Buffett's Investment in Coca-Cola

Dear investors,

On August 30th, Warren Buffett turned 90. To celebrate, we've decided to bring you an analysis of one of his most iconic investments: the purchase of a significant stake in Coca-Cola during the 1980s.

This is one of the cases that we present in our training program for new members of our team: “If you went back in time and valued Coca-Cola in 1988, would you buy the stock?” In this letter, we will try to summarize the main insights we learned from this training.

We begin with a quiz. A reputable business magazine once published the following statement:

“Several times every year, an investor looks at Coca-Cola’s track record with deep respect, but comes to the sad conclusion that they are already looking too late (to invest).” – Fortune Magazine

In what year was this sentence published? The correct answer is in the footer of the next page.³:

• a) 1938
• b) 1944
• c) 1957
• d) 1968
• e) 1979
• f) 1986

Investment context

In 1988, Buffett began buying Coca-Cola shares. Many analysts were skeptical, as the stock had been rising for several years and was trading at its highest levels in history (the share price more than tripled in the decade, not counting dividends).

Chart 1 – Coca-Cola share price (1980-1988)

The stock looked expensive. It traded at a price-to-earnings multiple¹ of 15-19x at a time when the long-term interest rate was 9% per year.

Even so, Buffett purchased 7% of Coca-Cola shares, representing a $1.02 billion investment. This was a significant amount and represented 21% of Berkshire Hathaway's net worth.² at the time!

¹ P/E (Price/Earnings) is a widely used multiple in the financial market. It measures a company's market value relative to its annual net profit. As a rule, the higher the multiple, the more expensive the company tends to be.

² Berkshire Hathaway is the holding of Buffett's investments.

³ Quote was published in 1938.

What Buffett saw in the company

In his 1988 annual letter, Buffett commented on his investment in Coca-Cola for the first time:

“In 1988 we made significant purchases from (…) Coca-Cola. We hope to keep these actions for a long time.. In truth, When we own a piece of an excellent business, with excellent management, our preferred investment time is forever. We are the opposite of those who rush to sell and book profits when companies are doing well, but who cling exhaustively to companies that disappoint. Peter Lynch aptly compares this behavior to “cutting the flowers and watering the weeds.”

We continue to focus our investments on a few companies that we try to understand well. These are just a few businesses where we have strong long-term convictions. So when we find one, we want to participate meaningfully. We agree with Mae West: "Too much of a good thing can be wonderful." – Warren Buffett, 1988 Berkshire Hathaway Letter

In 1989, he also praised the work that CEO Roberto Goizueta was doing to return the company to a growth trajectory after a period of stagnation during the 1970s.

Based on statements made by Buffett and Munger at the time and later, we understand that he based his investment decision on three main factors:

Potencial de crescimento do consumo per capita

In 1988, Coca-Cola was already a strong brand worldwide, it was the global leader with 45% of the market share global soft drink manufacturer, operating in over 160 countries. By 1990, the global average consumption of Coca-Cola was already 43 cans per person per year. With this already strong presence, how would the company grow?

Despite its strong presence, the brand's penetration varied greatly across countries. As the chart below shows, while the average US consumption was 289 cans per capita in 1990 (almost seven times the global average), in China that figure was a paltry 0.7.

There was clearly plenty of room for growth. Even with already very high consumption in the US and limited potential growth (indeed, consumption declined between 2000 and 2010), there was plenty of room to increase volumes abroad.

China, in particular, had very low penetration and presented a huge growth opportunity considering its population of 1.3 billion people. In fact, per capita consumption grew 49x between 1990 and 2010, and today it is one of Coca-Cola's main markets.

Chart 2 – Coca-Cola consumption per capita (cans per person per year)

Poder de precificação

One of the characteristics that makes Coca-Cola a great business is its ability to consistently raise prices above inflation. Coca-Cola has a loyal customer base and a relatively inexpensive product, which allows the company to consistently raise prices without hurting consumers' wallets. Today, for example, a 350ml can of Coca-Cola costs around R$1,000 (2.50). If the company raises prices to R$2.70 (an increase of R$1,000, double the inflation rate in one year), few people will stop consuming the product.

