October 31, 2014

An Example of Real World Value Investing Through the Lens of Dr. Pepper Snapple Group

One of the biggest dangers an investor faces when he or she decides to buy individual stocks for a portfolio is the temptation to chase something “exciting”, regardless of valuation.  That’s a foolish undertaking.  Valuation matters a great deal.  The exact same business might be a wonderful investment at 10 times earnings but a horrible investment at 50 times earnings.  It’s not enough for profits to rise, or dividends to expand; they have to offer a good return, based on what you paid, relative to a reasonable opportunity cost hurdle such as the long-term 30-year Treasury bond yield.

I’ll use a famous company that every American citizen knows that I have been buying for the past year for the KRIP: Dr. Pepper Snapple Group.  The flagship product has been around for more than a century.  Prior to being bought out (and later taken public, again), it was one of the best performing investments in the entire history of the United States stock market.  The merchandise hardly changes, prices go up with inflation, and the surplus money can’t be reinvested in a lot of things so the owners get sent checks.  It’s easy.  This is not like evaluating a BHP Billiton or something.  It’s a wonderful company by every conceivable metric.

Let’s think about Dr. Pepper Snapple Group as a type of “equity bond”, to borrow a concept from some famous value investors of the past.  The coupon on this “bond” is currently providing an after-tax earnings yield of 6.32%.  Of this, 3.20% is paid out in cash to you (which might be subject to some dividend taxes, depending on how you hold the stock, your income bracket, and state), and the other 3.12% is kept by the company to reinvest with the goal of growing future coupons.

Dr PepperOnce you buy the stock, those figures are locked.  Your entire experience is now determined by how much profit and dividend the share earns relative to your purchase price, which indirectly drives, over long periods of time despite some wild short-term fluctuates, the stock price.  Your cost is the cornerstone; the foundation against which everything is measured.

Compared to the 30-Year United States Treasury bond, which is yielding 3.64% before taxes (and subject to full taxation, which can reach up to 50% depending on the Federal, state, and local jurisdiction in which you live and your income tax bracket), this looks like a very good deal.  But the soda “equity bond” is even sweeter than it appears at first glance because the average Wall Street analyst covering the business thinks that the company will grow at 7.57% per annum for the next five years.  (For now, we’ll accept that as a reasonable figure, even though there is a long history of Wall Street being far too optimistic in profitability outlook.  That way, we have some hard figures to work with as I walk you through the theoretical concept of what you are doing.)

That means not only are you getting an initial earnings yield of 6.32%, but this is expected to grow at 7.57% each year for five years.  If it turns out to be accurate, 60 months from today, you’d be earning a 9.10% earnings yield on your initial cost.  And, you’d have collected cash dividends equal to 18.67% of your initial investment, serving as a sort of rebate that you could have reinvested, spent, saved, or given to charity.

The Treasury bond doesn’t even remotely compare to that risk/reward scenario. 

Where investors fail is they don’t focus on the right numbers.  They are looking at the stock price – what other people are willing to pay at any given moment – rather than what the company they own is pumping out in cash.  Once you’ve written a check to buy a piece of ownership, the market price is inconsequential to you unless you want to increase or decrease your ownership.  This is what Benjamin Graham meant when he wrote in The Intelligent Investor:

The real money in investing will have to be made – as most of it has been in the past – not out of buying and selling, but out of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value.

And

The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances.  He should always remember that market quotations are there for his convenience, either to be taken advantage of or ignored.

Volatility and The Possibility of Loss Is the Cost You Must Accept for the Possibility of Higher Rewards

The price you pay is the knowledge that other investors are out there, many not nearly as knowledgeable, buying and selling amongst themselves.  They can bid up, or drive down, prices; so much so that the average stock is going to gain or lose at least 30% of its quoted market value in any given year.  It is just a fact.  To the true investor, this is meaningless.  He or she is constantly looking that that profit and dividend figure relative to initial cost.  As long as it was reasonable, the market is efficient enough to work itself out over longer periods of time.

