In the fall of 1988, Coca-Cola's president Donald Keough noticed someone was buying large amounts of the company's stock. After the 1987 stock market crash, Coca-Cola's share price was 25% below its pre-crash high. But the stock had hit bottom because "some mysterious buyers were gobbling up shares through block trades." When Keough discovered all these buy orders came from Midwestern brokers, he suddenly thought of his friend Warren Buffett and decided to call him. "Hello, Warren," Keough began, "You wouldn't happen to be buying Coca-Cola, would you?" Buffett paused, then said, "Coincidentally, I am buying. But I would be very grateful if you could keep quiet until I make a statement." If news of Buffett buying Coca-Cola stock leaked, people would rush in, eventually pushing up the share price, and Berkshire's buying target might not be met. In the spring of 1989, Berkshire shareholders learned that Buffett had spent $1.02 billion to buy Coca-Cola stock, accounting for 7% of Coca-Cola's shares and one-third of Berkshire's portfolio. It was Berkshire's largest single investment to date, making Wall Street scratch its head. For this century-old soda company, Buffett paid 5 times book value and over 15 times earnings, both at a premium to the market. What did the Oracle of Omaha see that others didn't? Coca-Cola is the world's largest beverage company, selling over 500 sparkling and still beverages in more than 200 countries. Among these 500 products, 15 brands are valued at over $1 billion, including Coca-Cola, Diet Coke, Fanta, Sprite, Vitaminwater, Powerade, Minute Maid, Simply, Georgia, and Del Valle. Buffett's relationship with Coca-Cola dates back to his childhood; he first tasted Coca-Cola at age five. Soon after, he began to show entrepreneurial spirit. As you might recall from Chapter 1, he bought six-packs of Coke for 25 cents and sold them for 5 cents each. Over the next 50 years, although he witnessed Coca-Cola's extraordinary growth, he didn't buy. Instead, he bought textile mills, department stores, and farm equipment manufacturers. Even in 1986, when Coca-Cola's Cherry Coke was chosen as the official drink for Berkshire's annual meeting, Buffett still hadn't bought a single share. It wasn't until two years later, in the summer of 1988, that Buffett began buying. Simple and Understandable Coca-Cola's business is quite simple. The company buys bulk raw materials, then produces concentrate according to formulas, and sells it to bottlers, who combine the concentrate with other ingredients to make the finished product. Bottlers sell the finished product to retailers, including small shops, supermarkets, and vending machines. The company also provides soft drinks to restaurants and fast-food chains, where they are served in cups and glasses to customers. Consistent Operating History No company can match Coca-Cola's consistent operating history. Founded in 1886, Coca-Cola sold only one product. About 130 years later, Coca-Cola still sells the same beverage, with a few other products. The major difference is that the company's scale and geographic footprint are vastly different. At the turn of the 20th century, the company employed 10 salesmen to cover the entire United States, selling 116,492 gallons of syrup annually, with sales of $148,000. Fifty years after its founding, the company sold 200 million soft drinks annually (sales units changed from gallons to servings). Buffett said, "It's hard to find a company comparable to Coca-Cola, with a ten-year record and selling an unchanged product." Today, Coca-Cola is the world's largest provider of beverages, instant coffee, juices, and juice drinks, selling 1.7 billion servings daily. Favorable Long-Term Prospects In 1989, after Berkshire announced it held 6.3% of Coca-Cola's stock, Buffett was interviewed by Melissa Turner, a business reporter for The Atlanta Journal-Constitution. She asked Buffett a frequently asked question: Why didn't he buy Coca-Cola stock earlier? Buffett talked about his thoughts when making the final decision. He said, "Let's assume you're going to leave for ten years, and before you go, you plan to make an investment, and you know that once you make it, you can't change it during those ten years. What would you think?" Of course, it goes without saying that the business must be simple and understandable, must be proven sustainable over many years, and must have good prospects. "If I can be sure, I'm sure the market will grow, I'm sure the leader will remain the leader—I mean worldwide—I'm sure sales will grow enormously. Such an object, I don't know of any other company that can do it except Coca-Cola," Buffett explained. "I'm relatively certain that when I come back, they'll be doing better than today." But why buy at this particular time? Because the business attributes Buffett described had existed for decades. He said, what caught his eye was the change in Coca-Cola's leadership: in 1980, Roberto Goizueta became chairman, and Donald Keough became president. The change was enormous. Throughout the 1970s, Coca-Cola was plagued with troubles: disputes with bottlers, allegations of mistreatment of workers at Minute Maid's citrus groves, environmentalists accusing the company of contributing to pollution with one-way containers, and the Federal Trade Commission charging that its exclusive franchise system violated the Sherman Antitrust Act. Coca-Cola's international business was also faltering because the company licensed an Israeli bottler, leading to an Arab boycott that destroyed years of investment. Japan, once the fastest-growing market, was also a place of missteps: 26-ounce Coke cans exploded on shelves, and Japanese consumers were angry about artificial coal-tar coloring in grape Fanta. When the company developed a new drink using real grape skins, it fermented and spoiled, and was dumped into Tokyo Bay. Throughout the 1970s, Coca-Cola was fragmented and not innovative in the beverage industry. Nevertheless, the company continued to generate millions in profits. Paul Austin, who became president in 1962 and chairman in 1971, did not reinvest profits in the beverage business. Instead, he planned to diversify, investing in water projects and shrimp farms, despite thin margins, and bought a winery. Shareholders resentfully opposed, believing Coca-Cola should not be associated with alcohol. In response, Austin spent unprecedented amounts on advertising. Meanwhile, Coca-Cola's return