foolish takeaway

The unique mix of high barriers to entry and relentless demand make sin stocks worth a closer look, in my opinion. 

Despite this, the future for the FTSE 100 appears to be rather bright. The credit crunch is history, the UK economy is one of the fastest growing economies in the developed world, and global growth prospects remain very sound. As such, it could be a great time to buy a number of high quality companies.

Take, for example, Imagination Tech (LSE: IMG). Its share price continues to disappoint, with it being down 2% year-to-date and 27% down in the last five years. However, its financial performance over the next couple of years is forecast to improve massively, with profitability set to return this year and 22% growth in profit being pencilled in for next year.

This step-change in performance has the potential to act as a positive catalyst on the company’s share price following three years of disappointing performance, with the last two years’ of losses set to make way for a more prosperous period. And, with Imagination Tech having a price to earnings growth (PEG) of just 1.1, it appears to offer excellent value for money at the present time.

Of course, tech isn’t the only growth sector. Transport is also an appealing growth space at the present time, with Go-Ahead (LSE: GOG) forecast to deliver a bottom line rise of as much as 28% next year. And, unlike Imagination Tech, investor sentiment in Go-Ahead has been strong in recent years, with the company’s share price rising by 135% in the last five years.

Despite this, Go-Ahead trades on a PEG ratio of just 0.5 and, with dividends expected to rise by 17.3% next year, the stock could be yielding as much as 4% next year from a dividend that is covered 1.9 times by profit.

Meanwhile, neither Imagination Tech nor Go-Ahead can boast of the same level of growth as online takeaway company, Just Eat (LSE: JE). It is expected to post growth of 38% this year and 56% next year as its simple, effective and reliable online ordering system continues to prove popular with customers. And, while there is a move towards healthier eating across the globe, takeaways remain popular and, in the long run, have the capacity to adapt to changing consumer tastes. Moreover, with a PEG ratio of just 0.8, Just Eat appears to offer a wide margin of safety in any case.

Clearly, Diageo (LSE: DGE) (NYSE: DEO.US) has disappointed over the last couple of years, with its earnings falling by 12.5% in the last two financial years and its shares being down 4% since July 2013. Furthermore, its share price performance would have been much worse were it not for recent rumours surrounding a possible bid approach.

Still, Diageo remains a company with significant long term growth prospects. Its very wide geographical diversity and range of brands mean that it has most alcoholic beverage bases and growth regions covered. Furthermore, its excellent cash flow and robust balance sheet mean that it could take part in M&A activity itself so as to boost a bottom line that is set to return to growth in the current year, with a rise of 7% having the potential to improve investor sentiment moving forward.

Such companies have powerful brands, strong margins and prodigious cash flows. They perform relatively well when economic conditions are challenging. And, with their entrenched positions in developed markets, and increasing expansion into higher growth emerging markets, they have a structural tailwind for long-term growth. As such, investors are happy to pay a premium price.

“Buy on the dips” has been good advice over the years for these quality businesses, whose shares have risen without the great peaks and troughs that characterise cyclical companies.

With the world fretting about a Grexit, the FTSE 100 is down some 8% since hitting an all-time high in April. Unilever, Reckitt and Diageo have performed a little better than the wider market, but have certainly dipped significantly. Unilever and Diageo are both down 7% from their 2015 highs, while Reckitt is off by 6%. So, is now a good time to buy?

Unilever

When I looked at Unilever back in April, the forward price-to-earnings (P/E) ratio was a rich 22.5, with a prospective dividend yield of 3%. By May, the P/E had come down to 21.4 and the yield had edged up to 3.1%. I said at that time I thought Unilever could deliver decent long-term returns, but that, ideally, I’d be looking for an opportunity to buy a bit lower.

Despite the share price now being lower, the valuation is little changed — the P/E is 21.2 and the yield is still at 3.1% — due to some downward revisions in analysts’ earnings and dividend forecasts. As such, I have to reiterate my view on Unilever from May.

Reckitt Benckiser

In April, Reckitt Benckiser’s forward P/E of 25 was even higher than rival Unilever’s, while the yield of 2.1% was lower. By May, Reckitt’s P/E had come down to 23.8. I thought the rating was still a little high, but did note that Reckitt has often surpassed analysts’ earnings forecasts in the past.