In addition to protection in inflationary environments, pricing power also enables growth and margin gains when a company's revenue grows at a faster pace than its costs.

Evidence of this is the fact that, between 1988-2019, Coca-Cola's revenue grew 4.6x while the company's net profit grew 8.5x (net margin went from 13% to 24%).

Chart 3 – Coca-Cola revenue and net profit growth (in USD MM)

Novos investimentos com rentabilidade

As mentioned in the previous letter, in addition to growth, it's important to have good profitability to truly generate shareholder value. In this regard, Coca-Cola had excellent results. ROE^[1] The company's average earnings in the 1980s (before Buffett's investment) was 25% per year and showed a growth trend that continued throughout the 1990s.

But why is this important?

The importance of a high ROE is that the company could grow without compromising its capital or taking on debt. Indeed, the soft drink business requires little capital; the company's main annual investment is in marketing, investments that strengthen the brand and increase the company's competitive advantages. This characteristic allowed Coca-Cola to grow before and after Buffett's investment while paying generous dividends to its shareholders – historically, the company pays between 75% and 80% of its profits back to shareholders in the form of dividends or share buybacks.

The result

In the first 10 years of Buffett's investment in Coca-Cola, the stock performed spectacularly, delivering a return of 14x invested capital, equivalent to an annual gain of 30% per year (considering dividend reinvestment).

However, with the change in management following the death of CEO Roberto Goizueta in 1997 and, more recently, with the healthy eating trend, the company's stock hasn't performed as well as it once did. Even so, from the end of 1988 to August 2020, Coca-Cola's stock appreciated 36x, representing an annual growth of 12% per year, after factoring in dividend reinvestment. Considering the USD 1.30 billion^[2] initial investment that Buffett made in the company in 1988, Coca-Cola has guaranteed a profit of almost USD 30.0 billion for the investor over the last 30 years.

Chart 4 – Coca-Cola share price, not adjusted for dividends (1989-2020)

A constant question is why Buffett didn't sell his shares when the company peaked in 1998 and looked expensive at the time. There are three main reasons:

O primeiro são os impostos sobre ganho de capital que Buffett pagaria caso vendesse ações da empresa. Considerando a enorme valorização da ação, os impostos pagos seriam de quase USD 2,5 Bi. Essa preocupação tributária existe por que o investimento em Coca-Cola foi feito através da Berkshire Hathaway, que é uma empresa sujeita a pagamento de impostos sobre ganho de capital. Essa situação é diferente para fundos de investimento em ações, em que só há incidência de impostos quando o cotista solicita o resgate (o fundo pode comprar e vender ações sem a necessidade de pagamento de impostos)

Another reason is that the investment was so large. Buffett's stake in Coca-Cola was valued at $13.4 billion in 1998, making finding new investments as good as Coca-Cola quite challenging.

 In addition to the above points, Coca-Cola has always been an excellent dividend payer. Since at least 1988, Coca-Cola has paid quarterly dividends, increasing annually. This characteristic allowed Buffett to receive USD 8.4 billion in dividends from Coca-Cola alone. Currently, his position yields USD 656 million annually.

 Even with a lower return over the past 20 years, Coca-Cola generated a profit of USD 16.1 billion for Berkshire Hathaway between 1998-2019 (USD 8.7 billion in share appreciation and USD 7.3 billion in dividends) – a profit higher than the USD 13.4 billion invested in the company in 1998, which highlights the importance of long-term focus.

Buffett still considers Coca-Cola a "great business," but he admits that criticism of sugary soft drinks is a threat to the company.

The company has been expanding into other beverage categories (such as coffee, tea, and juice) to continue growing, but these categories don't generate the same high margins as its core product. Even so, Coca-Cola remains a giant and has the best beverage distribution system in the world, which should help the company expand into these new product categories.

¹ ROE (Return on Equity) is calculated by dividing a company's net income by its equity. ROE is a measure of a company's financial performance because it indicates how well the company uses its resources to generate profit for shareholders. The higher the profit for a given amount of equity, the higher the company's ROE.

² Berkshire Hathaway invested $1.024 billion between 1988-89 and added $0.275 billion to the investment in 1994, bringing the total investment to $1.299 billion. Buffett never sells a single share of Coca-Cola.