Basics of the research
This article presents a research on the Coca-Cola Co. (KO) stock. It is the second article of a series which examines some of the risk and reward characteristics of several well known dividend paying stocks - Johnson & Johnson (JNJ), Coca-Cola Co., Procter & Gamble Co. (PG), Chevron Corp. (CVX) and PepsiCo Inc. (PEP). Subsequent articles will build on the previous ones so readers could expect to find more information and stocks comparisons as the number of articles grows.
The first article was published about a week ago. It covered Johnson & Johnson. As a beginning article, it included information about the conventions used in the researches and explained why the tail risk, standard deviations, correlations, betas and some of the average returns are expressed on a monthly basis. It also presented expanded definitions of some of the main risk related characteristics of stocks' distribution of returns, namely skewness and kurtosis. Many of those environmental variables of the researches might be presented in a shorter form in each of the subsequent articles. The reader is encouraged to read the more complete explanations in the introductory article, if interested.
The main purpose of the analysis is to provide information about the historical risk, and especially the tail risk, which might be seen in a stock's distribution of total returns. The total return of a stock is a sum of its price change and the cash flow which the stock provides on a regular basis. The cash flow in the examined cases are basically dividends. Because dividends are a major part of those stocks' total return, a special attention will be paid to risk on dividends.
Throughout the analysis the prices adjusted for dividends and splits are used because they incorporate the total return available to an investor over a particular holding period.
Tail risk is among the major risks a stock return could face, mostly because of its potential magnitude. Tail risk is the risk of getting returns which stand as far as several standard deviations from the mean. Generally, such returns happen rarely but because they are so far from the mean, their value could significantly affect the stock's return for the period. The tail risk is represented by two characteristics of the distribution of returns - skewness and kurtosis.
The skewness and kurtosis were explained in more details in the Johnson & Johnson article mentioned above. Here we would say only that concerning the long-run risk of loss, a positive skewness is sometimes the preferred one. The reasoning behind such a view is that the positive skewness incorporates a higher historical probability that a large unexpected return would be on the positive side, i.e. larger than the mean. On the other hand, a negative skewness presents a higher probability of an unexpectedly large negative return during some period. Hence, it shows an increased risk concerning the available capital at the end. For a better understanding the reader could use the classic explanation where the negative skewness is compared to picking up nickels in front of a bulldozer. The large unexpected negative return comes with the bulldozer's move.
The kurtosis as a measure of risk indicates whether the return distribution could experience fat tails. Those are major risk descriptors which show whether there is a larger than the normal probability of having returns far from the mean, both positive and negative. For instance, a kurtosis value of zero shows there is no such higher-than-normal probability.
The current research of Coca-Cola Co. covers returns data from the last 44 years. This long period includes several different economic environments and cycles, both good and bad ones. Hence, the calculated long-run coefficients could be expected to be relatively free from sampling biases and closer to the true descriptors of the stock's population of returns.
Nevertheless, the readers should keep in mind that historical performance does not guarantee future results.
Readers should also account for the mean reversion tendency the returns generally exhibit in time. As mentioned in the first article, the performance in the more recent periods, i.e. the last 12 months or last 5 years, could be more important and useful for the moment but it would tend to get closer to the mean characteristics of the longer time frame periods, given that no significant change in the economic environment or the company itself has happened.
The Companies Selected
All of the companies examined in the series, including Coca-Cola Co., have a long history of distributing dividends. Moreover, they have increased the dividend size in almost each of the last 40 years, with the one exception of Chevron - the company has suspended dividends distribution in the period 1976 - 1984.
During the last 5 years the companies also distributed wealth to their shareholders through share repurchases. Generally this increases the demand for stocks and has a positive effect on their price. If at the end of the fiscal year the company has a different amount of basic shares outstanding than at the beginning, this change could also affect the size of the dividend paid and the payout ratio.
Coca-Cola repurchased stocks for 2.38B on average for the last 5 years. For 2011 the amount almost doubled to 4.5B and caused a decrease of the capital stock by 2.94B. For the first nine months of 2012 the number of basic shares outstanding has declined further by about 100mln, according to the company's Q3 20012 financial report.
In October 2012 the company's board of directors authorized a new share repurchase program. It will start at the completion of the current share repurchase program, authorized in 2006. The new program will include the purchase of 500mln shares of the company common stock. This will add another price supportive factor.
Coca-Cola Stock's Characteristics and Analysis
Coca-Cola Co. is an U.S. based company which operates in the nonalcoholic beverage business.
The Coca-Cola stock experienced a compound annual growth rate (CAGR) of 12.2% for the whole examined period of about 44 years. For comparison, the CAGR of S&P 500 for the same period is 6%.
A Johnson & Johnson Comparison
If we take the last 42 years of data, the period on which the calculation of Johnson & Johnson's CAGR was based, we see almost the same performance of both companies - 12.56% CAGR for KO and 12.63% CAGR for JNJ.
The returns of the two companies' stocks differ significantly when we zoom the time frame to the last 5 years. Whereas KO achieved an increase in its adjusted price by 40% for that period, the JNJ's increase was only 22%. During the last 12 months both companies made similar price increases, both around 9%. Hence, the big difference comes from the 4 previous years where the price growth of KO more than doubled the one of JNJ (24% against 11%).