Like Unilever, Reckitt has seen some recent downgrades to earnings and dividend forecasts, so the valuation is little changed from May, with the P/E at 23.9 and a yield of 2.2%. Once again, despite the dip in the shares, I have to reiterate my previous view on Reckitt.

Diageo

Global drinks group Diageo is another consumer goods company I looked at in April. At that time Diageo appeared somewhat better value than Unilever and Reckitt, being on a forward P/E of 20, with a yield of 3%. And I was bullish on Diageo’s prospects, when writing in May with the stock on a similar valuation.

Unlike Unilever and Reckitt, whose financial years coincide with the calendar year, Diageo has a June fiscal year end. When I was writing in April and May, my valuations were based on forecast earnings and dividends for June 2015. While Diageo hasn’t released its results for the year yet (they’re due on 30 July), I think it’s now appropriate to look to forecasts for the year to June 2016. The P/E is 19.6, with a yield of 3%, so, while I’m modestly positive about Unilever and Reckitt, I remain more attracted by Diageo’s valuation.

Most consumer goods firms enjoy stable cash flow fuelled by brand-loyal customers repeat-purchasing, but the added attraction of alcohol’s addictive ‘qualities’ makes drinks providers such as Diageo (LSE: DGE) and SABMiller (LSE: SAB) seem even more ‘defensive’ as investments.

Good, but pricey

Steady business growth and rising dividends seem likely to reward investors in those two firms over the longer term. However, in the short to medium term there is some risk due to the companies’ elevated valuations.

Diageo’s forward price-to-earnings ratio (PER) runs at just over 19 for 2016 with the share price near 1863p and SABMiller’s at just under 20 with the shares around 3280p, yet City analysts expect only 7% and 8% growth in earnings per share next year, respectively. Forward dividend yields leave us wanting more, too. Diageo’s sits at 3.1% and SABMiller’s at a mere 2.5%.

So I’ve been looking at cider-led consumer beverage company C & C Group (LSE: CCR). The firm’s a tiddler with its £844 million market capitalisation compared to Diageo’s £47,459 million and SABMiller’s £53,542, but with the smaller size comes a lower valuation, which makes the firm an interesting investment alternative in the consumer-drinks space.

A niche operator

At a share price near €3.35, C & C Group’s forward PER runs at just over 11 for year to February 2017 and City analysts following the firm have earnings growth of 5% pencilled in for that period. The forward dividend runs at 4%, a healthy payout, which forward earnings cover just over twice.

In some ways, C & C operates like a mini SABMiller. Where SABMiller based its growth on beer brands and spread its wings from origins in South Africa to the rest of the world, C & C operates with cider brands in the ‘Celtic’ lands of Scotland and Ireland, and has yet to take over the world — but it has been trying, with a few disappointments so far, which could account for today’s ‘value’ rating.

You’ve probably heard of some of C & C’s brands; names such as Magners, Bulmers, Gaymers, Blackthorn and Ye Old English in the cider market, Tennent’s and Caledonia Best in the beer market, and non-alcoholic drinks such as  Tipperary and Finches. The firm reckons it exports to more than 50 international markets, but last trading year the majority of the firm’s revenue came from Scotland and Ireland. There was a 4.8% revenue contribution from North America and just 2.2% from other export markets.

Glass half-full or half-empty?

The firm took a knock in the US last year where increasing competition battered what was a growing market share. Significant write-downs resulted, and I think that’s one reason we see a value opportunity in C & C today. Does that mean it’s ‘game over’? I don’t think so. It’s hard to miss the increasing popularity of cider-brands in the alcoholic drinks market, so C & C is potentially well placed. The trouble in the US is that other firms noticed the trend as well, and swooped in for a piece of the action.

Yet the setback seems to have galvanised C & C’s directors into action and the firm is in the process of reworking its marketing and corporate strategy from the ground up. I love situations like this. C & C operates in an industry with an apparent tailwind and the directors are planning a turnaround. What’s more, the firm’s penetration of world markets is at an infant stage with all that growth potential still ahead, the company is in addictive consumer goods — a defensive sector — and to top it all, we see the shares presenting on a ‘value’ rating. C & C is going on my watch list with a view to deeper research.

Where it certainly does not have relevance, though, is in the world of investing. That’s because, while many investors will become more and more excited if a company’s share price is high, and will speculate to a greater extent, the chance of making a better return from your investment does not improve. In other words, paying a higher price can limit your upside, and increase your downside.

