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Buffett Says to Smile on Pepsi

John Reese

The stock market, like life, can be filled with ironies. Warren Buffett's long-term love affair with Coca-Cola (KO) is well known. His investment vehicle, Berkshire Hathaway (BRKA), has owned Coke stock for decades.

Until last year, Buffett himself sat on Coke's board. But when I look at him, or at least, when I'm using my strategy based on his approach to investing, I see all the bubbles going Pepsi's way. According to my analysis, Coke's archrival PepsiCo (PEP) meets the Buffett strategy's criteria for buying, while Coke has gone flat.

Not surprisingly, things aren't also as simple as black vs. white, or Coke vs. Pepsi.

The complication here is that while the two are fierce competitors in the drink marketplace (Coke vs. Pepsi, Sprite vs. Mountain Dew, Dasani vs. Aquafina, Minute Maid vs. Tropicana, Diet Coke vs. Diet Pepsi), drinks only provide about 37% of PepsiCo's business. The bulk of the rest (nearly 60%) comes from a market Coke doesn't even seriously compete in, namely, salty snacks. PepsiCo's biggest business is its Frito-Lay division, which makes Lay's, Fritos, Ruffles and Doritos.

As tasty as the irony of the Buffett strategy favoring Pepsi over Coke may be, the more important factor is that it is telling investors that this is a good time to take a gulp of PepsiCo. Plus, there's a second guru strategy, based on the writings of Peter Lynch, which also thinks PepsiCo is the current generational leader. First, let's look at what the Buffett has to say about the company.

The Buffett Strategy

PepsiCo, with its strong brand names and dominant market positions, is certainly a Buffett-type company. Also in its favor is its predictable earnings growth. In eight of the past 10 years, EPS has increased. Further, EPS growth over this period has averaged 18.9% annually and is expected to grow 11.1% a year in the future, based on the analysts' consensus estimated long-term growth rate.

The company also has an acceptable amount of debt. Earnings are more than double debt, which means the company could pay off its debt within about six months if it wanted to. That's mighty impressive.

The strategy likes companies with an average return on equity of at least 15%; PepsiCo's average over the last 10 years is nearly double this at 29.2%. The strategy also wants ROE for the last three years to be above 15%, and in PepsiCo's case, it has been 31.1%.

Average return on total capital over the last 10 years is also nearly double the strategy's minimum (22.5% for PepsiCo vs. the strategy's 12% minimum). The company also earns kudos for having a positive free cash flow per share. Management gets accolades because it has earned shareholders 20.6% a year on earnings retained over the past 10 years.

All of these figures say that PepsiCo is performing well financially. The final step is to determine if the stock's price is low enough to generate a decent return to investors. The strategy has two different approaches to projecting the rate of future stock appreciation. One calculates the rate of return and compares it to the long-term Treasury yield, while the second calculates future EPS. The two approaches are then averaged, and the result needs to be about 15% a year or more to be acceptable. PepsiCo's expected rate of return is 14.9%, which is just fine.

The Lynch Strategy

As I mentioned earlier, the Lynch strategy also thinks PepsiCo should wet your investment whistle. With growth of 18.94%, PepsiCo is a "true stalwart," meaning its growth falls within the 10% to 19% range. The company's yield-adjusted P/E/G ratio (P/E relative to growth) is an acceptable 0.90 (1.0 is the maximum allowed). And the company's debt, as measured as a percentage of equity, is a nice 18.38%. These are among the major variables the Lynch strategy looks for when deciding which true stalwarts to recommend.

Buffett may have extolled Coke's virtues for many years, but today he should be paying more attention to PepsiCo. The company is performing extremely well, its stock is reasonably priced and its snacks ... well, as it has been long known, you can't eat just one.