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.
Once 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.
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 at those profit and dividend figures relative to initial cost. As long as they were 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 tests.
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. (Obviously these are historical examples of companies that have done well in the past. There is no guarantee those specific business will continue to do well in the future but, rather, are mentioned to underscore the wisdom of going through life attempting to identify assets that possess some sort of advantage and are likely to prosper over long periods of time. Diversification matters because you can’t be entirely certain ahead of time which assets will work out most favorably.)
You make sure that each individual holding is intelligent and rational, then you watch the composition of the entire portfolio to try to ensure you aren’t overexposed to any one particular economic sector or enterprise. Thereafter, time and compounding do the heavy lifting 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 should 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 even when and/or if one or more of them fail. 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.
Update: I restored this post on 05/16/2019 as part of a project meant to bring back some of the private archives that I feel have educational, academic, and/or entertainment value. In the years since it was first published, a lot has happened to Dr. Pepper Snapple. This post was originally written on July 13, 2013. The day prior, the stock closed at $47.46 per share. From there, each share generated $9.34 in cash dividends until a special buyout dividend of $103.75 was received on July 10, 2018 and the company re-named itself Keurig Dr. Pepper [KDP] following the consolidation with the single-serve coffee giant. Each old share of Dr. Pepper Snapple (with a much lower market value following the large one-time cash dividend) now represented a share of Keurig Dr. Pepper, which was entitled to less equity due to a higher outstanding share count. The now-renamed KDP stock has since distributed an additional $0.45 per share in cash dividends per share. The current market price of KDP as I write this is $29.09.
This means that each share bought for $47.46 when this post was published has since turned into $142.63, consisting of one share of the new Keurig Dr. Pepper stock with a market value of $29.09 plus $113.54 in cumulative cash dividends collected. This assumes no dividend reinvestment, which would have made the profit even larger.
Interestingly, an investor who bought shares at the time this post was written would now show a 38.7% unrealized loss on his or her brokerage statement despite having turned $47.46 into $142.63 because of how the merger was structured with a special dividend windfall and renaming of the old common equity. (Investors who bought the shares at higher prices in subsequent years, when the stock still represented a very attractive investment, would show an even larger unrealized loss due to the higher initial cost basis.) This is yet another reason that economic reality is not always reflected in your brokerage statements. It sounds nuts but that is how the accounting works. You can have an investment that generates enormous profits but is carried at an unrealized loss, making it look like you are losing money when you open your statement.
For what it is worth, I will say that at the time of the merger, Aaron and I decided to take our large cash dividend windfall and redeploy it to other opportunities. We did not reinvest it in shares of the new Keurig Dr. Pepper though we did keep our existing stake. This is because we wanted time to evaluate the new capitalization structure which includes substantially more leverage. The company has now fundamentally changed and requires an updated intrinsic value estimate.