Warren Buffett is regarded as one of the most successful investors of all time. He is a value investor and has built his fortune by investing for the long term in fundamentally strong companies. Coca-Cola is regarded as one of the most iconic and successful investments of all time. Not only it has yielded immense financial rewards for Berkshire Hathaway, it also has become symbolic of Buffett’s approach to investing.
In this article, we explore the investment tenets of Warren Buffett and see how Coca-Cola’s investment scored in all these tenets.
To get a complete picture of Warren Buffett’s decision to invest in Coca-Cola, one must start by analyzing the challenges faced by the company in the 1970s.
Coca-Cola in 1970s
Domestic Disputes
The 1970s were dismal years for Coca-Cola. The decade was marred by disputes with bottlers, accusations of mistreatment of migrant workers at the company’s Minute Maid groves, environmentalists’ claim that Coke’s one-way containers contributed to the country’s growing pollution problem, and the Federal Trade Commission charges that the company’s exclusive franchise system violated the Sherman’s Antitrust Act.
International troubles
The Arab boycott of Coke dismantled years of investments. It began when the company issued an Israeli Franchise.
In Japan, Coke’s 26-ounce take-home bottles were exploding literally on store shelves.
In addition, Japanese consumers angrily objected to the company’s use of artificial coal-tar coloring in Fanta grapes. When the company replaced it with a new version using real grape skins, the contents fermented and the rape soda was tossed into Tokyo Bay.
Diversification to business with thin margins
In the 1970s, despite its myriad problems, Coca-Cola continued to generate millions of dollars in earnings. But instead of reinvesting in Coca-Cola’s dominating beverage market, Paul Austin(then CEO), decided to diversify. He invested in water projects and shrimp farms despite their thin profit margins. He also purchased a winery.
Lack of candor
The diversification to businesses with thin margins caused dissatisfaction among the shareholders. When Paul Austin purchased a winery, shareholders bitterly opposed the move. They suggested that Coca-Cola should not be associated with alcohol. Instead of attending to the concerns of the shareholders, Austin preferred to deflect the criticism by directing unprecedented amounts of money towards PR and advertisement campaigns.
Underperformance
The pretax margins of Coca-Cola were slipping, From 1974 to 1980, the company’s market value increased at an average annual rate of 5.6 % only, significantly low compared to the S&P 500 Index. For every dollar that the company retained in those years, the company created only $1.02 in market value which is significantly lower than expectations from a brand like Coca-Cola.
Employee morale
Coca-Cola’s corporate woes were exacerbated by Austin’s intimidating and unapproachable behaviour. To make things worse, his wife was a disruptive influence and had autocratic tendencies leading to discontent among the employees. Employee morale hit an all-time low when Mrs. Austin ordered the company’s park closed to employees’ luncheons complaining that their food droppings attracted pigeons to the well-manicured lawns.
Roberto Goizueto appointed as new CEO
Robert Woodruff had heard enough complaints against Paul Austin and finally demanded his resignation after the luncheon incident. He replaced him with Roberto Goizueta. This started the era of Coca-Cola’s revival.
1988 – Buffett started buying Coca-Cola shares
In the fall of 1988, Donald Keough, president of Coca-Cola observed that someone was buying the company’s share in a big way. It was only a year after the 1987 stock market crash, and Coca-Cola shares were still trading 25% below the precrash high. The share had found a resistance level as some mysterious investor was buying loads of it. When Keough inquired, the mysterious buyer turned out to be Warren Buffett.
Buffett requested Keough to stay quiet for a while. He wished to add more Coca-Cola shares to his portfolio.
By the spring of 1989, Berkshire Hathaway learned that Buffett had spent $1.02 billion buying Coca-Cola shares. He had bet a third of Berkshire’s portfolio and now owned 7% of the company. It was the single largest Berkshire investment to date.
What changed from 1981 that led to Warren Buffett buying more than a billion worth of stocks in Coca-Cola?
To explain the rationale behind the purchase of Coca-Cola stocks, let us analyze how it scores in the Business, Management, and Financial tenets followed by Warren Buffett to judge the prospects of the business.
Business Tenets of Warren Buffett
Simple and understandable
Coca-Cola was a simple and easy-to-understand business model with a huge global demand and potential for growth.The company purchased commodity inputs and mixed them to manufacture a concentrate that is sold to bottlers, which combine the concentrate with other ingredients. The bottlers then sell the finished product to retail outlets, including minimarts, supermarkets, and vending machines.
The company also provides soft drink syrups to restaurants and fast-food retailers, who then sell soft drinks to consumers in cups and glasses.