Comparing the two graphs of adjusted monthly prices, we see somewhat of a different behavior which can explain the differences seen in stocks' returns during the last 5 years. While JNJ experienced a more smooth overall increase in price, the KO's price was in a consolidation period between the years 2000-2007. After that it started to gain speed and the result was the 40% increase for the 2007-2012 period. Despite the more bumpy road compared to JNJ, KO's graph also shows an uptrend.
It might be interesting to note that during the current worldwide economic crisis the stock decreased in price on annual basis only in 2008 (-21%), following the whole equity market downward direction. The S&P 500 lost about 39% during that year.
Similar to JNJ, Coca-Cola has split its stock 6 times in the examined period - in June 1977, July 1986, May 1990, May 1992, May 1996, and August 2012. The most common price at which the stock experienced a split of 2:1 was around $80. The one time the stock achieved a price above $100, the split was in a 3:1 proportion so the new price was again around $40 (down from around $125). The last split was in August 2012 and now the stock is trading close to the price it hit just after the split (around $37). In all of the splits to date, the price level after the split was able to provide somewhat of a relatively stable support area. The biggest monthly declines (about 21%) below the after-split level appeared in the years after the splits of 1977 and 1986. After the split of 1996 even the sharp decline in 2008 was not able to drive the price below $41, the price the stock was traded at in the month right after the 1996 split.
Having said all this, it seems the current price is in the support area, with a small monthly probability of reaching a decline of about 20% from the current level in some of the months ahead. This 20% would translate into a decrease of around $7. The potential on the upside however is significantly higher as the difference between the current price and a probable future split price ($80) is about $43. This makes the reward/risk ratio equal to a bit above 6. For comparison, the same ratio of JNJ as of its price of $69 (around which it traded last week) goes to about 1.1.
Concerning the risk adjusted price return, the KO stock shows a result better than the one of S&P500, with a Sharpe ratio of 0.18 for KO against 0.16 for S&P 500. The JNJ Sharpe ratio (0.19) shows a bit better risk-adjusted return. This is confirmed by the other risk characteristics of KO, presented in a while.
Analysis of Risk on Dividends
Because the total return consists of a price and a dividend return we should also examine the risks on the dividend portion of the total return.
Similar to Johnson and Johnson, Coca-Cola managed to increase its dividend size during each of the last 40 years. Since the 2008 the speed of dividend growth is lower than the one achieved in previous years. The average dividend growth for the 2007-2012 period is 8.7%. In the 5 years after 2001 dividends grew with double digit figures each year. This was close to the average annual dividend growth for the last 40 years of 10.75%.
The projected dividend range for 2013 (see the table above) seems realistic, without putting too much pressure on the company's financial results. It implies a dividend growth rate of between 9.6% and 10.75%. Having in mind the lower number of basic shares outstanding the company has as of Q3 2012, this would translate into a net income for 2012 of about $9.2B using the average payout ratio of 55% for the last 5 years. Such a net income does not seem so improbable given the financial results of Coca-Cola till now (earnings of $7.15B as of Q3 2012).
Other risk characteristics
Last 12 months
Last 5 years
a. Correlation is with S&P500;
b. Beta is measured towards S&P500
Examining the whole period of 44 years we see a returns distribution with a slightly negative skewness and a relatively high kurtosis. The negative skewness (-0.15) speaks of a higher-than-normal historical risk of an unexpected negative monthly return which would stand far from the mean value. The kurtosis (1.75) is higher than the one of Johnson & Johnson (0.39) and shows a distribution with fatter tails, both compared to the normal one and to the JNJ distribution. The fatter tails present an increased probability of having extremely large returns on both sides of the mean, generally. The combination with a negative skewness suggests more of those returns could be lower than the mean.
The closer time frames do not change the situation significantly. The skewness gets increasingly negative during the last 12 months due most probably to the monthly decline during August 2012, when the last split took place. The close to zero kurtosis shows that the probability of this decline was not higher than in a normal distribution.
We should also note the decreasing correlation and beta values the KO stock has for the last 12 months. This increases the stock's appeal as a defensive investment. Due to the low correlation with S&P500, KO might improve the risk characteristics of a portfolio which follows the general market.
In the absence of events like the recent split and if the company manages to keep its current direction of financial performance, the unexpected negative monthly return of the recent August might not be repeated soon. This will be in line with the mean reversion tendency which the characteristics of the returns generally follow. If the long-run coefficients are indeed closer to the true population descriptors than the more recent ones, we should expect the recent risk characteristics of KO to gradually revert to the longer-run values. This would mean a distribution with returns more evenly distributed around both sides of the mean with somewhat of a higher than the normal probability of returns which stand far away from the mean value because of the fat tails.
Possible Trading Strategies
The current low correlation and beta coefficient of the KO stock towards the S&P500 could be used in a variety of ways.
One option is to enhance the risk characteristics of a portfolio that tracks the general U.S. equity market. Such a portfolio could consist of one ETF - the SPDR S&P500 ETF (SPY). It is designed to track closely the movement of the S&P500 index (the correlation between them is currently 0.997) and has an expense ratio of 0.09. A long position in this ETF could be combined with a long position in KO in order to decrease the overall risk characteristics of the portfolio. This will be done using the low correlation between the Coca-Cola stock and SPY.
Another use of the KO coefficients would be in hedging. Because of the low value of Beta, the KO stock is expected to decline in price much slower than the general equity market. Thus, if investor expect a decline in the equity market to follow, they could protect their long investment in KO by a short position in SPY.