As such, stocks such as ASOS (LSE: ASC) are relatively unappealing. Clearly, investors in the online fashion company are getting excited; its shares have risen by 50% since the turn of the year, after all. And, while they do have considerable future potential via an improving UK economy and the scope to further expand abroad, ASOS’s valuation could limit future returns. For example, the company currently trades on a price to earnings growth (PEG) ratio of 2.7, which indicates that unless its bottom line begins to grow at a much faster rate, its share price may come under pressure.

In fact, Reckitt Benckiser (LSE: RB) is in a similar position. Certainly, it is a top quality business with excellent long term prospects in emerging markets, but its current PEG ratio of 2.8 indicates that its share price could come under pressure in the short term.

Of course, earnings growth is set to pickup next year following a number of challenging years, but the company’s price to earnings (P/E) ratio appears to be too high relative to other global consumer stocks, such as Diageo (LSE: DGE) (NYSE: DEO.US). It trades on a P/E ratio of 20.8, which is 10% lower than Reckitt Benckiser’s P/E ratio of 20.2. And, with Diageo’s outlook set to improve in-line with that of Reckitt Benckiser, Diageo appears to offer much better value than its consumer goods peer.

In addition, Diageo may prove to be an acquisition opportunity for one of its beverage peers. That’s at least partly because of its wide range of premium brands and strong position in the Asian market, with it having joint ventures in China and India, where growth in premium spirit consumption is set to increase dramatically over the medium to long term.

Likewise, Wolseley (LSE: WOL) appears to have sufficient potential to back up its premium rating. For example, it is forecast to continue to benefit from an improving US and UK economy, with the building materials company forecast to increase its bottom line by 15% this year, and by a further 14% next year. As such, its P/E ratio of 17.6 appears to be good value for money due to it equating to a PEG ratio of just 1.1. Therefore, while Wolseley’s share price has soared by 22% in the last year, it appears to be worth buying at the present time.

However, while the company would make a great addition to any portfolio, at present levels — and based on current trends — the company appears to be overvalued. 

Fashion trends

One third of Diageo’s sales come from the United States. The company’s largest brand by sales in the region is Smirnoff Vodka. Unfortunately, vodka is falling out of favour in the US.

Falling vodka sales have hurt Diageo and compounded the group’s troubles during the first quarter of this year. Diageo’s North American sales only increased by 0.9% year on year during the first quarter, well below estimates, which were calling for growth of 2%. 

But even though Diageo’s North American sales growth missed expectations, it was the only bright spot in the company’s first-quarter results release. Group net sales during the three months to March 31 fell 0.7%. Sales fell in every single one of the company’s markets bar Africa and the US. 

And it’s not just fashion trends that are holding back Diageo.

The group’s sales remain under pressure within China as sales of expensive cognac, baidu and whisky have fallen following the country’s anti-corruption drive. Further, a clampdown by the Indonesian government on sales of drinks with less than 5% alcohol volume hitting beer sales in the world’s fourth most populous country.

Subdued growth

All of these factors mean that Diageo’s sales growth will be subdued this year. Earnings per share are set to fall. 

Specifically, according to City figures Diageo’s sales will expand by 4.8% this year. Meanwhile, earnings per share will decline by 5%, following a decline of 7% last year. After two years of declines, Diageo’s earnings will have fallen back to the same level they were at four years ago. 

With this being the case, it looks as if Diageo is overvalued at present levels. If City estimates are to be believed, at the end of this year the company’s earnings will be 7% above the level reported for full-year 2011.

However, since the end of 2011 Diageo’s shares have gained 35%. Moreover, during the same period the company’s P/E ratio has increased from 15 to 21.

So all in all, Diageo is approximately 40% more expensive now than it was back in 2011, although the company has failed to achieve any growth over the period. 

What about a takeover?

Even though I believe that Diageo looks overvalued at present levels, I wouldn’t rule out a takeover. Rumours have circulated recently that 3G, an investment vehicle controlled by three Brazilian billionaires, has been eyeing up Diageo.

As the value of merger deals has recently surged to an all-time high, it seems as if there is a strong appetite for deals across the market. 3G might not make an offer for Diageo, but another suitor could be willing to fork out the cash.

Good-quality companies with consistent performance and attractive financial characteristics rarely sell cheaply, but periods of market weakness can provide an opportunity to buy the shares a little lower.

