I've previously written two articles (here and here) about The Coca-Cola Company (KO) and PepsiCo, Inc. (PEP) to see if there was a possible pairs trade. It was just announced that KO now has the top two soft drinks sold in the U.S. Diet Coke has just passed Pepsi to become the number two soft drink to regular Coca-Cola. The third beverage company considered is Dr Pepper Snapple Group, Inc. (DPS). In recent months, all three stocks have shown limited performance especially relative to the SPDR S&P 500 Trust ETF (SPY).
|Ticker||10/29/2010 Price||1/21/2011 Price||3/17/2011 Price||Total Return from 1/21 to today||Total Return from 10/29 to today||1 Year return|
Source: Yahoo!Finance for split and dividend adjusted closing prices. Note these prices are adjusted for dividends and so do not reflect the actual closing stock price on that day.
From the end of October, SPY has outperformed all three major soft drink companies. Over a 1 year period, it has outperformed PEP and DPS, but not KO. However, this is not completely unexpected given that these companies have recently shown very low betas. While it is using to hindsight to look at the returns, it raises a question of what type of return one should expect for a beverage company that is operating in a relatively mature market and has pretty good global penetration.
Modern portfolio theory would suggest that the expected return would be proportionate to the measure of risk taken as marked by beta according the capital asset pricing model (CAPM).
|Ticker||Monthly Volatility||Ratio to SPY Volatility||Correlation Coefficient||Implied Beta|
The 24 month time frame was selected to include DPS. A longer time frame of five years would show KO and PEP to have betas around .6 and .5 respectively - very similar to the most recent 24 months. These beta can then be plugged into the CAPM formula to find the hurdle rate.
|Ticker||Risk Free Rate||Equity Risk Premium||Beta||Hurdle Rate|
Source: Risk Free Rate is closing yield on 10-year treasury bond as noted on Yahoo!Finance and the Equity Risk Premium is estimated, using 5% to 7% could also be justified based on research.
The hurdle rate reflects the rate that an investor would, under modern portfolio theory, want to justify the risk of each stock. One interesting observation is that the rank of returns for the beverage companies is aligned with the required hurdle rate. KO had the highest required hurdle rate and produced the best returns among the three. PEP had the lowest rate and produced the worst returns. Now the hurdle rate can be achieved through price appreciation or dividend yields.
|Ticker||Hurdle Rate||Dividend Yield||Desired Price Appreciation||Yield as % of Hurdle Rate|
Source: Dividend Yields from Yahoo!Finance as of February 28, 2011.
The first observation is that for the beverage companies the dividend yield represents approximately half of the hurdle rate. For SPY, this ratio is much less. Hence, based on hurdle rates and yields, one would always expect SPY to show superior price appreciation.
While beverage companies should still be able to expand into developing markets, an investor should not expect high returns based on both the technical analysis and fundamental issues. So when you look at your holdings in these stocks and it appears that the price is not moving, realize that half your return is in the dividend and that these stocks provide diversification benefits as well.
However, opportunities to purchase these stocks on dips may prove beneficial for value oriented investors looking for familiar brands. All three stocks offer attractive dividend yields ranging from 2.7% for DPS to 3.0% for PEP, noticeably higher than the yield on SPY. At the right valuation, these stocks could be good additions to an investment portfolio.
Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.