Going back to a company like Dr. Pepper Snapple Group, the questions I ask myself include:

  • Do I think Dr. Pepper Snapple is reasonably valued at present relative to cyclically-adjusted earnings and assets?
  • Do I think that the growth assumption is reasonable?
  • Do I think that 5, 10, and 25 years from now, the company will still be profitable, doing largely the same type of activity?
  • Do I think there are any major competitive or regulatory weaknesses that could wipe out the business or industry?
  • Is the business superior to most other companies as measured by return on equity and return on assets?
  • Is debt modest relative to cash flows?
  • Does management show a respect for owners by returning surplus capital that it can’t profitably use, either in the form of dividends or share repurchases?
  • Have I accounted for the effects of taxes on my return assumptions (e.g., where the shares will be held, the rate to which they will be exposed, etc.)?
  • Is dilution from stock options or convertible interest modest, or if not, accounted for in the earnings per share projection?
  • Are there any assets or liabilities not fully reflected in the market price, such as a massively underfunded or overfunded pension?

If I am satisfied with the answers, I make the purchase.  Very few companies will pass all of those test. 

It is entirely possible that I will wake up tomorrow, and something will have happened that causes the stock to go from $47.46 at the moment to $10.00 or less.  Perhaps even bankruptcy.  That is life.  That is the risk you take for the chance to crush Treasury yields.  That is the risk you take for the opportunity to compound your real purchasing power without having to sell your time.  The best protection against such a disaster is diversification among asset classes (stocks, bonds, real estate, private businesses, et cetera), and among individual holdings.  If you have a problem with it, too bad.  As long as the profits and dividends remain intact, it should all be fine in the end, even if that means years of patiently collecting dividend checks as I wait for the world to heal itself.

What if this is an exceptional case so that an otherwise great business is wiped out entirely?  It’s happened in the past and it will happen again.  Dr. Pepper Snapple Group might be that company.  It doesn’t seem likely – the business is stable, the earnings are strong, the balance sheet conservative, the management talented, the brand name extremely valuable – but it could happen.  Your best line of defense is to own enough high quality assets that the loss of one or two wouldn’t devastate you.  That’s how compounding works; a single Clorox in the portfolio can make up for many of its fallen brethren.  A single Chevron in the safe deposit box can overcome an Enron or Lehman Brothers.  A single General Mills in the brokerage account can restore the damage done by a Wachovia collapse.  One great apartment building, with no debt against it, pumping out rents, can restore your failure elsewhere.

You make sure that each individual holding is intelligent and rational, then you watch the composition of the entire portfolio to ensure you aren’t overexposed to any one particular economic sector or enterprise.  Time and compounding do all of the heavy lifting after that, as long as you live in a fair economic system with just laws and political stability.  The rules would be very different if you were a resident of Zimbabwe.

For something like the KRIP, Dr. Pepper Snapple Group represents one of the few types of businesses – maybe less than 100 in the world – that gives me the clarity I desire to satisfy the mandate.  The odds seem very good that the shares, with dividends reinvested, will result in an increase in wealth of at least 10% to 11% per annum over the next 25+ years when bought at present prices; albeit with the wild fluctuations we’ve discussed.  Again, at the risk of repeating myself ad nauseum, there is no guarantee of that, but my job is to put together a portfolio of assets with similar characteristics so that even if a few of them were to fail, the overall collection of holdings would still produce a satisfactory return.

The Dr. Pepper Snapple Groups and United Technologies of the world are not going to rain down money on a 20 year old so they suddenly have a private jet and a mansion in the hills of California.  They are large, mature, and profitable.  Instead, they can serve as one source of funds, constantly pumping money into your life to use elsewhere, while growing in intrinsic value.  Bought intelligently, over long periods of time, in sufficient sums, they can add millions upon millions of dollars to an investor’s net worth as the decades roll by, providing funds to take vacations, upgrade your home, pick up a new car, or pay medical bills in retirement.  I like owning a mixture of assets, and I sleep well at night knowing these stable, competent, taken-for-granted enterprises are there, doing their job as no one pays attention to them.

If you are ambitious, and these are the only types of assets you buy in life, you are going to have a red ring problem unless you generate a very high income that can put a lot of capital to work for you during your 20’s and 30’s.  Still, they play a valuable role, and one that I cherish.  I think most investors would be wise to appreciate them, too, as long as they know what they are getting into, accept the risks, and actively seek to mitigate the dangers of equity ownership.

