The Comfort In Watching Coca-Cola Decline 25%

Aug.12.14 | About: The Coca-Cola (KO)


Many take the view that potential price declines far outweigh a company’s dividend yield.

With a short-term or ephemeral view, this could very well be the case.

However, as this article indicates, if you have a long-term mindset you should probably be rooting for lower prices.

In one of my recent articles I came across a particularly telling observation. Instead of hem and hawing around a summary, I'll cut to the quote:

"There is little comfort in watching Coke drop 25%, dividends will never make up the loss."

By "Coke" the commenter was referring to "The Coca-Cola Company (NYSE:KO)" often a staple and go-to example in the dividend growth crowd (it's hard to get more iconic or consistent). As you might imagine from this article's title and the summary above, I wasn't exactly swayed by the comments logic. In fact, I believe that there is comfort in watching the share price - but not necessarily the fundamentals of the business - decline by a significant margin.

Before I get to the reasoning, it should be underscored that this type of ideology seems to be a pervasive argument. That is, it doesn't just apply to Coca-Cola. You could just as easily say: "Procter & Gamble (NYSE:PG), PepsiCo (NYSE:PEP) or Johnson & Johnson (NYSE:JNJ) only yield 3%, the prices could go down 20%, thus the dividend won't 'save' you." The argument is that stock price swings are ordinarily larger than the lasting dividend yield. As such, one from this opposing crowd might argue, focusing on the smaller return component (the dividend) should come with a cautionary tale.

Yet this type of thinking, in my view, misses the point of investing quite completely. It focuses on the short-term, the unknowable and perhaps even the unimportant. More specifically, using price action as one's chief barometer likely does not tell you about the weather. This is especially true if it requires you to simultaneously ignore the business.

On a basic level, if you have no intention to sell tomorrow or next year, then a 25% decline should be of little importance to you. No different from if I offered you 25% less than what you just paid for your house or a gallon of milk. In fact, as I'm about to illustrate, you should actually be rooting for it.

Let's go back to that opening quote: "there is little comfort watching Coke drop 25%, dividends will never make up that loss." I believe this is strictly misguided for a variety of reasons.

First, the use of "never" is a bit overly dramatic. If shares dropped from around $40 today to $30 tomorrow, it would take the $1.22 annual dividend about 8 years to get back to "even." With a growing dividend of say 7% per annum, this would take less than 7 years. So even if the share price remained "forever" stagnant at the lower mark, you'd still have a positive investment return eventually. Less than 7 years hardly equates to "never." A seemingly small point, but vital in discerning the "woe is me" mindset from the "this is a temporary change in the bid price for a great business" philosophy.

Of course the likelihood of a stagnant lower share price with a growing dividend is low considering today's valuation and the math involved. A $30 share price would indicate a nearly 4.1% "current" yield - something that has happened just once, for a few weeks, during the past 20 years. So it's not impossible, but not altogether probable either.

More pertinently, a 7% growing dividend for the next decade and the same $30 share price would require an 8% yield. You can argue about the merits of Coca-Cola reaching a 4% yield again, but it seems an 8% yield (which would correspond to something like an 8 P/E with the same payout ratio) is probably a far stretch. Stated more directly, if Coca-Cola continues to perform as a business the probability that a price decline would be lasting is quite small.

The second quibble one might take with the beginning ideology is contained within the design of your personal investing goals. If you buy today and the share price drops 25% tomorrow you might think this is a near worst-case scenario; but only if you're chiefly concerned with short-term capital appreciation. For those with an income tilt or long-term view, this could actually be viewed favorably. Incidentally, I believe this is why a dividend growth strategy or something of the sort can be so appealing. The most likely outcome in a long-term partnership decision is that earnings and dividends continue to grow and thus price eventually follows suit. Yet even when the price doesn't "cooperate" you can still benefit.

Let's imagine you buy Coca-Cola in the expectation of a solid and growing income stream. You buy at $40 and expect say 7% average compound growth over the intermediate-term. For illustrative purposes we'll suggest that you invest a single $10,000 without follow up investments. You think of it like you might think of a 10-year CD. Over a 10-year period, this would equate to $4,200 in collected dividends and an end yearly income stream of $560. If you chose to reinvest the dividends along the way, and the yield remained constant, this would equate to an end income stream of about $720. If the yield increased to 4% for 10-years, as suggested by a 25% price decline, reinvesting would create an end income stream of over $1,000.

Now some might point to the absurdity of the scenario: how likely is Coca-Cola to trade at a 4% yield for the next 10 years? As described above, this is in effect my point: any negative price movement - however large - is likely to be temporary in the long-term. In fact, shares would have to trade 50% higher than they are today in order to keep this seemingly unsustainable yield. Moreover, this simultaneously provides 6.7% annual returns, despite the 25% immediate price decline. The bottom line is that regardless of your focus, a lower price could certainly equal a better reinvestment opportunity.

Finally, it seems unlikely that one would make but a single investment. If you believe in a company, and the fundamentals remain reasonable, it stands that you would continue to believe in that company. Thus you might make multiple investments over the years. As such, you benefit from buying at lower prices no different than you benefit from buying cheaper groceries.

We could work through more examples but I believe the point is clear. If you're primarily concerned with what someone else may or may not pay in the next year or two, then sure, you're at the whim of the market and anything can happen (including a 25% price decline in Coca-Cola). Yet if you take a long-term view - regardless of whether or not you're thinking about income or capital gains - a profitable business tends to take care of itself. In the case of Coca-Cola, if you believe it might yield 4% or below in the future and grow its dividend in the 6-8% range this concurrently requires longer-term returns over 6% as well. More significantly, the thing most people fear - lower prices - should be the exact thing that you welcome.

Disclosure: The author is long KO, PEP, JNJ, PG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.