Description

A number of money managers have recommended purchasing Treasury Inflation Protected Securities (TIPS) on the expectation that inflation will pick up in the near future. I propose that instead of buying TIPS, buy Coca Cola stock at its current price and treat the dividend as a Coke Inflation Protection Security, or CIPS for short – a term I coined, so it’s unlikely to be mentioned elsewhere.


CIPS vs. TIPS

Yield

Coke’s current dividend yield is approximately 2.5%, whereas 10-year TIPS are currently guaranteeing approximately a 2.0% real return over inflation. Even if Coke’s volumes remained flat ad infinitum, which is unlikely even in a worst-case scenario, they still have undeniably strong pricing power that has historically surpassed the rate of inflation. In this unlikely situation, CIPS would generate a minimum of 2.5% real return, easily surpassing the TIPS return. But if we look at a more likely scenario, CIPS yields look much better. Over the past five years, Coke has definitely struggled, but its dividend has increased an average of 8% during this time, far exceeding inflation. If we consider a scenario of 2% yearly volume increases plus cost savings due to economies of scale, it is not unrealistic that CIPS could yield a 5% return over inflation or more long term, even using these relatively conservative assumptions.


Taxes

CIPS win hands down when it comes to taxes. TIPS are taxed at a taxpayer’s ordinary rate – up to 35%; plus the phantom inflation component is also taxed, even though the investor doesn’t receive this money until the TIPS matures. CIPS real returns (i.e., the dividends) are taxed at a maximum of 15% and the “inflation” component (i.e., capital gains from a share price increase) can be deferred indefinitely; or if the shares are sold, capital gains are taxed at a maximum of 15% as well.


Share Repurchases

Historically Coca Cola has generated enough free cash flow to not only support its dividend, but also repurchase enough shares to fully counter all options issued plus reduce outstanding shares. This effect can also increase real returns in the long run because more dividend income is available to fewer shares. Also, keep in mind that virtually all Coke options are currently far underwater; the only way options become an issue near term is if there is a substantial increase in KO’s shares, an enviable “problem”.


Maturity

Unlike TIPS, CIPS don’t have a maturity date, but this may actually be an advantage. The only time an investor wants a bond to mature is when there are better opportunities elsewhere (i.e., interest rates have gone up). For example, during 2000, 10-year TIPS could be purchased that had a real yields over 4%; investors who bought them then and still own them aren’t eager for them to mature, given today’s interest rates. If the economy shows strength, CIPS have the ability to increase their real returns due to increased profitability, whereas with TIPS you’re stuck with 2.0% for the life of the bond.


Liquidity

Both TIPS and CIPS have ample liquidity for most investors.


Why Coca Cola?

Why not pick a stock with a higher dividend yield? In my judgment, in order for this strategy to work with a risk comparable to TIPS, a stock must pass several strict criteria. The company must have strong pricing power that can at least keep up with inflation; its business can’t be significantly affected by adverse economic conditions; it has to have a long history of dividend increases in all economic environments; it has to generate a surplus of free cash flow so the dividend can be maintained even if there is a dip in earnings; and it has to have a solid credit rating in case the company needs to borrow during difficult economic circumstances or for growth. Coke easily passes all of these criteria, but very few other companies do. A few come to mind – Pepsico, Procter and Gamble, and Wrigley – but all currently have lower yields than Coke.


I realize Coca Cola isn’t a new idea, or at least not one you’re unfamiliar with (though ironically it hasn’t been presented here before). At a minimum, perhaps this post will inspire you consider an alternative for long-term income that is hedged against inflation. In addition, even if you don’t buy the CIPS concept, KO is selling near an 8-year low at a PE that is slightly below the S&P 500; arguably, the stock is a bargain at this price.

Catalyst

Long term real income idea that is an alternative to TIPS.