  • Anon

    Can you please tell me where you get “after-tax earnings yield of 6.32%” from? Or what statistics you add/subtract/divide/multiply to get there? Thank you!

    • Anon

      (Is this the same as “Return on Assets”?)

      • DividendGrowth

        He is looking at a P/E of 15.83 right now. 100 divided by that P/E ratio, comes out to an earnings yield of 6.32%.

        • Anon

          Thank you!

        • Anon

          Is the dividend yield already included in the earnings yield? Thanks in advance!

        • DividendGrowth

          Anon,

          In general, as long as dividends per share paid out are less than earnings per share, the dividend yield will be lower than earnings yield. It might seem that it is already included. However, these are two separate terms. One looks at earnings per share divided by price, and the other looks at dividends per share divided by price.

          I actually look at P/E ratios for earnings, and yields when it comes to dividends. As an owner of a business, I receive a cash yield on my investment (dividends), while a portion of the earnings are plowed back into the business. I might or might not receive a future benefit from that reinvestment. That’s why I do not really focus on earnings as a yield, but as a P/E ratio ( it’s all the same thing, just a ratio flipped upside down, but from a psychological point of view makes sense to me)

        • Anon

          Thank you!

          I wanted to make sure the first graph/chart @ http://www.retirementoptimizer.com/articles/wisdomline.pdf‎ was correct!

  • Bill

    I enjoy these types of posts by you. While this is much the same stuff I repeatedly remind myself of every day, it still helps to focus the mind sometimes to hear/read it from someone else.

    Let me ask you a question concerning the red ring problem. I wrote you once about what you’d do if you woke up, were 28 years old, didn’t have all the assets and other things you do now, and didn’t hold the skills to create synthetic equity as you did in your college days – how would you go about starting from scratch again, and you made a post out of it and had quite a list of excellent points.

    I find myself having a hard time trying to weigh the possible future return in the long run (30+ years) by putting the bulk of my savings into stocks vs the benefit of building cash flow by investing in real estate. Then there is the point that starting a successful business can generate both. Due to each individuals temperament, skills, etc, the answer will be different for each individual. You have a great way to explain your position on things that makes the cognitive gears start turning, so I’ll ask – what would you do, if you were 28, had no experience running a business or ecommerce website, and had around $15,000 a year to invest?

    • jss027

      JK has said it…WB has said it… Buy wonderful businesses at a fair price! KO, WFC, JNJ, AFL, COP, BP, etc. after the framework is secure and growing… have fun spending 5% of the income on speculation…. UA, Dicks, kohls, etc.

    • Joel

      Bill, if I could just put in my two cents after some misguided efforts of my own, it would be to invest in many things. I have some modest real estate, a small share in a company founded by a relative and then a growing base of stocks mentioned on sites like this. With less than 15k per year to invest there are now multiple streams of income flowing in and I don’t have to work at them all. Write down your goals, draw up your paths to get there and then follow through on your plans.

    • Dylantherabbit

      Joel has pretty much hit the nail, multiple income streams using different assets, the more you have the less the effect of one failing. I think stocks are a good start, as you get an understanding of business at arms length and they have a relatively high liquidity, then look at real estate and maybe a private business. Franchising is worth further investigation, there are some great franchises available.

      • Bill

        Thank you Joel and Dylantherabbit for the replies.

        My thought was more along the lines of trying to weigh the time advantage of investing as much as I can in stocks as early as I can (I’m 28 now) and then working on real estate and such later to build cash flow. If I were to invest $15,000 a year over the next 8 years until I was (and including the year of) 35, stopped contributing and averaged 10% returns, I would have right around a $3 million dollar nest egg in stocks just for saving $15k a year from now until I was 35. After which, I could focus on real estate and other ventures that would produce cash flow for the balance sheet to either re-invest, live on, etc.

        Or… Would it be more beneficial to focus on increasing cash flow now to possibly free up my time requirement of a traditional job to focus more on a business, real estate, investing, etc.

        Or perhaps a combination of the three simultaneously.

