Warren Buffett purchased Coca-Cola stock in 1988 and 1989 for Berkshire Hathaway, which sat at 37% of Berkshire’s total equity value in 1989.
This article will analyse the investment, highlighting the key reasons Buffett and Munger added this business to their portfolio and why they made it such a huge, high-conviction position.
Key facts about Berkshire’s Coca-Cola Investment
When did Berkshire Hathaway buy Coca-Cola stock?
1988 and 1989 and 1994 (though the 1994 component was smaller than the other two)
How much did Buffett and Munger invest in Coca-Cola?
$1,023,920,000 in the first block of purchases or 37% of Berkshire Hathaway’s 1989 book value. As of 1995, $1,298,900,000 was invested.
What price to earnings multiple did Buffett and Munger pay for Shaw Industries?
16-18x
In 1987, Coca-Cola earned roughly $916m in net income and in 1988, Coca-Cola earned $1,045.
From Berkshire Hathaway’s 1989 Chairman’s letter, the average share price paid by Buffett was $43.85 (1,023,920/23,350).
Multiplying $43.85 by the 372m shares outstanding at the end of 1987 gives a market capitalisation of $16.3b.
Therefore, the P/E ratio was approximately 16-18x for Buffett’s 1988 and 1989 purchases of Coca-Cola stock.
Understanding the Business
What they do
Coca-Cola is a non-alcoholic global beverage producer. In 1988, they sold under the brands Coca-Cola, Diet Coke, Sprite, Fanta and Powerade to name a few. Their products were sold in over 155 countries and international sales made up roughly 70% of their total profits.
This is a quote from their current website, however, it applied in 1988 too.
Coca-Cola owned a 44% stake in Coca-Cola Enterprises (USA bottler) and a 53% stake in Coca-Cola Amatil (Australian bottler). However, most of their bottlers are independently owned. They also sell these syrups to fountain operators such as McDonald’s.
As a result, the business model is very capital-light. To illustrate this, in 1987, The Coca-Cola Company employed approximately 17,000 people. This is compared to the global Coca-Cola distributors and operators employing roughly 500,000. All the capital expenditures related to the plants and product distribution are borne by the bottlers. Coca-Cola themselves only needed a few plants around the world to produce the syrup. Capital expenditures in 1987 were $300m, on $7.6b of revenue. As we can see below, their return on equity was very high, demonstrating their capital-light and successful model.
The Coca-Cola Company’s relationship with its bottlers and fountain operators
Coca-Cola bottlers are given exclusive territories and the freedom to charge any price they want. As a result, the global bottlers end up a satisfied partners of The Coca-Cola Company. Coca-Cola also allows fountain operators and restaurants to charge whatever they like. Because of this, there are restaurant owners making a huge margin on a product that they know they can sell and sell in huge volumes. This existing model allows the brand to spread to the point where Coca-Cola products are essentially everywhere. If you are a restaurant owner, it is a relative no-brainer to serve Coke in your business.
Coca-Cola’s financials as of 1987
Here were Coke’s financials for the past 3 years as of 1987.
Below is a graph of Coca-Cola’s margins over time. Their margins were increasing, which indicates that their costs per dollar of revenue were declining. This means that for the same amount spent on creating the Coca-Cola products, they were able to generate more revenue. Increasing margins are therefore often a result of businesses raising prices or businesses benefiting from economies of scale and lowering their production cost per unit.
We can also see that Coke was growing rapidly in the graph below.
Coca-Cola’s 10 year revenue and net profit compound annual growth rates were 11% as of 1987.
Did Coca-Cola have the capacity to expand globally?
To continue to grow, Coke needed the ability to travel worldwide. Buffett and Munger had both experienced the failed out-of-state expansion attempt of their California-based chocolate producer, See’s Candies. Therefore, they needed to know that Coca-Cola could have an international presence with global consumers being able to enjoy the taste. Below are some quotes from the 1987 annual report addressing this:
Clearly, Coca-Cola had proven its product travels well and still had immense room for growth. This will be discussed further in the valuation section.
Durable Competitive Advantage
Coca-Cola has a brand moat, meaning customers value the reputation of Coca-Cola to the point where they trust the products more than the competition and are willing to pay a premium for its consumption. A great indicator of a brand moat is the ability to raise prices. The 1970s in the USA was a period of high inflation, and in the 1987 annual report, Coke’s management stated the following.
Assuming the above is true, it is fair to say that Coke has a brand moat.
In this section, we will discuss the formation of Coca-Cola’s brand moat, and also the factors that prevent the company from being destroyed by competition.
How strong is Coke’s brand at keeping competitors away?
Coke developed its brand through decades of intelligent advertising. This section aims to explain why other brands can’t do the same and take Coke’s market position away.
