Veteran investor Donald A. Yacktman finds much to like in Coke, Pepsi, and P&G which he views as bargains

SATURDAY, NOVEMBER 2, 2013

Why Three Big Stocks Look Like Bargains

By LAWRENCE C. STRAUSS | MORE ARTICLES BY AUTHOR

Veteran investor Donald A. Yacktman finds much to like in Coke, Pepsi, and P&G which he views as bargains.

Donald A. Yacktman is regarded as an insightful investor with a keen analytical mind, as his long-term results attest. The Yacktman Fund (ticker: YACKX) has a 15-year annual return of 10.62%, besting 99% of its peers in Morningstar’s large-cap blend category. Yacktman and his team hew to a buy-and-hold approach, content to hold stocks for years. Annual turnover averages about 20%. The fund’s top 10 holdings account for about 50% of assets. Yacktman, 72, who is president of Yacktman Asset Management in Austin, Texas, oversees nearly $30 billion of assets. To find out about a few of his holdings and his sense of where the markets stand, Barron’s caught up with him recently by telephone.Barron’s: Where are you finding value in the stock market?

Yacktman:We have two goals. No. 1: Protect our client’s money by making good decisions and protecting against inflation. In other words, we have to be proactive; we just can’t put the money under a mattress. No. 2 is to grow our clients’ money the most efficient way we possibly can on a risk-adjusted basis. The way we think about this—that is, beating the index from one market peak to the next—is by, in effect, using risk-adjusted forward returns. So it is much like buying 30-year bonds. Some people have asked us if we’re as near the top as we were in 2007. The answer is no, we are not at those kinds of levels. From a valuation standpoint, we don’t see an issue. The best values are in these great big consumer companies, and we get to them from the bottom up, not the top down.

“On a risk-adjusted long-term basis,” PepsiCo, Procter & Gamble, and Coca-Cola look “like undervalued AAA bonds.” — Donald A. Yacktman

What are a few examples?

PepsiCo [PEP], Procter & Gamble[PG], and Coca-Cola [KO] fit our pattern. They are very profitable, with slow unit growth, a nice dividend, and so on. But on a risk-adjusted forward-return basis, we view these stocks like undervalued AAA bonds. To take on a lot of additional risk in more-cyclical stocks doesn’t seem to be warranted. You don’t get enough extra return to make that leap.

What parts of the market look overvalued?

We don’t tend to think quite that way. I would say, though, that probably as people try to stretch for return, what happens is the spread between the less-good companies and the really good ones goes down, just as it does in the bond market, where BAAs start to draw attention, instead of the AAAs. The one thing that has been grossly overvalued, though not as much as it was, is 30-year Treasuries. When the yield was at 2.5% a little more than a year ago, I thought it was outrageous. The long bond has tended to be somewhere around three [percentage points] over inflation, which has tended to be close to 3%—or between 2% and 4%. But on a long-term basis, I would count on having inflation. So when you see bonds at these kinds of rates, recently at 3.6%, that’s just not a lot of premium over inflation. So there is a lot of danger in that kind of holding. But people are probably drawn to the long bond because we’ve had such a weak economy and things have been scary in the world.

And they want yield, right?

Yes, they do. But then, on a relative basis, that brings us back to what I said. If you could get Pepsi or Procter or Coke, for instance, at 3% yields versus where the 30-year Treasury is, which one would you pick?

What makes these dividend yields so attractive?

They are going to grow. Pepsi’s dividend yield is roughly 2.8%; Procter’s is 3%, and Coke’s is 2.8%. They should grow in line with earnings. Or, to put it another way, their dividends will grow faster than inflation.

During the financial crisis in 2008, you were able to use extra cash on hand to buy distressed stocks. The Yacktman Fund was down 26% in 2008, but it beat nearly all of its peers. What did you learn from that period?

Well, the irony is that we used up all of our cash before the end of 2008. We were so brilliant that the market went down another 20% after that. So, the best way I can describe this is to think of what we are doing as capital allocation. As I said, we are, in effect, buying bonds, and if you can get something above your cost of capital and above your hurdle rate, then you ought to be buying. So in 2008, we ran out of cash, and then we were starting to sell things that had held up pretty well, because we could find other things that were so cheap. For example, we sold Procter & Gamble to buy News Corp[NWS; the parent company of Barron’s] and Viacom [VIA], both of which just had been beaten to a pulp. That’s why we did well in both 2008 and 2009—we were objective and flexible. Our turnover rate normally is pretty low, typically around 20%, but it went up quite a bit during that period because we had to adjust to the environment.

How would you sum up your investing approach?

I’ll mention one of my sons, Stephen, and Jason Subotky, who also works here. Jason says: “It is almost always about the price.” And Stephen says that when you buy a stock, you should always be happy if, when the stock goes down, you are willing to buy more. If you can’t do that, then you probably own too much. A while back, my family and I were sitting around the dinner table, and we were talking about investing. Another of my sons, Brian, who does not work with me, but who has his own mutual fund, was in his late teens or early 20s at the time. And he said, “Let me see if I get this right, Dad. Basically, what you have said is that if you buy above-average businesses at below-average prices, on average it is going to work.” So what you are trying to do is stack the odds in your favor. It is a little more sophisticated than my son’s explanation, but it’s a good summary.