        The answer, obviously, can really only be answered by myself, based on my own goals, tolerance or lack-of for the “red ring problem” and a host of other things as I mentioned in the original comment. It’s nice to hear other view points on such things though to possibly turn a light on something I had overlooked, to compare other experiences to my own, etc. Thanks for the replies guys.

    • joe pierson

      If I were you I would be desperately looking for some business that generates 800% returns. As in spending all my free time looking for one. Josuha mentioned a couple on this site, but it’s specific to his knowledge (ecommerce web sites, sporting goods, perfumes,wedding supplies etc). In my case I knew about electronics, I bought out a small obsolete electronic distribution company’s inventory (they were retiring) and resold their products at 10x. It was a long path before I figured that out and the specifics will not help you. You need to find what you know and try to get creative. I didn’t try to compete with 10,000 engineers in silicon valley, but found a niche. Work the numbers first before doing anything. That got me from $10,000’s in net worth to several hundred thousand very quickly before it grew too big for me to handle and I sold out. But it led me to other business adventures that I would of never thought of otherwise. I had no experince in business beforehand.

      • Bill

        My wife and father are really into antiques and collectibles. My wife averages around 10k a year in profit from yard sale finds and the like on the weekends. We’ve talked about opening a little shop to pursue this to a larger degree. If we did that, I’d love to rent out parts of it to other antique/collectibles people in the area for several reasons. I also have a friend who ran several successful espresso stands in the puget sound area that said she’d help me get going if I were to decide to pursue it. When we buy our house in the next coming months, I’d like to pursue a few other ideas as well. I think it’s time to kick my butt into overdrive, I appreciate your reply =)

        • joe pierson

          Make sure you do the numbers first on that antique store. Charlie Munger said his first or second love is not definitely not investments, but that is where he initially concentrated his time because that is where the money is. He then used his financial independence later to pursue his real interests. There is a big lesson there. Maybe bigger money in antiques is not in direct ownership of the stores but of a secondary nature related to antiques.

      • Matt N

        I would love to know more about his private businesses – how they were started and financed, his role in them now (doesn’t seem to be involved in the day to day running which is unusual for someone who owns private businesses) etc. I don’t think it’s really on his agenda to discuss these that much though unfortunately.

  • Will

    Can you provide the source for the 7.57% consensus growth rate over 5 years? Thanks.

    • http://www.joshuakennon.com/ Joshua Kennon

      The consensus estimate is simply the mean of the growth estimates provided by the analysts that cover the stock. Again, I would strongly urge you to consider taking a particular figure with a very large grain of salt because academic research has demonstrated time and time again that analyst estimates are too optimistic, on the whole, leading to overvaluation.

      You can either manually calculate it yourself, get it from a research provider such as S&P, look it up on Yahoo Finance, or pull a tear sheet on the company from your broker. All of the sources update at different times, so they will be slightly different. For example, here is a PDF report on Dr. Pepper Snapple given to clients of most major brokerage firms, such as Charles Schwab, which shows the Consensus Estimates on page 5 (in this case, it estimates a LT growth Rate of 7.7%). Meanwhile, the Analyst Estimates page on Yahoo Finance calculates the 5-year average of consensus growth projections at 7.57%.

      I would not be relying on analyst estimates for my calculation of intrinsic value. It was simple a quick and dirty tool to illustrate a concept or see if your expectations and assumptions differ materially from those who study the business.

      (For what it is worth, the Thomas Reuters reports are my favorite. I know of no other source, besides Valueline, that does such an excellent job of presenting a clear, concise, summary view of the figures. If you have a brokerage account at a firm like Schwab, which provides these for free under the research tab of the ticker symbol quote, I would be taking advantage of them.)

    • http://www.joshuakennon.com/ Joshua Kennon

      The consensus estimate is simply the mean of the growth estimates provided by the analysts that cover the stock. Again, I would strongly urge you to consider taking a particular figure with a very large grain of salt because academic research has demonstrated time and time again that analyst estimates are too optimistic, on the whole, leading to overvaluation.

