ERIC SCHOENSTEIN
CO-PORTFOLIO MANAGER
THE JENSEN PORTFOLIO

COMPANY: PepsiCo
TICKER: PEP (NYSE)
PRICE: $59.25 (as of 4 p.m. yesterday)
52-WEEK RANGE: $51.75-$60.34
MARKET CAPITALIZATION: $98.31 billion

Eric Schoenstein is a co-portfolio manager of the Jensen Portfolio (JENSX) with more than $2 billion in funds under management. PepsiCo last year had revenues of about $32.5 billion. Mr. Schoenstein spoke to David Dalley of The New York Sun about his investment philosophy and about why Pepsi is one of his top buys.

What does Pepsi do?

Their primary operations are in beverages and branded snacks, most of which are very well known. Both of those have a domestic and an international presence. The other branded area that people might be familiar with is the Quaker foods.

Why do you like the company?

We look for what we consider to be high-quality growth companies – i.e. those that generate consistent growth in free cash flow at levels above their cost of capital, in other words ‘redundant’ cash flow. They can use the cash to invest and grow, and also to fund dividend growth.What we’ve found historically and through research is that if we invest in those companies that are consistently growing their redundant free cash flow over time, and if we pay a good price and hold onto them, then the markets tend to generate a return similar to the growth in free cash flow.

Our criteria for a company to come onto our radar is that they have to have generated a 15% return on equity every year for 10 years.That’s a pretty high hurdle. Only about 170 companies in the U.S. qualify. We’ve got a pretty limited universe of what we call quality growth companies, and we’ll only invest in the 25 best in that group,those with the most consistency and best predictability.

Why is Pepsi in your top 25?

The thing we really like is the terrific diversity of Pepsi’s product profile. There are beverages and snacks, and they both have local and international markets.The company has what I’d call a wide economic mote. It can withstand all sorts of economic changes anywhere around the globe. It has about 16 different brands and it generates over a bil lion dollars in revenue. That’s a pretty powerful statement on the development on their products.

One of the things we like the most is the potential for international growth. Internationally (particularly in China, Russia, and India) there are still tremendous opportunities and unlike Coke, which has always had strong international distribution chains, Pepsi has only just begun to tap into all that. In 2005, Pepsi experienced over 20% growth internationally. It’s going to be a big driver over the next few years.

What about the fundamentals?

We don’t really look at things like P/E ratios as a method for investing. The market to us is really just a way to monetize the value of companies. We invest in the business, not the stock.We want to buy companies at a discount to their ultimate intrinsic value.

How do you determine if a company is trading at a discount?

We use a discounted cash flow model with a 10-year horizon and discount back. We then compare that to the current market price, and if we see a significant discount in our model then we consider the company for investment.

We first purchased Pepsi back in 2003, and continue to see it trading at a significant discount to its intrinsic value. We are patient investors, and we’ll typically hold a company for seven or eight years. So as long as the company continues to generate growth in its free cash flow (indicating that the fundamentals of the business are performing), the intrinsic value will rise.

We don’t have any target prices per se. Ultimately if the stock keeps performing like we want it to, we’d never sell. The key thing is to monitor management, and make sure that they continue to execute on the business strategy. Pepsi continues to meet our criteria very nicely.