What I Wish I Wrote ~ June 2, 2017

This is a great twitter thread on how Amazon is disrupting consumer brands and which items are most likely to be disrupted.

And as a follow-up, the presentation from the 2017 Ira Sohn Conference on why Energizer Holdings (ENR) is a short. (Ira Sohn)

The Invest Like the Best Episode with Royce Yudkoff and Rick Ruback focuses on buying small highly profitable businesses in a model they call Really Private Equity. The criteria they look for in an acquisition candidate are equally applicable when looking for a publically traded company. Especially when they talk about recurring versus repeating revenue.

“More money has been lost reaching for yield than at the point of a gun.” If you’re investing in a high yielding retail stock, how safe is that dividend? (A Wealth of Common Sense)

Which would you rather own a Ferrari or a Tesla? Now, which stock RACE or TSLA? If you’re a Return on Invested Capital fan then Ferrari is your pick for both. Plus, RACE pays a dividend. (Intrinsic Investing)

Autonomous cars are coming. When exactly? I don’t know. But LIDAR will the be key. A brief introduction to LIDAR (Voyage)

Pepsi (PEP) dividend growth analysis (The Dividend Groth Investor)

The iPhone has a tremendous loyalty and retention rate in the U.S. and around the world. Except in China. The Chinese smartphone user is driven by WeChat and Apple needs to find a solution to this issue. (Stratechery)

On position sizing in your portfolio (Covenant-Lite on Medium)

Got 11 hours to listen to some music? The complete history of Punk Rock in 200 tracks. (Open Culture)

AMM Dividend Letter Vol. 29: Plane Crashes, Stock Market Crashes, & Why We Overestimate Them

This is from the AMM Dividend Letter released June 9, 2016. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

For the sake of argument let’s say you’re afraid of flying, but you have a wedding to go to on the other side of the country and you’ll have to fly to get there. Right before you get on that plane I ask you, “What are the odds of your plane crashing?”

I agree, this is a terrible question to ask someone who is afraid of flying right before they get on a plane. However, the emotional element is necessary as we’ll see later on. So how likely, expressed as a percentage, is your plane to crash? 1, 2, 5, 10%?

Since you’re afraid of flying you find yourself recalling with great ease several recent airplane crashes. The missing Malaysian plane, the Germanwings crash in the Alps, the Korean Air runway crash in San Francisco, etc. You also realize crashes don’t happen all the time but they do come up fairly often on the news. So you argue yourself into a 1% chance of your plane crashing.

At 1% you would be overestimating your odds of a crash by an extreme amount. Your chances to be in any commercial aviation mishap is 1 in 11 million. If you want the odds for your specific flight in your specific plane there’s an app for that.

Am I going down?

Click to enlarge.
Click to enlarge.

Let’s do another thought experiment. Similar to the emotions an airplane crash invokes.

Stock Market Crashes

How likely will the stock market crash in the next 6 months? We’ll define a crash as a one-day decline greater than 12%.

Just like the airplane crashes above you easily recall the 2008 financial crisis, the 2000 tech bubble bursting, Black Monday in 1987, the Flash Crash. Even the beginning of this year started off with a 12% decline. What is your guess at the chance of an equity market crash within the next 6 months? 5, 10, 20%.

If you’re like most people you probably guessed close to 20%.

The National Bureau of Economic Research sends out a survey asking investors this exact same question. They’ve been doing this for 26 years and on average the respondents put the chances of a market crash over the next 6 months at 19%.

Just like overestimating airplane crashes the average investor is overestimating the odds of a market crash. From Mark Hulbert’s piece in Barron’s Stop Worrying About the Stock Market Crashing.

Xavier Gabaix, a finance professor at New York University, has derived a crash-frequency formula that he believes captures a universal trait of all markets, not just equity markets or those in the U.S. According to that formula, the odds of a 12.8% crash in any given six-month period are 0.92%, almost as low as the actual frequency in the U.S. stock market over the last century.

Why do we drastically overestimate the odds of plane crashes, stock market crashes, and other catastrophes?

Availability Heuristic

The Availability Heuristic is another important quirk in our thinking processes. When we asked you about the chances of a plane crash or a stock market crash did you compile all of the relevant data to mathematically derive your answer? Probably not. That is a lot of work.

What your brain did was substitute the hard question with an easier one, “How easily can I recall past events?”

You could easily recall recent plane crashes and stock crashes and these became the most relevant data to answer the question.

The more salient the event the more attention you pay to it and the more easily that event is recalled from memory. Plane crashes and stock market crashes are extremely salient events receiving national multi-day coverage. When asked about them you easily recall past disasters and then overestimate their likelihood in the future. What you do not recall are all the non-events. All the flights that made it to their destination safely or all the days, weeks and months when stock markets are calm.

The more recent an event has occurred the more were likely to overestimate its chances too. When stock markets have experienced a period of losses right before the National Bureau of Economic Research survey has been sent out, respondents increased their odds of a market crash. The same effect happens when the news and other media talk more about market losses or use the word crash.