      You can either manually calculate it yourself, get it from a research provider such as S&P, look it up on Yahoo Finance, or pull a tear sheet on the company from your broker. All of the sources update at different times, so they will be slightly different. For example, here is a PDF report on Dr. Pepper Snapple given to clients of most major brokerage firms, such as Charles Schwab, which shows the Consensus Estimates on page 5 (in this case, it estimates a LT growth Rate of 7.7%). Meanwhile, the Analyst Estimates page on Yahoo Finance calculates the 5-year average of consensus growth projections at 7.57%.

      I would not be relying on analyst estimates for my calculation of intrinsic value. It was simple a quick and dirty tool to illustrate a concept or see if your expectations and assumptions differ materially from those who study the business.

      (For what it is worth, the Thomas Reuters reports are my favorite. I know of no other source, besides Valueline, that does such an excellent job of presenting a clear, concise, summary view of the figures. If you have a brokerage account at a firm like Schwab, which provides these for free under the research tab of the ticker symbol quote, I would be taking advantage of them. See the attached image for a screenshot of what it should look like if you want to get your own copy.)

    • http://www.joshuakennon.com/ Joshua Kennon

      The consensus estimate is simply the mean of the growth estimates provided by the analysts that cover the stock. Again, I would strongly urge you to consider taking a particular figure with a very large grain of salt because academic research has demonstrated time and time again that analyst estimates are too optimistic, on the whole, leading to overvaluation.

      You can either manually calculate it yourself, get it from a research provider such as S&P, look it up on Yahoo Finance, or pull a tear sheet on the company from your broker. All of the sources update at different times, so they will be slightly different. For example, here is a PDF report on Dr. Pepper Snapple given to clients of most major brokerage firms, such as Charles Schwab, which shows the Consensus Estimates on page 5 (in this case, it estimates a LT growth Rate of 7.7%). Meanwhile, the Analyst Estimates page on Yahoo Finance calculates the 5-year average of consensus growth projections at 7.57%.

      I would not be relying on analyst estimates for my calculation of intrinsic value. It was simple a quick and dirty tool to illustrate a concept or see if your expectations and assumptions differ materially from those who study the business.

      (For what it is worth, the Thomas Reuters reports are my favorite. I know of no other source, besides Valueline, that does such an excellent job of presenting a clear, concise, summary view of the figures. If you have a brokerage account at a firm like Schwab, which provides these for free under the research tab of the ticker symbol quote, or E-Trade, which provides it under the Analyst Estimates tab, I would be taking advantage of them. See the attached image for a screenshots of what it should look like if you want to get your own copy.)

  • DividendGrowth

    Joshua,

    I liked the fact that the stock is trading at 15.80 times earnings, and yields 3.30% However, the following information from the Annual Report looks like a warning sign about Dr Pepper Snapple Group:

    “67% of Dr Pepper volumes are distributed through the Coca-Cola affiliated and PepsiCo affiliated bottler systems.

    PepsiCo and Coca-Cola are the two largest customers of the Beverage Concentrates segment, and constituted approximately 30% and 18%, respectively, of the segment’s net sales during 2012.”

    Could you please care to elaborate what you think about that?

    • http://www.joshuakennon.com/ Joshua Kennon

      Coca-Cola and PepsiCo paid Dr. Pepper a lot of money ($1.6 billion) in 2010 to sign long-term contracts giving them those distribution rights because the deal benefits everyone involved. This meant that Dr. Pepper’s portfolio was largely sold through those two firm’s larger and more efficient distribution network, driving up DPS’ returns through reduced capital investment need, and letting both KO and PEP get a cut of the sales. It was a case of economic specialization; the businesses doing what they do best.

      Dr. Pepper decided to send all of that licensing money back to stockholders and bought back very large amounts to shares, reducing net outstanding share count substantially. It also jacked up the cash dividend by double digits.

      I consider it an example of management’s talent and focus on increasing returns on invested capital, as well as their dedication to an owner-friendly mentality by not using that cash to build an empire but instead returning all of it to those of us who have a stake in the firm. This is not, in my personal opinion, at all comparable to a vendor that has, say, 20% of sales with a single firm such as Wal-Mart.

      If, years from now, the contracts aren’t renewed, people will still want Dr. Pepper. DPS will find a way to get it into their hands.

