{"id":37795,"date":"2013-04-24T12:09:33","date_gmt":"2013-04-24T16:09:33","guid":{"rendered":"http:\/\/countingpips.com\/forex-news\/?p=37795"},"modified":"2013-04-24T12:09:33","modified_gmt":"2013-04-24T16:09:33","slug":"are-coke-and-pepsi-the-new-big-tobacco","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/forex-news\/2013\/04\/24\/are-coke-and-pepsi-the-new-big-tobacco\/","title":{"rendered":"Are Coke and Pepsi the New Big Tobacco?"},"content":{"rendered":"

By The Sizemore Letter<\/u><\/a> <\/p>\n

Earlier this year, I commented that semiconductor titan Intel (Nasdaq:$<\/span>INTC<\/a>)<\/b> was my favorite tobacco stock<\/a>.<\/p>\n

I said this tongue-in-cheek, of course.\u00a0 I am aware that Intel designs and manufactures microprocessors, not cigarettes.\u00a0 But my point was simply that slow-growth (or even no<\/i>-growth) investments, such as tobacco stocks, can be wildly profitable under the right conditions:<\/p>\n

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  1. There should be substantial barriers to entry for new competitors (what Warren Buffett likes to call \u201cmoats.\u201d)<\/li>\n
  2. The company should be financially healthy (strong balance sheet, manageable debt, etc.)<\/li>\n
  3. Management should be committed to rewarding shareholders with rising cash dividends and, to a lesser extent, share repurchases.<\/li>\n<\/ol>\n

    But most importantly, even if all of these other conditions are met, the stock must be cheap.<\/b>\u00a0 Remember, if this is an industry in decline, you cannot pay top dollar for the stock and expect to have decent returns going forward.<\/p>\n

    Big Tobacco giants such as Altria (NYSE:$<\/span>MO<\/a>), Reynolds American (NYSE:$<\/span>RAI<\/a>)<\/b> and Philip Morris International (NYSE:$<\/span>PM<\/a>) <\/b>easily pass the first three conditions.\u00a0 All benefit from the moats encircling the tobacco business (it would be all but impossible to start a new cigarette company today), all are financially healthy, and all solid dividend payers and growers.<\/p>\n

    Yet none is particularly cheap at the moment; all trade at a premium to the S&P 500\u2019s earnings multiple.<\/p>\n

    Big Tobacco\u2019s rich valuations these days are particularly noteworthy because tobacco is not just any run-or-the-mill no-growth industry.\u00a0 It\u2019s also a vice industry and perhaps, outside of firearms, the biggest of all social pariahs.<\/p>\n

    In many American cities, cigarette smoking is for all intents and purposes illegal.\u00a0 Smoking in indoor public spaces like bars and restaurants is not allowed, and in the most aggressive cases (such as New York City) even smoking in outdoor public parks is prohibited.\u00a0 But even where smoking is less persecuted, it\u2019s not exactly welcome.<\/p>\n

    And this brings me to the crux of this article.\u00a0 Princeton professor Harrison Hong and University of British Colombia professor Marcin Kacperczyk published an insightful paper in 2005 titled \u201cThe Price of Sin<\/a>.\u201d<\/p>\n

    The professors showed that social stigmas against investing in vice industries such as tobacco and firearms cause the stocks of companies in these industries to be depressed due to lack of institutional ownership.\u00a0 No college endowment fund, foundation, or pension plan wants to be labeled a \u201cmerchant of death.\u201d\u00a0 As a result, vice stocks tend to be priced as perpetual value stocks and thus deliver market-beating returns over time.<\/p>\n

    So\u2026by this rationale, wouldn\u2019t Coca-Cola (NYSE:$<\/span>KO<\/a>)<\/b> and Pepsico (NYSE:$<\/span>PEP<\/a>)<\/b> be vice investments too?<\/p>\n

    New York Mayor Michael Bloomberg certainly seems to think so.\u00a0 About the only thing he has fought as hard as tobacco is super-sized sodas.\u00a0 His controversial ban on all sugary sodas larger than 20 ounces in NYC was tossed out in court, but he\u2019s not throwing in the towel just yet.\u00a0 His war against Coke and Pepsi will be a war of attrition.<\/p>\n