Stock Crashes – A Red Herring Risk?

Perhaps most damaging is the red-herring effect that the availability heuristic often provides. Investors focused on the small but dramatic risks of a market crash, often miss the more nuanced risks being realized right in front of them. Take the investor worried about a market crash; he chooses to shift to the safety of cash until “things calm down”. His cash earns nearly zero so immediately inflation begins eating away at his purchasing power. This is a risk with a near 100% certainty of happening.

Even worse, however, is that by going to cash he has eliminated from his portfolio the opportunity for upside. If the great crash doesn’t come to fruition he must make a decision: buy back in at higher prices or continue to wait for the crash while his cash savings are eroded by inflation. Neither is a good decision and both are wealth destructive. In one case inflation continues to slowly eat away at his wealth, in the other he sold low and bought high.

Of course, a third option is that he is right about the pending crash and times his exit near the top. Now he has a second decision, when to re-enter? If he is like most investors, he will wait until markets are calm again (i.e. at higher prices) so while he avoided much of the downside it was ultimately for nothing. Additionally, if he sold dividend paying investments when he went to cash then he missed out on the additional cash flow these investments provide.

It is for this reason that of our firm’s five core principals we rank Asset Allocation number one. If you can’t sleep at night because of your portfolio’s volatility, it may mean you have too much invested in stocks and should re-evaluate your portfolio strategy to include more conservative non-stock assets. Alternatively, it could mean that your asset allocation is just fine but your are being held hostage by the availability heuristic. In either case, tune out the financial media (which tends to exaggerate market events to attract viewers) and call us to determine if any changes to your strategy are in order.

We can never fully remove our biases or gain control over our irrational thinking processes. What we can do is be aware of them. When we have to make important decisions, it is important to slow down and review our decision-making process. We need to ask ourselves if we’re making a rational decision or one based on emotions.

Stock markets will decline. It is a normal part of a functioning market, and a critical part of the risk-reward dynamic in investing. There can be no reward without risk. Another of our core investment principles is “the price you pay determines your return”, so market declines should be viewed through the lens of opportunity since they allow investors the opportunity to buy lower thus increasing their long-term return potential.

Dividend Stock in Focus

Pepsi, Inc. (PEP): $103.66*
*price as of the close June 9, 2016

When you hear Pepsi you probably think soda. A soda originally called Brad’s Drink which was a mixture of pepsin (a digestive enzyme), kola nut, vanilla, and sugar.

But Pepsi is now so much more than Soda. Today, Pepsi owns 22 well-known brands that each generate over $1 billion in revenue

Click image to enlarge.
Click image to enlarge.

Pepsi owns a lot other brands outside of soda too, including Sabra Hummus, Naked Juices, and Stacy Pita Chips.

Not bad for a company that went bankrupt twice during the early 20th century and was almost bought by Coca-Cola three times during the 1920s and 1930s.

Dividend History:

Over the last 10 years, Pepsi has grown their annual dividend at a compound annual rate of 9.05%. Pepsi has been paying and growing its dividend for 43 years. The foundation for your dividend growth portfolio is dividend stalwarts. Companies like Pepsi with well known and loved brands that stand the test of time. This allows a company like Pepsi to maintain pricing power and grow their dividend year-in and year-out.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

Catalysts for Dividend Growth and Price Appreciation:

Frito Lay

Pepsi’s future is more about food than soda. The crown jewel of Pepsi’s food business is its Frito-Lay division. Frito-Lay generates 23% of Pepsi’s revenue but it contributes over 39% to Pepsi’s operating profit.

The snack business is growing while Pepsi’s carbonated drink business is under pressure. More on this in the Pre-Mortem below. In North America, Frito-Lay commands a 25% market share while none of its competitors have a market share higher than single digits. Frito-lay also sports industry leading operating margins.

Operational Efficiency

A couple years ago Pepsi attracted a large activist investor in Trian Partners, run by Nelson Peltz. One of Trian’s main points was that Pepsi’s food business was subsidizing Pepsi’s beverage business. The food business was growing with large operating margins. The beverage business, mainly soda, was shrinking and had lower margins than food. The other point was that each business, both food and beverage, had its own corporate structure and then there was the added layer of the overarching parent corporation’s operating structure. Pepsi’s corporate structure was too bloated. The food and beverage businesses we’re not operating in tandem to reduce overall corporate costs.

The presence of the activist investor motivated Pepsi’s top management to push for greater synergies between its two businesses and to reduce costs at every level. Pepsi is currently about $5 billion into a $9 billion cost savings plan. Better operational efficiency means less capital is needed to reinvest back into the business to help it grow. This leaves more cash for Pepsi to buy back shares and increase its dividend.

Pepsi already generated high returns on capital and equity but after the recent initiative by management, returns have crept upwards as margins have improved too.