      • DividendGrowth

        Interesting, I viewed this statement I posted as a warning sign that Coca-Cola and PepsiCo can squeeze Dr Pepper out of their distribution systems at will. This is what is preventing me from buying DPS today – of course I could be wrong, and these agreements can lead to great things for DPS. Because of this warning sign however, DPS has a much narrower moat than the likes of KO. If KO & PEP drop it from their networks, I doubt DPS can start distributing quickly enough to avoid losing significant market share…Other warning signs include

        “In addition, in many countries outside the U.S., Canada and Mexico, our rights to many of our brands, including our Dr Pepper trademark and formula, were sold by Cadbury Schweppes beginning over a decade ago to third parties including, in certain cases, to competitors such as Coca-Cola.” “For example, the Dr Pepper trademark and formula is owned by Coca-Cola in certain other countries. ”

        This explains probably why the company derives revenues from mainly three countries – US, Mexico & Canada.

        I do own PEP and KO, but I would much rather pay 20 times earnings for KO than 16 for DPS. Let’s talk in 5 – 10 years on that one, and see what happens ;-)

        Good luck and hope you get a nice week!

        • http://www.joshuakennon.com/ Joshua Kennon

          I’m a big fan of all three soda companies and am happy to own shares of any of them.

          Did you read the contract summations? There is no way what you just described could happen. Coca-Cola and Pepsi are required to (and get paid well for the task) distribute Dr. Pepper products for 20 years, with a 20 year renewal option. Meaning, unless Dr. Pepper wants out of the contract, the terms won’t come up for renegotiation until the year 2053.

          I’ll be 71 years old when that happens. The firm will have had four decades to prepare for it.

          As part of the deal, Dr. Pepper also got back the rights to distribute many of its brands from Pepsi under an old contract, including Sunkist and Hawaiian Punch, in those areas where it has a distribution footprint.

          As for Coke owning the international rights to Dr. Pepper, that would give them a far greater incentive to protect the brand equity as they have what amounts to, in spirit, a joint partnership equity exposure to anything harmful that happens to it. Would it be better if DPS owned it? Sure, but profits would be higher so the valuation already reflects that.

          But like i said, all three appear to be attractive for 25+ years based on present known factors, if bought as part of a diversified portfolio to mitigate individual firm risk. I still have my youngest sister buying up shares of Coca-Cola. Were I to fall into a Rip Van Winkle sleep for 50 years, I’d perfectly fine having 30% of my net worth split equally between the three firms (10% in each) at today’s prices, with dividends reinvested. There are very few companies on the planet with which I have that degree of comfort.

        • DividendGrowth

          Very interesting. Unfortunately, I was unable to find the contracts with Coca-Cola and PepsiCo. I could just find references to press releases, and mentions in the annual reports. Could you please send a link to those contracts if you were referring to anything outside to what I described above?

          Anyway, it looks like DPS is attractively valued, but then would my performance be better if I owned 3 (KO, PEP and DPS) vs owning just 2 “soda” companies (of course PEP has a large snack business, but for sake of argument lets say it is a soda co).I guess everyone has to decide what works for them.

          I already own 40+ individual dividend stocks, so at this stage I am trying to curtail my dividend hoarding of quality companies. My personal limit would be at around keeping up with 100 securities, but then, I do want to have a life too ;-) This is why adding DPS might not add to an incremental benefit for my portfolio.

          Thanks a lot for the Q&A, if I ever meet you in KC ( i am based here), I would love to buy you a coke. I saw “mexican” Coca-cola in a WMT here today in Raymore, MO.. It contains sugar, and not the corn syrup that “regular” Coke sold in he US offers.

        • DividendGrowth

          Hmm I guess I should have bought more DPS last year when I read this ;-) I guess lesson to learn is that a good company purchased at a low valuation can deliver a solid return if things just improve slightly. In the case of DPS – returns will be decent.

          It is interesting that in today’s day an age, people can start investing in DPS KO PEP with as little as $10 using plans like Loyal3. I like the fact that we are having democratization of investing – anyone can be a capitalist if they had a few bucks. Over a period of 50 years, each dollar turns into $100 – not too bad if you ask me..

  • Chris Bazzle

    Thanks for sharing your knowledge, Mr. Kennon. I am obsessed with reading your educational content every day, and I wish I had understood and applied these concepts a long time ago.

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