The Peak of Crazy
We all played this game when we were kids.You say a number. Your friend tries to demonstrate his knowledge by saying a bigger number.At some point you proudly get to infinity – the largest number of all.-Vitaliy Katsenelson
Capital Thinking • Issue #1017 • View online
We all played this game when we were kids.
You say a number. Your friend tries to demonstrate his knowledge by saying a bigger number.
At some point you proudly get to infinity – the largest number of all.
I Kid You Not Crazy
Your friend doesn’t blink; he says, “Infinity times a hundred,” then he thinks for a second and spouts out, “Infinity times infinity!”
How do you beat that?
When assets get overvalued and get into crazy territory, explaining their overvaluation feels like playing this “infinity times infinity” game. But at least, if we line up different crazy valuations next to each other, it is going to be easier to distinguish levels of craziness.
Let’s start with the least crazy of all the crazies – bond-substitute type stocks. In this example I’ll focus on Coca Cola, but I could have written this about almost any consumer goods company – the likes of Kimberly Clark, McCormick, WD-40, and many others that pay a stable dividend. Coca Cola has been spreading joy (and diabetes) globally since 1886.
It is truly an incredible business: the company makes a concentrate and ships it to bottlers, who put in the hard capital, bottle that syrup, and distribute it to every corner of the world. Coke, in concert with its bottlers, has the best distribution system in the world. Since bottlers do all the heavy lifting, this business earns a very high return on capital.
Coke is one of the most beloved brands in the world (unless you are a Pepsi person). This company has experienced incredible growth over the last century.
However, unless Coke gets penguins at the South Pole to consume its fine bubbly, it has run out of new markets to sell into. This is exactly what has happened to Coke since 2010 – its revenues and earnings have stagnated.
If you look at its financials, only two things have grown: its dividend (due to an increased dividend payout) and its debt – which has tripled. Coke is a high-quality company – it can raise prices along with inflation on its namesake product, which is about half of its revenue. It may struggle to do this on other more commoditized parts of its product portfolio, but nobody questions whether Coca Cola will be around in ten or twenty years.
Most importantly, investors are convinced Coke will continue to manufacture its 2.6% dividend till the end of time. They are so focused on the shiny object – the dividend – that they are ignoring how much they are paying for this seemingly endless income stream.
Mr. Market will let you have Coke today at 30 times earnings. But.What happens to Coke’s stock price if interest rates dare to go up? Coke’s 2.6% “infinite” dividend will not be so shiny when interest rates go up a few percentage points.
If the 10-year Treasury is yielding 5%, Coke’s dividend will lose its luster and the stock will decline to a valuation multiple with a “1” in front of it.
Today, many Coke shareholders are experiencing what behavioral economists call “empathy gap.” They tell themselves, “I am fine even if the stock declines 30–50%. I will stick with getting my 2.6% dividend, which will rise with inflation.”However, when the stock price declines and safe alternatives offer double the yield, they’ll change their thinking – thus the gap.
Side note: Dividends don’t need to be a shiny object that lead you to eventual financial ruin if/when interest rates rise. Just change the sequence of your analysis. Here is what we do at IMA in dividend portfolios: We identify the universe of stocks in the US and other countries that pay stable dividends, but only the ones that are both high-quality and undervalued end up going into the portfolio.
Coke is a lightweight on the crazy spectrum. The degree of crazy will increase with each further example, culminating with smelly, hot air, I promise. The next one is Tesla. I’ve spilled a lot of ink on this company. I even wrote a series of essays that I turned into a small book (you can get it here with one-click).
I love my Model 3. Almost three years after I bought it, I still enjoy driving it, and I am not even a “car guy.”We are about to get my wife a Tesla. I like a lot of things about the company.
But.
Vitaliy Katsenelson
Photo credit: Tengyart on Unsplash