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Stock Strategist

A Paired Trade Idea in Soft Drinks

Hedge the next market swing with our paired trade idea: long Pepsi, short Hansen

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 PepsiCo (PEP) is undervalued, as the market is fixated with the floundering soft drinks business. PepsiCo is trading at an historically wide valuation discount to its great rival  Coca-Cola  (KO). Over the last five years, Coke has traded at median and mean forward P/E ratios of 18.0 times and 17.9 times, respectively, while Pepsi has traded at 16.5 times and 17.2 times, respectively. Today, that valuation gap has widened While Coke still trades at around 18 times forward earnings, Pepsi has been trading in a range of between 14 and 15 times for several months. We think that falling unemployment and Pepsi's rebranding efforts could provide a catalyst for that valuation gap to close later this year. We think value investors should take a close look at Pepsi, while growth investors may like the emerging markets story. Dividend investors may be interested in the 3% yield.

Will Overseas Investments Keep Profits Fizzing?
Coke is investing more in emerging markets, which could justify a higher multiple. As shown in Exhibit 1 below, the company has stated it will invest $20 billion in four emerging markets over the next decade, a theme repeated by management at the meeting. This investment is more than Pepsi's $15 billion, and represents a commitment to long-term growth that could justify a slightly higher multiple, particularly as Coke already has leadership positions in most markets. We think the $12 billion investment in Africa could yield the highest payoff. With a population of around 1 billion people, around 65% of whom are under 25 years of age according to the World Health Organization, a GDP of $1.6 trillion in 2009, and per capita consumption below the global average, the continent offers the Coca-Cola Company years of growth. We're told that the investment in Africa will increase the firm's manufacturing and distribution footprint, particularly in noncarbonated categories. The 1,200 distribution centers that will be built in 2011 should help make distribution more efficient.

Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.