Rule Maker Portfolio
Time to Shore Up the Defense
ALEXANDRIA, VA (Sept. 27, 1999) -- Today, I'm going to complete my recent Coca-Cola trilogy (September 20 Rule Maker and September 24 Fool on the Hill) with my screed explaining why the Rule Maker Portfolio's next $500 investment should go to shoring up our position in the true Breakfast of Champions. Big Red. The Real Thing. Coca-Cola (NYSE: KO).
More specifically, I am going to try mightily to make the case that the big fat loser of the Rule Maker port is the best place to derive long-term value at the current price levels. How? Well, I don't know yet; I'm reading along with you.
Even in the context of an ugly year for Coke shares, this past month the market punished the company in a particularly vindictive manner, dropping it by almost 22% in the past 30 days. This has come on the tail of reduced earnings, debilitating health scares in Belgium and Poland, and potential sanctions by the European Union for non-competitive practices. It hasn't been too much fun holding Coke stock this year.
But what effect do these short-term issues have on the overall status of Coke as a Rule Maker? None at all, really. Coincidentally, "none at all" is the exact amount of compunction I have in suggesting that Coke provides the best "value" of any Rule Maker at the current prices. And no, it's not just because Coke has lost the most for us in the portfolio.
Let's look at some metrics important to the Rule Makers. For the Foolish Flow Ratio, Coca-Cola has remained stable from last year to this year, with a solid 1.04 in 1998 to just above 1.06 for 2nd Quarter 1999. At least one Rule Maker has a consistently better Flowie -- Rule Maker King Microsoft, with its cash-rich balance sheet clocking in at a consistent 0.029. Even so, Coke is still doing a better cash management job than almost every other company in the world, and it's not doing such things as padding sales numbers through increased inventory or accounts receivable, two of the four horsemen of the balance sheet apocalypse. (Guess the other two and win a free subscription to the Rule Maker daily column!)
But no one is really arguing that Coke is doing a poor job of managing its cash. Coke is being punished for its perceived reduction in growth prospects, manifested in its decrease in earnings for the last two quarters. Therein lies the rationale I suggest we take in resisting the tendency to act like all the other lemmings. Mr. Market is a known manic-depressive, so do we believe him this time or not?
I say no. Coca-Cola, as I discussed in last week's column, has responded in an extremely effective way to market pressures that would punish any company deriving more than two-thirds of its revenue from outside the United States. But, just as every company should be valued upon its future earnings potential, our purchase decision should be made by taking a look at those potential earnings and then deciding if the current stock valuation gives us sufficient margin of safety. In effect, it is Foolish to take advantage of the Market's foolishness (small f).
Yes it is.
Coke, as we discovered last week, has not seen a decrease in its net margins commensurate with such a punishing drop in share price. In fact, as we discovered last week, the most negative thing we can say about Coke's current earnings is that they are stagnant in trend whereas through 1997 they grew consistently at an average of 11% over the decade. But again, have the 1990s seen anything like the wrenching economic losses in Asia and Latin America last year? Some would argue that the LAST Latin Crisis would rate mention, and so there, I mentioned it. But it was several orders of magnitude smaller than what we have endured over the last two years. And Coke responded to the crisis in a way that increases its book value, its goodwill value, and eventually, once the smoke clears, its distributive power.
Namely, Coke responded in Indonesia, for example, by taking advantage of cheap labor and local capital and expanding its bottling and distribution facilities. It expanded facilities in China, Russia, and Japan. It signed up new bottling partners. And most importantly, it did not abandon these countries even when it was suffering significant operating losses in them due to the turmoil. In fact, over the last year Coca-Cola increased its marketing budget in several of the countries hit hardest economically. Throughout all that, Coke still only suffered a 15% drop in net profits in 1998 from the previous year. For a company that derives 56% of its sales in developing countries, that is perhaps the most important number to focus upon.
There is one further item for consideration: Even though I do not put too much currency into the wider concept of "asset allocation," I do believe that the DRIPers get this right. Simply, they pick excellent companies, and send a certain amount of savings to them on a regular basis. So, DRIPers are usually quite satisfied when their company's share price gets hit, because they then derive a larger number of shares for the same amount of money.
The Rule Maker Portfolio has 41% of its value held in three companies: Microsoft, Cisco, and Gap. These companies have performed the best over the life of the portfolio. But that, in effect, has not been very long. Right now, we have the chance to add to our Coca-Cola holdings at a price far below where the company has traditionally been valued in regard to its P/E. We should take advantage of this discount; it provides a cushion of safety in one of the world's top brands of a scope we have not seen since the portfolio was launched.
The market has given us an opportunity with this company. We need to take it.
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