Charles Norton has been testing his investment thesis: that certain industries, cigars included, will continue to grow even in an economic downturn.

In times of broader uncertainty, companies catering to luxury indulgences are usually the first to suffer a slowdown: Your luxury-consuming professional hesitates to buy that Rolex come bonus time, refuses to order another aged scotch at the bar, and even -- horror of horrors! -- cuts back on the Montecristos. U.S. cigar imports approached an all-time high in 2007, however, a trend the smart money thinks will only continue. Charles Norton couldn't be happier.

That's because Norton is a portfolio manager for Dallas-based GNI Capital, and manages the Morningstar five-star rated Vice Fund (VICEX). With approximately $180 million under management (a figure four times higher than when Norton began managing the fund in September 2005), this Sultan of Sin Stocks focuses his investments on four industry sectors that have proven to be reliable bets over the years:

Tobacco: Because who doesn't love a good smoke?
Alcohol: Happy Hour never goes out of style.
Gaming: Slot machines in convenience stores. 'Nuff said.
Aerospace/Defense: There's always a war going on somewhere.

It should be noted that Norton, who eschews the "socially responsible" investing mantra because "it comes at a significant financial cost to investors," keeps his own vices to a minimum: "I don't smoke, rarely gamble and drink only on occasion." But that doesn't prevent him from focusing on a handful of international tobacco conglomerates that have made recent pushes into the cigar business through acquisition.

"There is no pure play in cigars," says Norton. "But the major tobacco companies have started to recognize the major growth opportunities ahead."

In the United States, indoor smoking bans, high taxes and a strict regulatory environment have pushed cigarette consumption down at an annualized rate of 1 to 2 percent. But cigar imports to the United States reached a near record of 335 million in 2007, according to the Cigar Association of America -- 16.5 percent higher than in 2006.

"Much of the growth of cigars is focused in the United States and Western Europe," says Norton. Asked whether he thinks increased cigar consumption replaces the fix derived from cigarette smoking, he responds, "I don't really think so. When it comes down to it, cigars are social and highly profitable."

The most recent acquisition in the cigar space made by one of the Vice Fund's holdings took place in November 2007, when Altria Group purchased machine-made cigar manufacturer John Middleton for $2.9 billion in cash (once the fund's largest holding). Michael Szymanczyk, chairman and CEO of Altria-subsidiary Philip Morris USA, proclaimed at the time of the merger: "The acquisition is both strategically compelling and financially attractive. It fits squarely with our announced strategy to grow our U.S. tobacco business beyond cigarettes and complements our recent initiatives in the smokeless category."

Also in 2007, U.K.-based Imperial Tobacco bit the bullet and swallowed up Spanish conglomerate Altadis S.A. for an eyebrow-raising $22 billion. Imperial's CEO called the deal "a great strategic fit" at the time of its close. Imperial is likewise a holding of the Vice Fund.

While Altadis had a strong, diversified franchise before its sale to Imperial, the company first made inroads into the burgeoning U.S. market in 2003 by purchasing a controlling interest in retail behemoth JR Cigars. In the midst of the acquisition flurry, Swedish Match (yet another Vice Fund holding) threw its hat into the ring in 2005 when it purchased General Cigar.

To Norton, this focus on the States and Western Europe is significant. "Over 90 percent of the worldwide cigar sales volume comes from these two regions," he says. "While cigarette consumption is growing briskly in Asia and other developing regions, the cigar boom has not quite taken hold there as much as it has revived itself in the U.S. and Europe."

Despite all of the positive business momentum among the Vice Fund's tobacco holdings, Norton reserves the right to sell short some names in the space that he does not see as attractive: "I'm short RJ Reynolds." (Perhaps it's a coincidence, but the maker of Camel cigarettes does not have much of a cigar portfolio, unlike its cash cow competitors.)

The thesis of the Vice Fund is surely to face to a stiff test going forward, however. The fund was down 9.3 percent in the first quarter of 2008, calling its recession-proof mantra into question. "Since this fund was established [in August 2002], and certainly since I took over in September 2005, we have not been in an economic downturn in the U.S. until now. So this coming period should be telling," Norton says.

Keep in mind that the equities market as a whole had a similarly bad time in the first quarter, with the S&P 500 down 9.4 percent and the Dow Jones Industrial Average knocked back 7.6 percent. The tech-heavy Nasdaq endured a 14 percent decline during the same period. Still, the Vice Fund's overall return to date is one that any money manager would envy: Through the first quarter of 2008, the fund has returned a steady annualized 15.2 percent since its inception. With that type of track record, expect Norton and the fund to continue to smoke the competition.

Next article » Gift Guide

Previous article « Stogies Without Bogeys