I was recently going through a new clients portfolio
and found it full of the likes of Coca-Cola, Kimberly-Clark and
Campbell Soup what I call (pseudo) bond substitutes.
Each one is a stable and mature company. Your mother-in-law
would be proud if you worked for any one of them. They have had
a fabulous past; theyve grown revenues and earnings for
decades. They were in their glory days when most baby boomers
were coming of age. But the days of growth are in the rearview
mirror for these companies their markets are mature, and
the market share of competitors is high. They can innovate all
day long, but consumers will not be drinking more fizzy
liquids, wearing more diapers or eating more canned soup.
If you were to look at these companies financial
statements, youd be seriously underimpressed. They paint
a stereotypical picture of corporate old age. Their revenues
havent grown in years and in many cases have declined.
Some of them were able to squeeze slightly higher earnings from
stagnating revenue through cost-cutting, but that strategy has
its limits you can only squeeze so much water out of
rocks (unless someone like 3G Capital takes the company, sells
its fleet of corporate jets and starts mercilessly slashing
expenses like the private equity firm did at Budweiser and
Heinz). These businesses will be around ten years from now, but
their profitability probably wont be very different from
its current level (not much higher, but probably not much lower
However, if you study the stock charts of these companies,
you wont see any signs of arthritis; not at all
youll have the impression that youre looking at
veritable spring chickens, as these stocks have gone vertical
over the past few years. So this is what investors see
old roosters pretending to be spring chickens.
Lets zoom in on Coke. Unlike the U.S. government,
Coca-Cola doesnt have a license to print money (nor does
it have nuclear weapons). But it is a strong global brand, so
investors are unconcerned about Cokes financial viability
and thus lend money to the company as though it were the U.S.
government. (Coke pays a very small premium to Treasury bonds.)
Investors ignore what they pay for Coke; they only focus on a
singular, shiny object: its dividend yield, which at 3 percent
looks like Gulliver in Lilliput (fixed-income) land.
And as investors do so, they are ignoring an inconvenient
truth: They are paying a very pretty penny for this dividend.
Coke is trading at 23 times earnings. This is not the first
(nor will it be the last) time this has happened to Coke stock.
Investors who bought Coke in 1998 were down 50 percent on their
purchase ten years later and have not broken even for more than
And this brings us to the problem with shiny objects: They
dont shine forever. Investors are paying 23 times
earnings for a very mature business. Consumption of
Coca-Colas iconic carbonated beverage is on the decline
in health-conscious developed markets, and you can clearly see
this in its income statement sales and earnings have
languished over the past decade.
Lets say Coke does what it has not done over the
previous decade and grows earnings 3 percent a year, despite
the shift in consumer preferences away from sugar-powered and
chemically engineered (diet) drinks. If at the end of this
journey its priceearnings ratio settles to its more or
less rightful place of 13 to 15 times, then jubilant Coke
investors will have lost a few percentage points a year on
Cokes price decline. Thus the bulk of the dividend will
have been wiped out by Cokes P/E erosion.
Coca-Cola to some degree epitomizes the U.S. stock market.
If over the next ten years, despite all the headwinds it faces,
Coke is able to grow earnings at a faster pace than 3 percent
and interest rates remain at current levels (so that the
companys P/E stays at the present I want this 3
percent dividend at any cost level), then its stock will
provide a decent return. However, there is a lot of wishful
thinking in this paragraph.
If interest rates rise and/or consumers tastes
continue to shift from high-margin sugary drinks to low-margin
(commodity) water, then Coke will be hit from both sides
its earnings will stall, and investors will take their eyes off
its shiny dividend. Suddenly, they will see Coke for what it
is: a 124-year-old arthritic American icon whose growth days
are sadly behind it.
I am using Coke just to demonstrate the importance of
differentiating between a good company (which Coke is) and a
good stock (which it is not), and the danger of having an
exclusive focus on a shiny object dividends when
you are analyzing stocks.