Unilever (LSE: ULVR), Whitbread (LSE: WTB), Shire (LSE: SHP) and Diageo (LSE: DGE) are all firms with attractive underlying businesses and may be worth keeping an eye on for a decent entry point.

Fast-moving consumer goods

Fast-growing brands such as Dove, TRESemmè, Knorr and Hellmann’s power Unilever’s cash-backed growth. The ‘defensive’ qualities of the firm’s business model are attractive, but macro-economic headwinds made forward progress challenging over recent years.

However, the outlook is turning up as Unilever strengthens its innovation pipeline, increases investment in core brands, and extends operations into premium segments and new markets. Although currency and commodity volatility persists, the firm reckons it will see further improvements in volume growth during the rest of 2015. 

At a share price of 2783p, Unilever’s dividend yield runs at 3.3% for 2016 and the payout is covered one-and-a-half times by forward earnings.

Fast-growing coffee and hospitality

It’s true that there’s an element of cyclicality in Whitbread’s hospitality and coffee business — quite a large one — but there’s a heck of a lot of growth going on, too! In fact, the firm’s large double-digit yearly earnings increases are mouth-watering.

The company owns the Premier Inn, Costa Coffee, Beefeater, Brewers Fayre, Table Table and Taybarns brands, with Costa and Premier standing out as the greatest drivers of growth. The shares have multi-bagged since 2009 despite looking expensive on conventional price-to-earnings measures the whole time.

At today’s 5075p, share price the dividend yield runs at around 1.8% for 2016 with forward earnings covering the payout about 2.6 times.

Growth in pharmaceuticals

Back in April, Shire released a healthy set of first-quarter results demonstrating that growth remains on track. The firm’s chief executive said the firm exemplifies the characteristics of a leading biotechnology company, delivering strong revenue growth and cash generation, while advancing its innovative pipeline and boosting its future growth profile through its acquisition strategy.

It’s hard to argue with the firm’s success, which has seen the shares power ahead. The man at the top thinks there’s more to come. Shire specialises in behavioural health, gastro intestinal conditions, rare diseases, and regenerative medicine, and there is a healthy development pipeline to keep things rolling along. The firm certainly makes an interesting investment alternative to sector peers GlaxoSmithKline and AstraZeneca.

At a share price of 5230p, Shire’s dividend yield runs at just 0.4%, but forward earnings cover the payout almost 13 times, suggesting the directors see plenty more opportunity for further growth.

‘Sin’ cash

Alcoholic consumer brands are attractive. Any consumer brand with repeat-purchase credentials tends to throw off cash, but the addictive nature of alcohol makes firms like Diageo seem even more ‘defensive’. People don’t tend to drop their favourite tipple from their shopping lists no matter how tough the economic times become.

Diageo owns well known brands such as Johnnie Walker, Crown Royal, J&B, Buchanan’s, Windsor, Bushmills, Smirnoff, Ketel One Vodka, Ciroc, Captain Morgan, Baileys, Tanqueray and Guinness. Last year Diageo earned about 37% of its operating profit from emerging markets such as Africa, Eastern Europe, Turkey, Latin America, the Caribbean, and the Asia Pacific, with the rest coming from Europe and North America.

Today’s 1874p share price sees the dividend yielding about 3.1% for 2016 with forward earnings covering the payout around 1.7 times.

Diageo

Supported by recovering consumer spend in emerging markets, I reckon that dividends at drinks giant Diageo (LSE: DGE) should hot up significantly in the coming years. Not only are blue-chip labels like Johnnie Walker and Smirnoff helping to drive revenues in these territories, but the firm’s expanding global presence — from the acquisition of Tequila Don Julio in Mexico to United National Breweries in South Africa — is also bolstering its rosy sales outlook.

Previous sales troubles are expected to push earnings 5% lower in the year ending June 2015, but Diageo’s sunny long-term picture is expected to keep its progressive dividend policy trucking — a 53.9p per share payment is currently slated for 2015, up from 51.7p last year and yielding a handy 2.8%. And a projected 57.9p payment in 2016 pushes the yield to 3.1%. These numbers are far from spectacular, but I believe dividends should charge higher further down the road in line with electric earnings expansion.