Coke, Pepsi, and Procter & Gamble have underperformed the S&P 500 in recent years. What’s to like about them?

They all have incredibly good business models. We are looking for businesses that have high returns on tangible assets, and they fit that profile. They’re almost like printing presses, because of the kind of business they have. The other side is, as most people say, “Yes, but they are dull as dishwater.” And that’s probably true. They have relatively slow unit growth, but they are different stories. In the case of Procter, it’s a household-products company with brands such as Tide, Pampers, and Gillette. They have some wonderful businesses with high market share and slow unit growth, and they are gradually moving more toward international exposure, but it will take time.

What about Pepsi?

With Pepsi, the key component is the snack-food business. The other parts are beverages, which includes Gatorade, and Quaker Oats, which includes cereals. Coke has mainly a soft-drink business, 80% of it outside the U.S., so it is heavily international. All of these companies are slightly different from one another. Coke is the most exposed internationally. Pepsi and Procter are moving that way, but don’t have the same level of exposure yet. But all three fit that same pattern of high profitability, low unit growth, and so on.

Why have investors shunned them?

Coke has been struggling a little bit more than the other two companies. Procter, and to some degree Pepsi, have been a little bit more aggressive in their pricing, and there have been economic disruptions in recent years. So, to keep up their standard of living, people are sometimes willing to downgrade slightly, because they feel like they may be a little better off doing that. But, thanks to their research-and-development efforts, these companies keep coming up with products that people love and that are better. In the case of Pepsi, you hear them moving more and more toward healthier products in some of their categories. So over time, you see they are doing the same thing, but for different product categories. And for all three, once you have as much market share as they have, while you can lose it, nobody can really take it from you.

Investors have been concerned about Procter’s growth, and its former CEO, A.G. Lafley, has been brought back to improve things. What’s your view?

Yes, Lafley came back in. Part of it, too, is that all these companies have had to deal a little bit with ingredient price pressure, and it is harder to raise prices in an environment like we’ve had in the past few years.

What about the concern that Procter can’t generate enough growth to make it a worthwhile investment?

Yacktman’s Stock Picks

		Recent
Company	Ticker	Price
Coca-Cola	KO	$39.57
PepsiCo	PEP	84.09
Procter & Gamble	PG	80.75
Source: Bloomberg

There is no doubt that unit growth, particularly in companies that have high market share, is profitable. But while the growth may be slower, you can still make a lot of money. An example is a company like Philip Morris International [PM]. Cigarettes are a declining product category, but look at how well this company has done over the years, in spite of that. Part of that is because they’ve increased their international operations significantly. So the demise of these companies is grossly overstated.

How does Coke compare with Pepsi?

We like both companies, but for very different reasons. Or I should say that conceptually we like both for the same reasons, because they are selling at decent prices, and they are great businesses. But their business models are different. They could change the name of Pepsi to Frito-Lay, because they make so much money in snack food, whereas Coke is heavily in beverages. One thing Coke has been pressured by is the concern about sugared soft drinks. Mexico recently had been threatening to put more tax on those drinks.

What are Coke, Pepsi, and Procter & Gamble worth?

Everything boils down to inputs. To get a value, you have to have a cost of capital, and you have to have projections of growth and all the rest to come up with those numbers. But by looking at forward rates of return and risk-adjusting them, it allows for more objectivity. You can say, “All right, this is only an 8% or 9% return. But here is where the 30-year U.S. Treasury bond is, and here is where historical returns have been on equities, and here is where other stocks are.” That method is a little better, because a price target is no better than the inputs.

Could you give an example?

Fifteen years ago, Coke hit its all-time high of $44. We didn’t own any then, as we thought it was overpriced and the rate of return was pretty low. But 10 years ago, we started buying it when it was less than half of where its all-time high was. And then, by the middle of 2007, it was our biggest holding at over 10% of the portfolio. Even as the stock rose, it started to become a lower and lower percentage of the portfolio. We never eliminated it, but it became a smaller piece. But over the summer, the stock came down again, and we added to our position. It’s our fourth-biggest holding now.

What kind of annual returns do you expect from Coke, Procter & Gamble, and Pepsi?

There are several components to look at. One is how much cash a company is throwing off. For most businesses, the cash flow is divided into two forks. One fork goes to the shareholder in the form of a dividend—that is, what the dividend is when you are buying a stock, and you ought to have a pretty good idea of what your rate of return compounding will be. So that’s the cash.

The other fork, which is the wild card in investing, is what is going to happen, long-term, to the money that’s reinvested in the business. Now, with the money reinvested, there’s unit growth, and you have potential changes because of things like acquisitions. It boils down to management’s ability to allocate capital effectively, and it relates to reinvesting the cash flow. And then there’s inflation, which affects every asset across the board.

At these prices, these companies are capable of putting up inflation plus more than 6%, maybe 7% returns per annum, on average, over the long term. Those are pretty good numbers. If you figure inflation today is 2%, you are looking at returns slightly below 10% for these stocks. Again, with the long-term Treasury at 3.6%, which would you rather own?

Thanks, Don.