There are two main segments of Coca-Cola’s competitors. The first to consider are new startups that try to take market share away and the second are existing businesses that have some existing brand presence with consumers.
1. New startups
There have been many of these over time. Some examples that Warren and Charlie had not experienced yet in 1988, but are still relevant to discuss were Sam’s Cola and Virgin Cola (founded by Richard Branson). These failed to kick off because the Coca-Cola product is already affordably priced and highly regarded. As a result, for another cola to take market share away, they would need to undercut Coke by a substantial amount to catch the consumer’s eye. The only problem is the combination of Coca-Cola’s distribution system and scale means that Coca-Cola can always match a competitor on price. This makes the barriers to entry into the market immovable.
As you can see below, Costco tried their luck too. Even with their scale advantages, they couldn’t find a way to profitably undercut Coca-Cola to take a meaningful market share away.
2. Soft-drink brands that have been around for decades
Developing a successful brand-based competitive advantage takes time hence older businesses have the highest chance to compete with Coca-Cola. These include brands such as Dr Pepper, Pepsi and Royal Crown Cola. Warren and Charlie have expressed their opinions on Coca-Cola, consistently believing they will continue to be the market leader.
One of the pillars of a successful brand is the ability for it to be seen and experienced by consumers. Coca-Cola was the market leader with $880m in soft drink income compared to Pepsi’s $263m in 1985. This shows that they have the strongest brand presence meaning the Coke product is available in more places to more people around the world. RC Cola for example had 10% of the market share in the late 1960s. But, in the 70s and 80s, they fell out of the cola wars as they were not able to keep up with the marketing expenditure of Coca-Cola and Pepsi. Essentially, though there were alternatives to Coca-Cola, given Coke was the largest and most established brand in the industry, they would’ve had the highest chance of not only keeping their share but also gaining market share over competitors.
I believe Buffett and Munger recognised that Coca-Cola is the largest soda company with the strongest brand in terms of its associations, availability and deals with different schools, theme parks etc. Along with this, they were earning huge sums of cash and they likely had the highest probability of using that cash in a way to build their brand even further and expand it around the world. RC Cola didn’t have this same ability (due to lack of marketing power), and neither did any other new cola brand.
What should Coca-Cola do to maintain its brand moat?
In 1996, Charlie Munger delivered a talk called “Practical Thought About Practical Thought”, where he described some of his mental models and applied them to the brand of Coca-Cola. I have extracted some main points from the speech in this section and highly recommend you read the whole piece!
Paraphrasing Munger, he argued that ideally, there should never be another business that uses the name “Coca” or “Cola” in their branding. The second point of avoidance Charlie mentioned was that the Company “must avoid making any huge and sudden changes in the flavour”. Even if a competitor comes up with a better flavour, changing to this new flavour would do the Company little good. This is because the original flavour was so entrenched in consumers’ minds that changing the taste would trigger a hostile reaction of deprival which competitors could take advantage of by simply recreating the old flavour and branding it as their own.
What is interesting here, is that Coca-Cola did lose half of its name to Pepsi-Cola. They also introduced a new flavour called “New Coke” which was a response to Pepsi using blind tests to convince consumers that their product tastes better. Despite making these two errors, The Coca-Cola Company still managed to tread the right path and perform successfully. This is evidence of the strength of Coca-Cola’s brand, in that even though they made these two marketing blunders, they still managed to maintain their market share and continue to grow internationally. This evidence is likely a main reason why Buffett and Munger were willing to invest so much in this particular brand.
Closing brand moat thoughts
New competitors were not able to displace the Coca-Cola image in consumer minds and didn’t have the economies of scale to compete on price. Existing brands did not have the same size, and therefore reach, as Coca-Cola, therefore it was fair for Buffett and Munger to assume that Coke would continue to gain market share over these brands that were lesser known especially internationally.
Management
Warren Buffett has always stressed the importance of a good manager being in charge of a business he invests in. The tenets he looks for in a CEO are passion, focus, integrity and talent. Therefore, below we will describe some evidence showing how the management team of Roberto Goizueta (CEO) and Donald Keough (Chairman) had these traits.
Why Berkshire Hathaway waited until 1988 to buy Coca-Cola stock
Firstly, you might be thinking why Warren didn’t invest in Coca-Cola before 1988. The reason I believe is because of the management team. Here is a quote from Robert Hagstrom’s book The Warren Buffett Way, which I highly recommend reading.
Probably the largest detractor for Buffett was Paul Austin’s (CEO before Goizueta) capital allocation decisions. Austin diversified Coca-Cola’s operations, investing in a shrimp farm and a winery. Given their biggest trademark was their Coca-Cola soft drink, these were not the optimal capital allocation decisions which would grow the brand and create shareholder value over time.