Data from S&P Capital IQ. Click image to enlarge.
Data from S&P Capital IQ. Click image to enlarge.


We first started buying Pepsi for clients in January 2012. At the time, Pepsi was cheap on an absolute basis and extremely cheap when compared to other companies with similar portfolios of valuable brands. Pepsi’s low price combined with such valuable brands made it an attractive target for activist investors.

Trian Partners took a large stake in Pepsi and then authored a white paper on why the company should be split into two, a drink business and a snack business. Pepsi pushed back on the break-up but worked with Trian Partners in achieving cost savings and improving operations. Trian’s activism ended last month, May 2016, when they sold their shares in Pepsi after a couple years of very good gains.

Even though Trian Partners is out and no immediate catalyst exists for splitting up Pepsi, the possibility still exists. As we’ll discuss below in the Pre-Mortem, soda consumption habits are changing and if carbonated drinks become too much of a drag on the true value of Pepsi’s snack business then the two companies should be split up.

Or Merger?

The other possibility is Frito-Lay buying another food company like Mondelez (MDLZ). It would be a combination of Mondelez’ portfolio of sweets with Frito-Lay’s portfolio of salty food.

Mondelez is the international business of the former Kraft. Mondelez formed when Kraft split itself into two businesses. At one time post spin-off, Mondelez was viewed as the better company to buy but it has struggled lately. Mondelez has attracted its own activist investor, Bill Ackman, and the odds are he will push for a sale of the company. The only two contenders right now to buy Mondelez are Pepsi and Kraft Heinz (KHC), another portfolio holding.

A merger of this magnitude would fundamentally change Pepsi’s operations and it would most likely lead to a spin-off of the beverage business so that Frito-Lay can focus solely on its larger food business.

Nelson Peltz and Trian were big proponents of Pepsi buying Mondelez but they just sold their shares. Trian still has a person on the Pepsi board but Trian’s sway in matters is greatly reduced. The other proponent for a sale of Mondelez would be Bill Ackman. Bill is currently distracted with two other large positions that are deeply hurting his fund. A short position in Herbalife (HLF) and a long position in Valeant Pharmaceuticals. Herbalife and Valeant have hurt Bill Ackman’s fund so much that he has sold off some of his stake in Mondelez to help regain control of his portfolio.

The likelihood of an activist lead merger is dimming but it could still be championed by current management.

Pre-Mortem (Potential Risks to our Thesis):

Changing Consumer Drink Tastes

Soda consumption is on the decline in most developed markets. In the U.S. soda consumption has been declining for the last 11 years. Lead by diet sodas.

Chart courtesy of The Wall Street Journal. Click image to enlarge.
Chart courtesy of The Wall Street Journal. Click image to enlarge.

Snacks are the crown jewel of Pepsi right now but beverage sales are a large generator of free cash flow for Pepsi. This free cash fuels dividend growth and share buybacks. Decreased demand will affect Pepsi’s overall growth and the growth of its dividend. Soda is essentially the new cigarette. Can Pepsi and other soda companies raise prices to offset volume decline like the tobacco companies do? Can Pepsi and other soda companies reduce costs and improve efficiencies like tobacco companies to keep growing free cash flow?

Like cigarettes, soda is now facing demands for taxes to reduce its consumption.

Sugar Tax

Excessive sugar intake is considered to be one of the reasons we are seeing higher rates of obesity and diabetes. It is not the only reason. Like a lot of health issues, it is a combination of factors but that doesn’t stop policy makers and activists from singling out one item as the root cause. In a gross oversimplification of a larger problem, sugary drinks, most notably soda, have been labeled as the main culprit for higher obesity rates.

The solution put forth is to tax soda in the hope that higher costs will lower consumption. Higher tax rates have helped lower smoking rates in the U.S. Recent reports out of Mexico show a decline in soda consumption after the implementation of their soda tax. It is still too early to tell if this is causation or just correlation. The main goal is lower obesity rates. Reduction of calories from one food source is usually replaced by another. If that new food source is full of added sugar than nothing changes. Likewise, no study has yet shown a decline in obesity rates after an introduction of a soda tax.

The absence of clear factual data has never stopped public policy makers from making large decisions before. There is a good chance we will see more and more soda taxes. The higher cost of soda will likely effect Pepsi’s carbonated drink business for the worse.


When we first bought Pepsi we believed the company was undervalued. The discrepancy between price and value did not last long, especially when Trian Partners got involved. Since then Pepsi has traded at or slightly above our estimate of fair value which has made it tough to continue to add to our position. We currently value Pepsi at $105 per share. Even the news of Trian Partners selling their stake in Pepsi hasn’t taken its share price down far enough to where we would like to buy more Pepsi. Newer accounts may not have exposure to Pepsi, yet. As soon as Pepsi trades at a big enough discount to our estimate of fair value we expect to add to the position.

All previous letters are archived here.