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A Secret Recipe: Pepsin and Kola Nuts
First introduced in North Carolina as “Brad’s Drink” in 1893 by Caleb Bradham, the name was changed to Pepsi-Cola in 1898 mainly because of Pepsi’s secret ingredients. Digestive enzymes named pepsin and kola nuts were used in the creation of this special drink. However, when Bradham unsuccessfully speculated on wildly fluctuating sugar prices (shown below), the company faced bankruptcy.
A series of buyouts and structural re-organizations occurred between 1922 and 1934. In 1931, the National Pepsi-Cola Co. reorganized as Pepsi-Cola Co., selling its assets to Roy C. Megargel. After Megargel also failed to make Pepsi-Cola Co. profitable, he sold the company to Charles Guth, President of Loft, Inc. Loft, a candy manufacturer and retailer that owned Happiness Candy Stores had been around for 20 years prior to acquiring Pepsi . The Loft-operated Happiness Candy Stores had soda fountains and saw the marriage as a good fit.
Pepsi– Rejected by Coke, Acquired by Loft
Losses and Loft Suits
Where there are losses, there are law suits. Claiming that the companies had been mismanaged, shareholders sued Happiness Candy Stores, Inc. as well as Loft, Inc. Loft, Inc. sued Guth since he had used the finances and facilities of Loft, Inc. to help Pepsi-Cola, Co. succeed.
Guth not only increased Pepsi’s profits by selling the syrup to his former employer, but he made one of the most brilliant marketing decisions in history. He had the excellent idea of packaging Pepsi-Cola in twelve-ounce bottles rather than 6.5 ounce bottles while keeping the price the same at five cents. Coca-Cola and other soft drinks were then sold in 6.5 ounce bottles at the same price. Guth introduced the clever jingle “Pepsi-drink for you”. As a result, Pepsi’s sales increased and profits doubled between 1936 and 1938. Pepsi stock soared, rising one-hundred-fold within two years, as shown in the chart below:
Loft, Inc. may not have been able to run a candy business or a candy store business profitably, but they did know how to win a lawsuit. When Guth v. Loft, Inc. was decided in Loft’s favor, the company was saved. The real question was how to turn all of these law suits for and against Loft, Inc. to the company’s advantage. E. A. Le Roy Jr., President of Loft, Inc., made a series of brilliant moves that not only resolved all of the law suits, but put Pepsi on the road to becoming a hundred-billion dollar company.
First, Le Roy spun off the Happiness Candy Stores, Inc. He eliminated the $1.5 million owed to Loft, Inc. by Happiness Candy Stores, Inc., absorbed the candy store, of which the company owned over 70%, then spun the company off to shareholders as Loft Candy Stores, Inc. The loss-making candy business was eliminated from the company.
Compare this performance with that of Loft, Inc. whose stock had fallen from $25 in 1919 to $2 when the company established its 80% ownership of Pepsi-Cola, Co. The stock rose to $22 by the time the reverse acquisition of Pepsi-Cola Co. occurred on June 30, 1941. The story of the Happiness Candy Stores was similar, with its stock falling from $25 in 1919 to $0.125 in 1941 when the company ceased to exist.
Today, Pepsi is one of the strongest brands in the world. Had it not been for the decisions of Charles Guff and E. A. Le Roy Jr., Pepsi might have met the same fate of Loft Candy, to become something you only read about on the Internet. Of course, PepsiCo had to make many good corporate decisions over the past 75 years to bring the company to the point it is at today, but you have to admire the way Guth and Le Roy turned around a loss-making company to become one global giant. Along with Coca-Cola, Pepsi dominates the soft drink business worldwide and shows no signs of slowing down.
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The Impact of Hyperinflation
Interest rates at that level can only occur because of inflation. The problem is that as inflation rates rise, they become more unstable and unpredictable. Consequently, the maturity of debt instruments shrinks as the uncertainty increases. Annual interest rates become meaningless, and the maturity shrinks to months or days. What about 3% per week? At this level, the compounding of interest rates takes over. An interest rate of 3% per week works out to 365% per annum. Interest rates rose significantly beyond even this level during the German hyperinflation of 1923. The interest rate charged at the Berlin Stock Exchange in October 1923 hit a high of 7950%, the equivalent of 9% per week. Although this interest rate is high enough to even make a Payday Loan store blanch, it didn’t even come close to compensating for the inflation that occurred in October 1923. The monthly inflation rate in Germany during October 1923 was 24,380%, which far exceeded the 45% monthly interest rate implied by the 7950% interest rate the Berlin Stock Exchange charged. During that month, the US Dollar exchange rate went from 242 million Marks to the USD on October 1, 1923 to 100 billion Marks by November 1, 1923.Investors and Speculators Get Wiped Out
At these levels of hyperinflation, interest rates become meaningless. When prices are rising at the rate of 30% per day, as occurred during Germany in October 1923, fixed-income assets are completely wiped out by the inflation, and no one will deposit or lend cash that will become worthless in a few days. During hyperinflations, the future ceases to exist and cash becomes the only medium of exchange as the value of assets with a maturity over a few days is completely wiped out. Interestingly enough, government bonds rose in price along with inflation during 1923 in Germany. The German 3% bond paying 3 marks in interest actually traded for 37 million Marks in September 1923, right before the inflation came to an end. This provided a yield on the bond of less than one-ten millionth of a percent (i.e. 0.0000001%). The price on the bond had risen from 475,000 Marks just one month before, and a chart of the stock is illustrated below.
Why, you might ask, would someone pay 37 million Marks for a bond that pays 3 marks in interest? The answer is easy, speculators were hoping that once the inflation was over, the government would redeem the bonds at their inflation adjusted value. The people buying the 3% Perpetuities of Germany thought the government would revalue the bonds providing them with both a hedge against hyperinflation as well as a huge profit.
The German government decided that all outstanding bonds would be redenominated at one-tenth Pfennig on the Mark. In other words, a government bond that had originally been issued at 100 Marks was now worth 10 Pfennig. In effect, investors lost 99.9% of their investment. The price of the bond traded up from there to reflect higher interest rates after the inflation was over with, but the difference was small.
The German bonds also traded in London where the price reflected the devaluation of the currency. The value of the bonds on the London Stock Exchange fell from 100 Pounds to 5 shillings (25 pence), a loss of almost 99.9%.
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As can be seen by the chart, the Emerging-Developed Equity Cycle lasts around seven to ten years. Developed markets outperformed Emerging Markets from 1945-1968, 1979-1986, 1994 to 2001 and since the beginning of 2010. Emerging Markets outperformed Developed Markets between 1968-1979, 1986-1994, and from 2001 to 2010.
We are now four years into the current market cycle. Based upon the past, you would expect the current underperformance of Emerging Markets to continue until 2017 or 2020 at the latest when the trend would reverse itself.
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