Bovis Homes Group

Make no mistake: Britain’s housing crisis is set to remain for some time to come, great news for the sector’s major players like Bovis Homes (LSE: BVS). The rate at which houses are being put up simply cannot meet demand, a situation not helped by home loans becoming more and more easily attainable for the average buyer. Consequently house prices continue to leap higher, and latest Rightmove stats showed values increase 3% month-on-month in June, to £294,351.

The City expects this backdrop to drive earnings 28% and 20% in 2015 and 2016 respectively, predictions that should keep the annual payout rattling higher. Indeed, last year’s 35p per share reward is anticipated to rise to 40.2p this year, yielding a decent 3.6%. And this figure jumps to 4% in 2016 amid expectations of a 45.2p payment.

TalkTalk Telecom Group

Like its heavyweight sector rivals like BT and Sky, entertainment provider TalkTalk Telecom (LSE: TALK) is embarking on a huge investment programme to copper-bottom its position in the ‘quad play’ market. While recent acquisitions and organic investment — such as its super-fast broadband drive in the North — are helping to bolster the quality of its bundles, the company is also enjoying solid customer take-up as it tries to smash its rivals in the value stakes.

These measures are already proving exceptionally successful for TalkTalk’s bottom line, and the London business is expected to clock up further growth of 90% for the year ending March 2016, and 50% the following year. Subsequently the telecoms giant is predicted to lift last year’s 13.8p dividend to 16.1p this year, resulting in a bumper yield of 4.1%. And a prospective reward of 17.9p for 2017 drives this readout number to a brilliant 4.6%.

Royal Mail

With extensive restructuring well underway, I believe that Royal Mail (LSE: RMG) is in terrific shape to hurdle the challenging conditions currently affecting the courier market, and effectively respond to the growing role of e-commerce — indeed, the Daily Mail recently reported that Royal Mail has inked an accord with a major retailer to send marketing material to online shoppers based on what people place in their ‘baskets.’

The rapid growth of online shopping, and consequent impact on parcel traffic, is expected to propel earnings 5% higher in the year concluding March 2017, recovering from a rare 19% predicted decline in the current period. And thanks to this bubbly long-term outlook Royal Mail is expected to fork out a 21.6p-per-share dividend in 2016, up from 21p last year and yielding 4.1%. And this rises to 4.3% for 2017 due to forecasts of a 22.6p payout.

Growth Potential

However, Diageo remains a company that is proving to be far less stable and defensive than was previously thought. While growth during the credit crunch separated the company from many of its more cyclical FTSE 100 peers, with double-digit growth being achieved in 2011 and 2012, for example, last year and the current year are much more disappointing for the business. In fact, following last year’s 7% fall in earnings, Diageo’s bottom line is set to drop by a further 6% this year.

Of course, growth of 7% is forecast for next year and, while this is very much welcome after two tough years, it may not be enough to significantly improve investor sentiment – especially while the company trades on a price to earnings (P/E) ratio of 21.4. As such, and while its long term prospects remain sound due to its excellent stable of brands and exposure to what are set to be the fastest growing markets for beverages across the globe, its share price could come under pressure over the medium term.

Smaller Peers

One company that has underperformed in 2015 is central and eastern European-focused spirits company, Stock Spirits (LSE: STCK). Its share price has fallen by 11% since the turn of the year and, while it lacks the size, scale and breadth of premium brands of Diageo, it appears to offer growth at a very reasonable price. For example, Stock Spirits is expected to grow its bottom line by 16% in the current year, followed by a rise in earnings of 10% next year. And, with it having a P/E ratio of just 15.6, it equates to a very appealing price to earnings growth (PEG) ratio of 1.

Meanwhile, producer of Vimto, Nichols (LSE: NICL), has turned the tables on a disappointing 2014 by posting growth of 40% thus far in 2015. Certainly, it has a rather high rating, with it trading on a P/E ratio of 21.9, but it has an excellent track record of net profit growth and a very strong balance sheet. For example, Nichols has increased its earnings at an annualised rate of 18.6% during the last five years, which indicates that it is worthy of such a high rating.

Looking Ahead

Although Diageo is an excellent company that is currently enduring a tough patch, it remains a top notch investment for the long term. However, the likes of Stock Spirits and Nichols also have considerable appeal and, as such, a mixture of all three companies could be a sensible way forward for Foolish investors. And, if you can only pick one, then Stock Spirits’ excellent growth prospects and relatively low valuation appear to mark it out as the stock with the greatest capital gain potential.