We're on the cusp a new month and, like always, that means it's time to roll out another round of Dividend Stock Wars.
Now, given the market's wild swings over the past two weeks, many investors are undoubtedly in search of some stable ground. So I'm going to take this occasion to return to the classics - big, low-volatility (read: defensive) dividend stocks.
Rules of Engagement
As many of you already know, the concept of a stock war couldn't be simpler.
Pit two companies against one another, conduct a blow-by-blow fundamental comparison of each, and (based on the results) pinpoint the most investment-worthy stock.
Armed with the analysis, you can then consider buying the winner - or both, if it's a close matchup.
We'll use our seven guiding principles of dividend investing - plus one more critical fundamental (valuation) - to determine the winner.
So without further ado, let's kick off the first round…
~Round 1: Simple Business
Usually, the rule is easy: The simpler the business, the better the investment.
This holds especially true for income investing. The fewer the moving parts, the fewer the risks - and the more likely you'll be getting that dividend next quarter (and the next, and the next).
But sometimes a business can be too simple for its own good.
Case in point: Coca-Cola recently lost its long-held lead over Pepsi in sales. Why? Because while Coke does one thing very well (i.e. - sell soda), Pepsi has managed to beef up its revenue in a big way through its Frito-Lay division.
With more than 40% of the world's salty snack market under its belt, Pepsi did become a bit more complicated, but it remains relatively simple and understandable, nonetheless.
So I'm going to amend our rule by quoting Einstein: "Everything should be as simple as possible, but not one bit simpler."
~Round 2: Steady Demand
Despite the fact that neither sells consumer staples or essential goods, the demand for Coke and Pepsi products remain stable even during economic downturns.
Actually, scratch that. The brand reach for both companies is so thorough, that even when consumers cut spending in nearly every corner of their lives, revenue for Coke and Pepsi continues to flourish.
Case in point: Between 2007 and 2010, Coke's revenue rose from $28 billion to $35 billion, and Pepsi's from $39 billion to $58 billion.
However, while revenue for both companies is beyond "stable," Coke's revenue continued climbing from 2011 to 2012, from $46 billion to $48 billion. Pepsi's, on the other hand, declined slightly over the same period, from $67 billion to $65 billion.
~Round 3: Cash Flow Positive
If a company isn't generating cash each quarter, the only way to pay a dividend is by borrowing or tapping into cash reserves. Such practices aren't sustainable over the long term - and the dividend will eventually be cut.
No surprises here. Neither Coke nor Pepsi is even close to having an issue in the cash department.
In 2012, Pepsi's free cash flow (FCF) was enough to cover its dividend payments 1.74 times. That's basically equivalent to Coke's FCF, which covered dividends paid by 1.71 times.
Now, when you're talking about companies as large as Coke and Pepsi, the likelihood of cash flow getting in the way of dividends is basically nil. And while both look healthy, the difference isn't enough to declare a clear winner.
~Round 4: High Cash Balance
Dividend payments don't grow on trees. And neither does money. So we want to make sure that there's enough cushion to sustain dividends through harder times. And the more cash-rich the company, the better.
Fortunately, both companies have a substantial amount of cash on the books. It's prudent to insist on enough cash to cover at least two quarters' worth of dividends.
Pepsi's cash balance of $6.6 billion leaves it just short of that mark - but only by a hair, covering 1.9 quarters in payouts. Given the size and stability of Pepsi, kicking the company out of the running on a technicality isn't exactly justified.
But because Coca-Cola outshines, it hardly matters. Coke has enough cash on the books to pay 3.6 quarters' worth of dividends, making the winner clear.
~Round 5: Minimal Need for Credit
The more pressure there is to pay down debt and reduce payments on interest, the more likely management will be to give cash distributions the shaft.
Because of the potential squeeze debt can put on cash distributions, finding those companies with manageable amounts of debt on the books should be a priority when looking for long-term dividend investments.
In this case, each company carries a hefty amount of debt. In fact, because of major acquisitions, both have increased their debt loads substantially over the last decade.
In 2009, Coca-Cola carried $11.8 billion in total debt. Now, after acquiring CCE's bottling operations, it's saddled with $32.6 billion in debt. Likewise, in 2009 PepsiCo carried just $7.8 billion in debt. Now, because of its acquisition of a similar bottling business, it's underwater to the tune of $28.3 billion.
But remember, Pepsi and Coke claim strong enough cash flows that the likelihood of default or debt putting the squeeze on dividends is negligible. Both will almost certainly continue to pay down debt, keep cash distributions flowing and still have room for acquisitions and share repurchases.
Still, having said that, PepsiCo's debt is smaller by a significant margin of around $4 billion.
~Round 6: Earnings Buffer
Just like cash, earnings can provide a buffer, as well. We can track this buffer by calculating a company's dividend payout ratio (DPR), which is earnings per share divided by the annualized dividend.
As a general rule, I recommend investing in companies with DPRs of less than 80%. The lower the percentage, the less chance there is of a cut if earnings go south.
And here, neither company is remotely in danger of hitting unmanageable DPR levels. Coca-Cola and PepsiCo clock in with DPRs of 54.8% and 55.1%, respectively. The difference is negligible.
~Round 7: Dividend Yield and Growth
It doesn't get any more basic than yield and growth, so I'll spare you the 101…
Coca-Cola and PepsiCo yield 2.67% and 2.78%, respectively. In each case, that's above the average yield on the S&P 500 - around 2.2% - but not by much.
As well as being average payers, both are middling in the dividend growth department, too. The average five-year growth rates of 8.45% for Coke and 8.35% for Pepsi are certainly substantial. But neither are enough to make up for their initial paltry yields - unless they're held for the very long term.
Again, the differences here between yields and growth aren't enough to make a clear impact.
~Round 8: Valuation
Last, but not least, it's always prudent to make sure you're not overpaying.
Unfortunately, given the fact that the S&P 500 average price-to-earnings ratio is 16.9, neither company is looking like a bargain at the moment.
Coca-Cola is currently trading at 21 times earnings, while PepsiCo is trading at - wait for it - 21 times earnings.
Apart from the obvious tie, here, there's one thing to note: Purchasing these stocks at an above-average valuation might be worth it. Or not. In this case, it depends on how long an investor intends to hold them.
In the near term, neither would be worth the trouble. Average yields plus average dividend growth won't (relatively) generate a heck of a lot in returns over five years.
But because these stocks are about as stable as you can get, they're perfect for long-term holdings. In addition to being worry-free, eventually the growing dividends will amount to an excellent yield on cost, which I've called the ultimate number in dividend investing.
So are Coke and Pepsi too expensive? In the short term, yes. But in the long term, the valuations are right on the money.
Let's Go to the Scorecard…
If you thought I was going to supply the answer to the age-old question, "Coke or Pepsi?" think again. After eight rounds, it's a dead heat, with two wins for each and four draws.
For the purpose of long-term investment, both would be excellent income-oriented additions to any portfolio. What they lack in terms of high yields and aggressive growth they make up for in stability.
Still, in the end, I'm willing to declare Coke the winner. Why? Because Pepsi tastes horrible. Just horrible. There, I said it.