    And Bloomberg is not alone.\u00a0 First Lady Michelle Obama has actively campaigned against soda consumption as part of her anti-child-obesity efforts. Calorie counts started appearing in menus a few years ago, and calls for assorted \u201cfat taxes\u201d have sprung up across various parts of the United States and Europe.\u00a0 Japan\u2014not normally a country associated with an obese population\u2014started measuring the waist lines of its citizens<\/a> in 2008 and requires diet changes for anyone deemed too fat.<\/p>\n

    How fat is \u201ctoo fat\u201d?\u00a0 Try a 33.5-inch waist line for men and 35.4 inches for women.\u00a0 I\u2019m willing to bet that most of my readers would fall outside these bounds given that they are well below the American average.<\/p>\n

    Anti-tobacco laws did not spring up overnight.\u00a0 It was a gradual process taking place over decades.\u00a0 Smoking rates declined over time, driven more by changing attitudes than changing laws.<\/p>\n

    Is something similar happening to soft drinks?\u00a0 Indeed it would appear so.\u00a0 U.S. soda consumption fell in 2012 for the eighth consecutive year<\/a>.\u00a0 Even more foreboding, consumption per person is at the lowest levels since 1987.<\/p>\n

    Sales are still strong in emerging markets\u2026for now.\u00a0 But rising emerging-market incomes will only provide a temporary boost, if tobacco is any indication.\u00a0 As incomes rise, so does health awareness.<\/p>\n

    But does any of this actually matter to Coke and Pepsi shareholders?\u00a0 I made a strong case for slow-growth companies, and both Coke and Pepsi meet my first three criteria.\u00a0 Both have enormous moats due to their branding power and global distribution (If you\u2019re the investor of a new soft drink, you shouldn\u2019t waste your time; Coke and Pepsi will bury you.) Both companies are financially healthy, and both have long histories of strong dividend growth.\u00a0 On the dividend front, both Coke and Pepsi are proud members of the Dividend Achievers Index and major holdings of my favorite ETF: the Vanguard Dividend Appreciation ETF (NYSE:$<\/span>VIG<\/a>)<\/b>.<\/p>\n

    \u00a0\"Coke<\/a><\/p>\n

    But what about price?\u00a0 Coke and Pepsi have both seen price\/earnings multiple contraction since the go-go days of the 1990s; for that matter, so has the entire U.S. stock market.<\/p>\n

    Yet both sport current multiples well above the market average of 17, making them too expensive to be \u201ctobacco stocks.\u201d\u00a0 (Of course, tobacco stocks are too expensive to be \u201ctobacco stocks\u201d too, so at least they have something in common.)<\/p>\n

    \"marlboro_man\"<\/a>Pricing here is complicated.\u00a0 Coke has what is by most accounts the most valuable brand in the world, and Pepsi\u2019s brands are also quite valuable.\u00a0 It is the value of these brands that allows the stocks to trade at premiums to the market even while their core products are seeing weak demand.\u00a0 But then, 20 years ago, I might have said the exact same thing about the branding power of the Marlboro Man<\/strong>.\u00a0 Altria still has branding power relative to its Big Tobacco rivals, but this has to be viewed within the context of a shrinking industry.<\/p>\n

    In other words, I don\u2019t expect Coke\u2019s brand, as iconic as it is, to justify a premium valuation forever.<\/p>\n

    Bottom line:<\/strong> It would appear that Coke and Pepsi are slowly transitioning into vice stocks, though they are not quite there yet based on valuation.\u00a0 Both stocks pay solid dividends and have a history of growing their dividends.\u00a0 But at current prices, I wouldn\u2019t expect either to outperform the market by a wide margin.<\/p>\n

    And on a final note, I\u2019m going to be a proper Texan by enjoying a Dr. Pepper with my lunch.<\/p>\n

    Sizemore Capital is long VIG<\/p>\n

     <\/p>\n

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    Related posts:<\/p>\n