Passing The Potato Chips

December 5th, 2011


If you have any nuts at your house (the edible variety, not your next of kin), then you may be familiar with a company called Diamond Foods (DMND), a purveyor of walnuts, almonds, and other snack foods. Diamond's stock started 2011 trading at about $53 per share. Then, in April, the company announced its plans to purchase the Pringles brand of potato chips from Proctor and Gamble (PG). This caught the attention of Wall Street and sent the shares rocketing higher over the next five months, eventually trading above $90 in mid-September. The thinking was that the Pringles acquisition could more than double Diamnond's sales and position the company as a smaller version of global snack-food behemoth Frito-Lay (owned by Pepsi, PEP). 

Then the chips hit the fan. Diamond announced in the fall that they were conducting an internal investigation of some accounting practices involving how the company paid its walnut growers. Investors don't like accounting problems, so they started dumping the stock. In November there was a news report that Joseph Silveira, a member of the company's board of directors and audit committee, had died. CNBC subsequently reported that Mr. Silveira's death was, in fact, a suicide. Diamond stock closed Friday (December 2nd) at $29.30, and the Pringles transaction has been postponed until some time in 2012.


Any suicide is a tragedy, and it is certainly possible that this one had nothing to do with developments at Diamond Foods. However, as an investor (not in Diamond Foods, thankfully), I have come to appreciate the "cockroach theory" of bad news. If you see one cockroach on your kitchen counter, that probably means there are hundreds more living behind the walls. When investors get a whiff of "accounting issues" they tend to assume there is more to the story, and they head for the exits. In fact, more cockroaches have already surfaced in the form of some class action lawsuits that have been filed against Diamond by some shareholders.

Not surprisingly, short sellers have also pounced on the stock. Short selling is the practice of selling a stock that you don't actually own to profit from a decline in the share price. Here's how it works. Let's say that XYZ stock, which you do not own, is trading at $50 per share, and you are convinced that it is overpriced. You enter into an arrangement with your broker to sell short 1,000 shares, which your broker will "borrow" to deliver to the buyer of those shares. You receive $50,000 as the proceeds of that sale. If the stock trades as you predicted and falls, say, to $30 per share, then you buy 1,000 shares to return the shares you borrowed, but that trade is costing you only $30,000. You just made $20,000 profit. However, if the stock goes to $70 instead of $30, you have lost $20,000, because you ultimately have to buy 1,000 shares. So, stocks can fall quite violently when the short sellers get involved, because in addition to the investors who are selling shares they actually own, you have additional selling pressure from traders who are selling shares they don't own. An important thing to remember about this, from a trading perspective, is that short selling creates future buying pressure. If Diamond stock rallies from its current price, you will probably hear the commentators saying that this is due to "short covering," which refers to investors buying the stock to close out their short positions.

Is it possible that Diamond shares are a buy here at around $30 per share? If it turns out that all of this is about nothing more than some arcane but legal accounting practices, and the company can explain this with clarity and transparency,  then perhaps the stock could get on the road to recovery. Remember, though, that the meteoric rise in the stock was predicated on the Pringles deal. If Diamond plans on paying for Pringles with some of its own stock, that currency is worth quite a bit less than it was a few months ago. Would Diamond have to take on more debt to make this work? And what about those lawsuits? I consider the stock "toxic" until we get some explanations and resolutions.


A stock I do like here is that of the company on the other side of the Pringles transaction, Proctor and Gamble (PG). PG is not likely to make you rich, but it is the type of stock that I believe has a place in most diversified investment portfolios, for several reasons. Because PG is in the consumer staples sector, it has a relatively low Beta (.60). Beta is an index number that measures how a stock's price is correlated with the overall market and is calculated using regression analysis (how the stock and the market have moved together in the past). A Beta of 1.0 means that the stock tends to move in lockstep with the broader market; a Beta greater than one suggests the stock will move in the same direction as the market, but with greater magnitude, and so on. PG's relative stability derives from the nature of the products it sells. In hard economic times, people will postpone purchases of consumer discretionary items such as new cars and vacations to Disney World [Ford (F) has a Beta of 1.50, Disney (DIS), 1.05], but they are likely to keep buying PG's products--Tide detergent, Pampers diapers, Gillette razors, Olay skin care products, to name a few. The flip side, of course, is that I am not going to buy more razors or paper towels just because the economy is stronger and my income goes up. Investors tend to favor such stocks when the economic outlook is questionable, but these stocks are likely to under-perform the market when the economy is stronger. 


Another thing I like about the stock is its dividend. At about $65 per share, PG has a dividend yield of just under 3.3%. That's pretty compelling when you consider that the yield on the 30-year U.S. Treasury bond is right at 3%. Even more important, though, is that PG has the very welcome habit of increasing its dividend every year (at least it has in the past, for years). The U.S. Treasury, or any other bond issuer for that matter, is not going to increase the interest it pays you while you own their bonds. PG's dividend payout ratio is just about 50% of earnings. This means that the dividend is well-covered by the profits PG makes and that they still have money to invest in new products and other areas of growth.


Regarding PG's sale of Pringles, it is worth noting that this is maybe the last move in a years-long strategy of exiting the food business. PG once owned such brands as Folgers coffee (remember Mrs. Olsen?), Jif peanut butter ("Choosy moms choose Jif"), and Crisco oil and shortening. PG sold those brands so it could focus more on higher-margin personal care products (Gillette, Olay), so the Pringles sale makes sense.


I'll be writing more about dividends in particular and many other investment and economic topics in upcoming posts. As they used to say at the end of PG's soap operas, "tune in again." And remember: Life is short, so get busy.


Jim


Disclaimer and Disclosure: This blog is not intended to serve as specific investment advice. Individual stocks are mentioned here to illustrate various investment concepts and to serve as starting points for interested investors to pursue additional research. My family members and/or I own shares of PG, PEP, and DIS.