Coca-Cola’s performance under the new management
In the 1987 annual report, Goizueta describes the Coca-Cola growth strategy.
The management team demonstrated they recognise they need to ensure the product is readily available, affordable and of high quality to keep competitors at bay and drive growth.
Goizueta took over the company in 1981, and as we can see above, substantially grew the value of the business over his tenure up until 1987. The quote below is another example of an improvement made by Goizueta and the team.
This means that The Coca-Cola Company could pass more of the costs of sugar and transportation to the bottlers, further enhancing their business quality.
Goizueta and Keough’s capital management skills and integrity
The management team in 1986 also imposed a ceiling on the Company’s net debt-to-equity ratio to 35%. In 1987, the total debt, net of temporary investments, notes receivable and excess cash and current marketable securities was 15.3% of total capital. The management team also elected to decrease dividends down to 40% of earnings. This allowed them to:
Clearly, Goizueta and Keough understood how to manage the capital of the business, and were focused on increasing shareholder value over time.
Goizueta described the company’s plan to repurchase 10% of the total shares outstanding over a three-year period. In addition, he described his plan to “continue to explore new and innovative methods of using The Coca-Cola Company’s financial resources to increase shareholder wealth.” Here is another quote from the 1987 annual report.
This is contrary to Austin, who reduced shareholder wealth with his diversification efforts. Clearly, Buffett and Munger could see that over Goizueta and Keough’s tenure, they had improved the operations of the business significantly.
Valuation
The return achieved from an investment in a business is the sum of the increase in intrinsic value the business achieves from profitable reinvestment of retained earnings and the dividend yield it pays out to shareholders.
In 1987, Coca-Cola paid $421m in dividends. On Berkshire’s purchase price (assuming they bought the whole business) of $16.3b, this represents a dividend yield of 2.5% p.a..
For the intrinsic value growth component, the first item to note is that over the past decade, Coca-Cola had grown their revenues and earnings at roughly 11% p.a.. They also noted in the 1987 report that they expect volume to grow in the USA from 274 eight-ounce servings per capita to 315 by 1990. This is a 4.8% growth rate over the three years.
As of 1987, 74% of operating income was from international markets. Assuming the international growth rate is 12% p.a. based on the international numbers quoted above, this means a conservative weighted average growth rate is 4.8%*26% + 12%*74% = 10%.
So adding this with the dividend yield gives an expected 12.5% annual rate of return for Buffett and Munger from this investment on a fundamental business level. If Coca-Cola could expand margins or grow sales faster, this expected return would increase. This return could also materialise through much higher growth in early years coupled with slower growth in the future.
With the benefit of hindsight, here is an approximate analysis of Berkshire’s Coca-Cola investment:
- Total amount invested = $1,299m (Berkshire invested slightly more in Coca-Cola in 1994)
- Value of investment as at 31-Dec-2021 = $23,684
- Therefore, the average annual growth rate from 1989 to 2021 was 9.5%.
- Assuming an average dividend yield of roughly 2.5% over that period means Buffett and Munger’s investment approximately yielded a 12% return
Note also that Berkshire received a $672m dividend payment from Coca-Cola in 2021 (400m shares owned by Berkshire multiplied by Coca-Cola’s $1.68 per share 2021 dividend). As a percentage of Berkshire’s original investment, this is a 52% dividend yield!
A key lesson from Buffett and Munger’s Coca-Cola investment
Not all brands have equal strength. Brand moats can be wide and deep, or narrow and fleeting
This case study demonstrates that there is a huge difference between the economic value of different brands. One of the lessons I took away is that just being well known or a name that people have heard of before does not classify the business as having a brand moat. Most Americans would’ve heard of RC Cola, but it didn’t do nearly as well as Coca-Cola. There are plenty of other brands we can think of that just don’t hold the same cache as brands such as Apple or Louis Vuitton. When analysing a business with a brand moat, considering how widespread the brand is, and whether they are continuously investing in growing the brand are key components to the process. With Coke, Buffett and Munger had evidence that consumers were willing to pay higher prices for the product (as seen in the increasing margins) and also saw that even after Coke offered a brand new taste, customers still desired the old flavour and remained loyal to the brand. This same outcome would not have happened for all brands, and therefore distinguishing between weak and strong, long-lasting brands is key in my opinion!
Sources
- Lowe, Janet. Damn Right! : Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger. New York ; Chichester, John Wiley, 2003.
- The Coca-Cola Company website
- Berkshire Hathaway 1989 Chairman’s letter
- Berkshire Hathaway 2021 Annual Report
- The Warren Buffett Way, Robert Hagstrom
