Looking at Warren Buffett Investment in Coke

(Continuing on the wonderful compilation of Warren Buffett's sayings done by Bud Labitan called "The Warren Buffett Business Factors" but unfortunately the link I had recorded is broken.)

The true investor welcomes volatility. Ben Graham explained why in Chapter 8 of "The Intelligent Investor"

There he introduced "Mr.Market," an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two.

In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.

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The investor is totally free to ignore the market or exploit its folly.

Timeless advice. What the investor wants or rather the goal of the investor should be to exploit the folly of the market and buy shares of companies offered at irrationally low prices (due to the folly of Mr. Market) provided IF that share of the company is backed by a SOLID BUSINESS.

Paying a cheap price for an average business does not gurantee one success. The success comes from paying a cheap price for a solid business. Pay more, get less, Pay less get more

Simple and such commonsense advice.

The certainty with which the long-term economic characteristics of the business can be evaluated;

That perhaps is one of most important point Warren is saying here and Coca Cola was one of the most used example.

The following is Coke's actual earnings per share since 1983.

Year_____Coke's EPS
1983_____$0.17
1984_____$0.20
1985_____$0.22
1986_____$0.26
1987_____$0.30
1988_____$0.36
1989_____$0.42
1990_____$0.51
1991_____$0.61
1992_____$0.72
1993_____$0.84
1994_____$0.98

The long term characteristics of the business (Coke's) was best desribed as ...

Quote:

What was Buffett able to observe as he studied the long-term business prospects of Coca-Cola that others missed. Buffett's overarching strategic approach to equity investing was baffling to analysts who were focused on tactical market interpretations. Buffett was probably first impressed with Coke's consistent per share earnings growth that spanned a decade.

Looking at the table again, it is extremely clear to see that Coke had a consistant set of earnings and that one could note that it was also growing at a steady rate for the last 10 years. This, according to Warren, was the certainty in which the long-term economic characteristics of the business can be evaluated.

In Mary Buffett's second book, The New Buffettology , she dwelves a lot deeper on this competitive edge and in fact she terms it as Durable Competitive Advantage. (pg 56)

... Warren likes to use the castle-and-moat analogy. Pretend that the business in question is a protective moat we'll call its competitve advantage. The competitive-advantage moat protects the castle from attack by other businesses, such as attempts to lure customers away. It can be as simple as a brand name. If you want to eat a taco Bell Chalupa you have to go to Taco Bell. The same goes that finger-lickin'-good chicken that KFC serves. You want tax advice, go to H&R Block. You want a Bud after work, you have to buy it from Budweiser. Wrigley's controls the gum game. Hershey's is America's favourite chocolate. Coca-cola makes America's best selling soft drink. ... the same can be said of a large town with only one newspaper. If you want to advertise in the paper, you have to pay the raye the paper is charging or you don't advertise. (the newspaper has what is called a regional monopoly.) These companies have a competitive advantage - a brand name or regional monoploy - that enables the business producing the product or service to earn monopolylike profits. Competitive advantage allows these businesses greater freedom to charge higher prices, which equates to higher profit margins, which means greater profts for shareholders. Competiting with them head-on is financial insanity.

Yet for Warren, the presence of a competitive advantage and the resulting consumer monopoly are not enough. For Warren to be interested in a company, it must possess a competitive advantage that is durable. What he means by durable is that the business must be able to keep its competitive advantage well into the future without having expand great sums of capital to maintain it. That last phrase is key, for there are companies that do have to spend great sums of capital to keep their competitive advantage, and Warren wants no part of them.

==> for example, Intel has a competitive advantage BUT it does not have a durable competitive advantage. pg.58..

In 2000, Intel spent over $3 billion on research and development alone. If it doesn't spend the money, its product line becomes completely outdated in a few years. How much money do you think hershey's spend on research and development of new products?

Intel's competitive advantage is dependent on management's ability to create new and innovative products th beat the competition. If management misses a beat, Intel and its shareholders lose the game....

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Warren continutes by saying:

In the 1920s, Coca-Cola first began to transform itself into a global enterprise. For more than 60 years, it has been developing business relationships and investing in a system that today carries an estimated replacement cost of more than US$100 billion. Buffett has noted how difficult it would be to compete with Coca-Cola today, "If you gave me $100 billion and said take away the soft drink leadership of Coca-Cola in the world, I'd give it back to you and say it can't be done."

Is it really so difficult to conclude that Coca-Cola and Gillette possess far less business risk over the long term than any computer company or retailer? Worldwide, Coke sells about 44% of all soft drinks, and Gillette has more than a 60% share (in value) of the blade market. Leaving aside chewing gum, in which Wrigley is dominant, I know of no other significant businesses in which the leading company has long enjoyed such global power.

Let me bring out another snipet from Charlie Munger's The Art of Stock Picking, in which he talks not on Coca-Cola but instead on Wrigley.

And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime? So, in effect, Wrigley , simply by being so well known, has advantages of scale what you might call an informational advantage.Another advantage of scale comes from psychology. The psychologists use the term “social proof”. We are all influenced subconsciously and to some extent consciously by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. We don't like to be the o­ne guy who's out of step. Again, some of this is at a subconscious level and some of it isn't. Sometimes, we consciously and rationally think, "Gee, I don't know much about this. They know more than I do. Therefore, why shouldn't I follow them?"

And this is what Munger has to say about Coca-Cola:

The social proof phenomenon which comes right out of psychology gives huge advantages to scale ‑ for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup which is slowly won by a big enterprise gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you.

Yes, perhaps one could argue that these highlights the importance of branding but with the power of branding, the company is able to have a strong 'durable' long-term competitive advantage over its competitors.

And because of the strong competitive advantage the company has, the individual investor is able to evaluate and access if whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.

Sounds complicated eh?

Not really. Cos what Warren is saying is that when we invest in a stock over a period of time, we want to able to evaluate the possibility of whether our investment could generate a modest return of investment after deducting taxes (for local investors, this tax issue is a non-issue) and after including the inflation factor.

And in 1989 Warren noted that this stock whose name itself represents one of the greatest brand name worldwide carried on the balance sheet for zero value. A company with strong, consistent profit growth for a long period of time. And best of all, this great franchise was selling for a mere 12-times earnings in 1989. What else could Buffett asked for? As they say, the rest was history! With Coca-cola expanding its franchise worldwide, return on equity grew to 39% by 1990, and then to 56.2% by 1995, becoming ever more efficient as it grew and along with Coca-cola growth, Warren's investment simply grew along with it!

Err... isn't this also a good example of winning when it is easier to win?

All we need to do is just wait patiently for the opportunity to make the killing of a life-time!