We recently had the opportunity to speak with Charles Norton, CFA, portfolio manager of USA Mutuals’ Vice Fund, to get his perspectives on the year that was and outlook for 2009.  Specifically he discusses recent media attention around so-called ‘vice’ industries as being more rescission resistant, the potential impact of a new administration and thoughts around future investment opportunities.

Read about all this and more in our talk with him below.

Of the sectors that the Vice Fund invests in, which do you believe the incoming Obama administration will impact the most?

Most people would probably expect the answer to be the defense sector. But the widely held view that the defense sector fares better with a Republican president is a myth that is simply not supported by the data. In fact, historically there has been little correlation between which political party controls Congress (or which is in the White House) and the growth in the defense budget. We expect the Obama administration to largely support most of the baseline defense investment, with potential cuts coming from war-related supplemental spending. The major bipartisan drivers of defense-budget growth, we believe, are the need to recapitalize our aging military, job creation during a recession, and the continued high threat levels.

On the other hand, we believe that domestic tobacco faces higher risks and a more challenging environment with Obama moving into the White House. First, the current State Children’s Health Insurance Program (SCHIP) is set to expire in March 2009, and we believe that one of President Obama’s first initiatives may be to fund an expansion of that program with a $0.61/pack increase in federal excise taxes on cigarettes. That bill was twice vetoed by President Bush; we feel that it is likely to get passed in 2009. On top of that, broader healthcare initiatives could potentially push the federal excise taxes on cigarettes even higher. Finally, it’s now more likely that FDA tobacco legislation will eventually be signed into law. Of course, with Congress’ attention squarely focused on the financial and economic crises at hand, FDA regulation might not be a near-term issue.

State budgets are hurting. How will your investment universe be affected by states’ efforts to cut costs and increase revenue?

States may be more apt to pass gaming legislation, which would be a positive for the slot makers. State excise taxes on cigarettes are almost certainly going to increase in 2009, possibly by 15-20% on average. State excise taxes affect the retail price, and thus hurt consumption, but are not borne by the manufacturers. Key states to watch are California and Florida. Taxes could go up on sales of alcohol, too, though California lawmakers recently failed to pass legislation that would add a five-cent tax on beer, wine and spirits sales. But similar legislation is certainly a risk. The aerospace and defense industry is much less impacted, though the industry supports more than 2 million middle-class jobs.  Keeping those defense-industry workers employed is important for many state economies.

Looking across your entire global universe as we enter a New Year, where are your best ideas right now; where do you believe the opportunities are?

We have the greatest conviction in international tobacco, where the major companies have all been reporting the same thing: consumer up-trading in emerging markets has continued and the global pricing and excise-tax picture has been favorable. The “hard landing” in emerging markets has been discounted, we believe, but the affordability of cigarettes in the emerging markets is largely misunderstood. For example, Parliament is a super-premium brand in the Ukraine but costs less than a Snickers bar; a can of Red Bull is more expensive in Russia than a pack of Marlboros. Resiliency of demand, global diversification, strong balance sheets, pricing power, incredible cash generation… the list of reasons we are excited about international tobacco is long, with currency fluctuations the primary risk.

As you reflect on 2008 and look forward to 2009, what were some of the surprises, and what changes have you made to ideally turn those surprises into opportunities?

Of the four sectors that we invest in – alcoholic beverages, tobacco, aerospace/defense, and gaming – we have always known that gaming has been relatively more sensitive to fluctuations in the business cycle than the others. The big surprise of 2008, though, was the magnitude and speed with which this sector suffered.

The gaming sector has been hit from all sides, with increasing levels of balance-sheet (and, by extension, development) risk as credit tightens around the world. Many construction projects have stalled and development plans have been put on hold as capital is expensive or entirely unavailable. At the same time, gaming revenues have been under severe pressure while consumers reduce their discretionary spending as the economy contracts.

We have since actively reduced our exposure to the sector – and, in fact, have been shorting some gaming securities since March 2007. Currently, as of January 2009, we only own the shares of one casino operator and one slot maker. We are confident this sector should once again present a major opportunity during the next economic expansion but for the time being, we’re finding better uses of capital elsewhere.

Many have written about the Fund, and the sectors in which it invests, as being “recession resistant.” Yet, this has been a tough year for all sectors. What are your thoughts on the defensive nature of these sectors?

There was no true recession-resistant sector in 2008. These sectors have historically acted as a sort of investment levee that could withstand most storms, but starting in the summer of 2007, an economic hurricane developed that drowned all corners of the equity market. In recent months and quarters, stock-price movements have been driven by macro factors, with little distinction between one company’s fundamentals and the next. That said, the operating performance of the businesses – not the stocks, necessarily, but the business itself – has been very resilient. International tobacco is a classic example. Consumers around the world have continued to enjoy cigarettes – even in this global economic crisis – and have even been trading up to higher priced international brands.

Opinions expressed are those of the portfolio managers and are subject to change, are not guaranteed and should not be considered a recommendation to buy or sell any security.