Why Investors Shouldn't Care About The Coca-Cola And PepsiCo Downgrades

 |  Includes: KO, PEP
by: Eli Inkrot

On January 11th of 2012, UBS downgraded Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP). Coke slid 1.85% on the news, while more diversified PepsiCo lost nearly 1%. For KO, UBS cited slower volume growth, currency headwinds and a premium valuation as reasons behind the downgrade. For PEP, UBS cited the multiple downward guidance revisions as a key reason for their downgrade. A more thorough explanation can be found here.

These concerns are likely well founded as the people at UBS are apt to be both intelligent and well aware of the industry’s in-and-outs. But as a long-term dividend growth investor you shouldn’t care about short-term adversarial fluctuations. Your goal is to buy the greatest amount of future payouts, discounted appropriately. Sometimes Mr. Market offers irrational prices to due extraneous events, other times stock prices can be affected by impacts to earnings. If the latter is true, and the foreseeable future is short-term, then the long-term investor must decide whether or not earnings will be impacted for a year or two, or forever. In the case of Coca-Cola and PepsiCo it’s hard to imagine a world where we won’t be drinking more Cokes and buying more Frito-Lay products in a decade or two.

Perhaps a short story about Coca-Cola from Warren Buffett will better illustrate this point. The complete tale can be found here.

“Coca-Cola went public in 1919. The stock sold for $40 a share. One year later it’s selling for $19. It had gone down 50% in one year. And you might think that’s some kind of disaster. And you might think that sugar prices increased and the bottlers were rebellious and a whole bunch of other things, you can always find a few reasons why that wasn’t the ideal moment to buy it. Year’s later you would have seen the great depression and you’d see World War 2, and you’d see sugar rationing, and you’d see thermal nuclear weapons, the whole thing. There’s always a reason, but in the end if you’d bought 1 share for 40 bucks and reinvested the dividends it’d be worth about $5 million now... And that factor so over rides anything else. I mean if you’re right about the business, you’ll make a lot of money. The timing part of it is a very tricky thing. So I don’t worry about any given event if I’ve got a wonderful business... You can figure out what will happen, you can’t figure out when it will happen. You don’t want to focus too much on when; you want to focus on what. If you’re right about what, you don’t have to worry about when very much.”

As Buffett alludes, the only thing that matters for KO and PEP investors is whether or not you believe in the long-term prospects of these two companies. There will always be headwinds; and if it’s smooth sailing for the moment, rest assured choppier waters await. It matters not that they come, which they will, but more how you deal with the turbulent times.

If you take a look at Coca-Cola, the pure fundamental nature of the product is inherently palpable. Just walk into your local Wal-Mart (NYSE:WMT) and sit by the soda isle for an hour or two. Standing next to the tried and true red Coke label is the cheaper, however somewhat comparable, generic Wal-Mart cola. The generic pop sits and waits, while the more expensive Coca-Cola is overwhelming chosen over and over. It’s not as if the Coca-Cola products are a cent or two more expensive, we’re talking dollars on dollars per purchase. And if KO decided to raise its prices tomorrow, I would be willing to bet that consumers wouldn’t change their vote. That’s the kind of company I like, a company that can make its own rules.

Perhaps an obvious oversight in the KO example is the inclusion of secondary stalwart PepsiCo. If you don’t like Coca-Cola, then the logical next choice is a PepsiCo product. And while Pepsi has lagged as of late behind both Coke and Diet Coke, consumers are still willing to pay up for the name. Second place has long made PepsiCo money, billions a year in fact, which appears just fine for investors. But more than a beverage producer, PepsiCo has become a snack behemoth. If you’re still in Wal-Mart, just take a mosey on over to the chip isle to find the snack monopoly that is PepsiCo owned Frito-Lay. A more complete PepsiCo analysis is found here.

Over the past 3 and half years, Coca-Cola has been upgraded 4 times, downgraded 5 times and followed an Up-Down pattern in 3 different years. Sure you could have come late to the party and followed the analysts’ moves. But then again a buy 3 and a half years ago around $57 would be worth about $68 a share today, not to mention the $6.04 in dividends paid. Comparatively, during this time period the total gain on the S&P 500 was effectively flat. In the same manner, PepsiCo was downgraded 4 times in that period and upgraded twice. It’s important to note that neither company was downgraded to ‘Sell/Underweight/etc’ only to ‘Hold/Neutral/etc.’

In the end, the long-term investor shouldn’t care about the price of a company in 1-year, 5-years or even a decade. If the company has a strong fundamental business that uniquely creates a lasting experience then investors will be rewarded over time. Timing the market is oft a fool’s game, while taking advantage of opportunities is a level-headed investor’s duty. It is impossible to know what lies ahead, but the cool part is that you don’t have to.

Of course, price has to be appropriate such that one is not paying, say, 40 times earnings for Heinz (HNZ) ketchup. But given that prices are in a ‘reasonable range’ the dividend growth investor needs to be concerned with only two things: Long-term sustainability of the business and growing payouts. The coupling of the two is paramount in that you want earnings to grow rather than the payout ratio to increase. After-all retained earnings are useful for the investments you yourself cannot make like a Coca-Cola factory in India for example. Short-term fluctuations will come and go. Your job is to identify the lasting impact of these events and determine the appropriate attitude moving forward. The recent UBS downgrades make very reasonable short-term assumptions. However, it’s hard to imagine that they will have a lasting impact on the long-term profitability of Coca-Cola or PepsiCo. Tomorrow 1.7 Billion Coca-Cola products will be served and 62% of the salty snacks bought in the U.S. will be of the Frito-Lay variety. I can think of nothing more that would set an investor's mind at ease.

Disclosure: I am long KO, PEP.