Historically one of the great things about investing in Coca-Cola stock (NYSE:KO) was that its growth would have bailed you out of investments made in periods of high valuations. Let’s face it there’s no better way to make up for a huge valuation multiple than by making sure it’s in a super high quality company with good or great growth prospects. If you were buying into the mania of the Nifty Fifty in the early 1970’s, for example, that combination would have meant you still saw decent returns assuming you were prepared to hold for the long-term. That’s despite investing in a period in which blue chip stock valuations were hitting anywhere between 40-70x yearly profits.
The thing with Coke stock is that even though you’re still looking at one of the best businesses on the planet in terms of cash generation you get investors writing it off because its growth isn’t going to match its past rates. You see it all the time in the comments section of Seeking Alpha articles, often followed by a cherry picking of timeframes to indicate poor investment returns. One of the favourite start dates for doing that is around the 1998 “Coke mania” peak – a time when paying nearly 40x annual earnings was practically guaranteed to lock in sub-par investment returns going forward. As it happens you would’ve been bailed out with 3.65% annual compounded returns despite brutal multiple compression as earnings spent the next eighteen years catching up with the P/E ratio.
Take the most recent five year period as well. Between 2010 and 2015 Coca-Cola stock underperformed both the S&P 500 and a peer group index containing a few dozen blue chip food & beverage stocks, with a $1,000 investment returning only $1,510 against $1,810 and $2,180 for the S&P 500 and the peer group index respectively.
When you check out the company’s recent financial data you see where the criticisms come from. In 2012 the company was reporting around $10.75 a share in revenue and clearing $1.97 of that into net income per share. In addition stockholders were entitled to a cash dividend of $1.02 per share, which at the time represented a fairly conservative pay-out ratio of 52% of net profits.
Now fast forward to the last full financial year. The company reports approximately $10.25 per share in revenue and net profits of $1.67 per share – some 15% below its 2012 number. In addition the pay-out ratio has now shot up to just under 80% of net income courtesy of increasing the dividend to $1.32 per share in 2015.
Net debt has also gone in the same direction – moving from $16 billion in 2012 to approximately $24 billion by the end of the second quarter of 2016, a lot of which has gone on funding stock buybacks.
With that you have the classic duo that hits investor sentiment: poor stock returns and poor short term operating performances. The way to deal with it is to consciously separate the underlying business from the stock. That way you aren’t blaming the the business for the stock trading at 40x earnings in 1998 and the subsequent poor investment returns. Or that in 2012 you still had to pay around 20x earnings for Coca-Cola stock in order to own a slice of the underlying business.
The Business Of Coca-Cola Stock
Here’s what you’re getting when you concentrate on the business: a primary product that’s been served for 130 years; one of the world’s most valuable brands; an extremely diverse set of sales in over 200 countries across the globe; over 500 brands of still and sparkling beverages and over 1.9 billion daily servings of said brands.
(Source: Coca-Cola At A Glance)
The nub of the issue comes down to growth versus value. Back in 1998 The Coca-Cola Company earned $3.5 billion in net income and by 2015 that figure had grown to $7.35 billion. Translated to a growth rate that’s about 4.60% a year on average. On a per-share basis the results are a little bit better – over 5% a year on average because of share buybacks.
The stock price chart for that period looks particularly poor though because it spent so much of that time trading at high valuations that ended up basically absorbing all the growth. In other words expectations were so high to begin with that investors in 1998 got no upside from it. The trick with the stodgy blue chips and low growth stocks is to try to get the opposite scenario.
Say you get offered a special deal on Coca-Cola stock. You are told that from this point on that growth will only ever come in at inflation because they’ve reached a point of maximum saturation. To compensate for this fact you get to buy the stock at a special price of 10x annual earnings. You bet your last dollar that you’ll be ploughing into the shares with these conditions. Why? Because at 10x earnings you’ll do fine just by collecting and reinvesting dividends – you won’t even need any organic growth to see decent returns.
Remember Coca-Cola is a company with extreme returns on equity and tangible capital owing to their brands and scale dominance in the beverages industry. Not only that but those results have stood the test of time for decades with remarkable stability because of their competitive advantages. The company retain the number one position in sparkling and still beverages with twenty billion-dollar brands. It’s not going to post blockbuster organic growth every year, but it will mint cash for stockholders.
(Source: Coca-Cola At A Glance)
You also have the fact that with relative ease you can set up a low cost plan with Computershare to regularly buy shares at relatively low fees. They’ll even save you the hassle of reinvesting dividends should you choose to use them to buy more stock. The great thing that you don’t need to anything else in life as far as this investment is concerned – it can just be left to run on autopilot to the point, hopefully decades in the future, where you decide to check out the final results.
The strength of brands like Coca-Cola, Diet Coke, Sprite and Fanta practically ensures that in those decades they will maintain an extraordinary level of profitability. Granted, the period of high growth that meant investors could take more liberties with the valuation is over, but you’re still left with an unbelievably high quality underlying business that mints cash year after year with 15% net margins. Organic growth is great but it’s just one component of returns. All it means is that you’ve got to get a bit smarter with the price you’re paying, or else commit to a regular investment plan and dollar collar cost averaging.