Consistent operating history
The Coca-Cola business started in 1886 selling one beverage product and has thrived for more than 130 years. Even now it is selling the same beverage plus a few other products. The only thing that has changed significantly is the company’s size and reach.
Favourable long-term prospects
Buffett was confident of the long-term prospects of Coca-Cola after observing the turnaround in the performance post the appointment of Roberto Goizueta as CEO. He was closely following the changes occurring at Coca-Cola during the 1980s under Goizueta, and President Donald Keough.
Management Tenets of Warren Buffett– Performance under Goizueta leadership
Rational
Growth in net cash flow allowed Coca-Cola to increase its dividend to shareholders. It also enabled the company to initiate its first buyback program. In 1984, Goizueta announced that the company would repurchase six million shares of stock in the open market.Repurchasing stock only makes sense if the intrinsic value of the company is higher than the market price. The strategic changes by Goizueta, with emphasis on increasing the return on equity for shareholders, suggested to him that Cola-Cola has reached that tipping point.
Candid
Goizueta’s strategy for the 1980s pointedly included the shareholders.
“We shall during the next decade, remain totally committed to our shareholders and to the protection and enhancement of their investment”
Roberto Goizueta
“In order to give our shareholders an above-average total return on their investment, we must choose businesses that generate returns in excess of inflation”
Roberto Goizueta
Coca-Cola by increasing its profit margins and return on equity (ROE), was able to pay dividends while simultaneously reducing the dividend payout ratio. Dividends to the shareholders in the 1980s were increasing 10 percent per year while the payout ratio declined from 65 percent to 40 percent. This enabled Coca-Cola to reinvest a greater percentage of the company’s earnings to help sustain its growth rate while not shortchanging shareholders.
Coca-Cola’s mission statement under Goizueta was to maximize shareholder value over time. This would be reflected in the increase in the growth of cash flow, increased return on equity, and ultimately an increased total return to shareholders.
Institutional imperative
Goizueta jettisoned the unrelated business and returned the company to its core business of selling syrup. It was a clear demonstration of Coca-Cola’s ability to resist institutional imperative. Reducing the company to a single-product business was a bold movie. This came at a time when others in the industry were doing the exact opposite.
Highest returns
Not only did Goizueta’s action focus the company’s attention on its largest and most important product, but it also worked to reallocate the company’s resources into its most profitable business. The economic returns of selling syrup far outweighed the returns from other businesses. So, the company was now reinvesting its profits in the highest-return business.
Financial Tenets of Warren Buffett – Impact of Roberto Goizueta’s Management
High profit margins
In 1980, Coca-Cola’s pretax profit margins were a low 12.9%. The company’s margins fell for five straight years till 1980 and were substantially lower than the 18% margin in 1973. After Goizueta took over as CEO, the trend reversed. In his first year, the pretax margin rose to 13.7%. By 1988, when Buffett bought Coca-Cola shares, margins had climbed to a record 19%.
Return on Equity
In “Strategy for the 1980s,” Goizueta pointed out that the company would divest any business that no longer generated acceptable returns on equity. Any new business venture must have sufficient real growth potential to justify an investment. Coca-Cola was not interested in battling for a share in a stagnant market.
Goizueta announced, “Increasing earnings per share and effecting increases in return on equity are still the name of the game”.
Goizueta was not impressed with the 20% return on equity during the 1970s and demanded better returns. His interventions and management improved the return on equity to 31% by 1988.
Earnings on every dollar retained
The market value of Coca-Cola increased from $4.1 billion in 1980 to $14.1 billion in 1988. This was despite the 1987 stock market crash. The average annual rate of increase was 19.3%. For every dollar Coca-Cola retained during this period, it gained $4.66 in market value.
Owner Earnings
From 1973 to 1980, the owner’s earnings increased from $152M to $262M at an annual compounded growth rate of 8%. From 1981 through 1988, the owner’s earnings grew from $262M to $828M at a 17.8% annual compounded growth rate.
The growth in the owner’s earnings reflected in the share price of Coca-Cola. From 1973 to 1982, the share price of Cola-Cola grew at an average annual rate of 6.3%. Following 10 years, from 1983 to 1992, the average annual return on stock was 31.1%. Thus, the impact of Goizueta’s management approach was clearly visible.
Bottom Line
Coca-Cola is a perfect case study for any aspiring investor who follows Warren Buffett. It is more than just a financial success story. It is a testament to the success of his long-term investment philosophy, a source of guidance that investors could apply during their investment decisions. The immense success of the investment is evidence of the enduring value of a well-chosen investment.