on equity was as high as 20%, but its pre-tax profit margin began to decline. In 1974, at the end of the bear market, the company's market value was $3.1 billion; six years later, it rose to $4.1 billion. In other words, from 1974 to 1980, the company's market value grew at only 5.6% annually, significantly underperforming the S&P 500. During those six years, every dollar retained by the company created only $1.02 in market value. Austin's autocratic style damaged Coca-Cola's spirit of shared honor and disgrace. Worse was the damage caused by his wife, Jeanne, who replaced the classic Norman Rockwell paintings with modern art to redecorate the company headquarters, and even used the corporate jet to search for art. But that might have been her last act, as her behavior hastened her husband's downfall. In May 1980, Mrs. Austin forced the company park to close to employees for lunch. She complained that food falling on the ground attracted pigeons and ruined the lawn's appearance. Employee morale hit rock bottom. Robert Woodruff, the 91-year-old patriarch and chairman of the finance committee (who had led the company from 1923 to 1955), had had enough. He demanded Austin's resignation and replaced him with Roberto Goizueta. Goizueta, raised in Cuba, was Coca-Cola's first foreign-born CEO. Unlike the taciturn Austin, he was outgoing. One of his first actions was to convene a meeting of Coca-Cola's top 50 executives in Palm Springs, California. He said, "Tell me what's wrong. I want to know everything. Once problems are solved, I want 100% loyalty. If any of you are still dissatisfied, we'll make proper arrangements and say goodbye." From this meeting, the company launched "The Strategy for the Eighties," a 900-word booklet outlining Coca-Cola's goals. Goizueta encouraged his managers to take reasonable risks. He wanted Coca-Cola to be proactive, not reactive. He began cutting costs and demanded that any business Coca-Cola owned optimize its return on assets. These measures quickly took effect, and profit margins began to rise. Profit Margins In 1980, Coca-Cola's pre-tax profit margin was as low as 12.9%. The margin had fallen for five consecutive years and was significantly below the company's 18% margin in 1973. In Goizueta's first year, the margin recovered to 13.7%. By 1988, the year Buffett bought Coca-Cola stock, the margin had climbed to a record 19%. Return on Equity In the "Strategy for the Eighties" booklet, Goizueta stated that the company would divest any business that could not generate satisfactory returns on assets. Any new investment must have sufficient growth potential to be considered. Coca-Cola was no longer interested in fighting in stagnant markets. "Increasing earnings per share and increasing return on equity are the name of the game," Goizueta declared. He backed his words with action: Coca-Cola's wine business was sold to Seagram in 1983. Although the company achieved a respectable 20% return on equity over seven years, Goizueta did not stop; he demanded more. By 1988, Coca-Cola's return on equity reached 31%. By any measure, Goizueta's Coca-Cola was worth two or three times the Austin-era Coca-Cola. This result was reflected in the company's market value: $4.1 billion in 1980, rising to $14.1 billion by the end of 1987, despite the October stock market crash. Over those seven years, Coca-Cola's market value grew at a compound annual rate of 19.3%. During this period, every dollar retained by Coca-Cola generated $4.66 in market value. Candor Goizueta's "Strategy for the Eighties" included consideration for shareholders: "In the next decade, we will continue to commit to our shareholders to protect and enhance their investment. To give shareholders above-average returns, we must choose investments that can beat inflation." Goizueta not only needed to ensure business growth—which required investment capital—but also needed to enhance shareholder value. To achieve this, Coca-Cola improved profit margins and return on equity, while increasing the dividend amount and lowering the payout ratio. Throughout the 1980s, the company increased its dividend by 10% annually, while the payout ratio fell from 65% to 40%. This allowed Coca-Cola to reinvest a larger proportion of earnings for growth while still rewarding shareholders. Under Goizueta's leadership, Coca-Cola's vision became clear: the primary goal of management was to maximize shareholder value over time. To achieve this, the company focused on the high-return soft drink business. If successful, this success would manifest as rising cash flow, rising return on equity, and ultimately, rising shareholder returns. Rationality The rise in net cash flow not only allowed Coca-Cola to increase dividends but also gave the company the opportunity to try share buybacks for the first time. In 1984, Goizueta announced that the company would repurchase 6 million shares in the open market. Share buybacks are rational only when intrinsic value exceeds market price. This buyback mechanism, pioneered by Goizueta, aimed to increase shareholders' return on equity, indicating that Coca-Cola had reached a tipping point. Owner Earnings In 1973, Coca-Cola's owner earnings (net profit after tax + depreciation - capital expenditures) were $152 million. By 1980, owner earnings reached $262 million, growing at a compound annual rate of 8%. From 1981 to 1988, owner earnings rose from $262 million to $828 million, a compound annual growth rate of 17.8%. Looking at ten-year periods, it's clear that Coca-Cola's stock price reflected the growth in owner earnings. From 1973 to 1982, Coca-Cola's stock return grew at 6.3%. In the next decade, from 1983 to 1992, under Goizueta's new policies, the company's average annual compound return was 31.1%. Resisting Institutional Imperative When Goizueta took over, he first discarded the unrelated businesses developed by former chairman Paul Austin and returned to the company's core business: selling syrup beverages. This was a clear demonstration of Coca-Cola resisting the institutional imperative. Undeniably, returning the company to a single-product enterprise was a bold move. Even more commendable was that while the entire industry was diversifying, Goizueta had the mindset and drive to go against the tide. At the time, several beverage giants were investing their earnings in unrelated industries: Anheuser-Busch used profits from its beer business to invest in theme parks. Brown-Forman, a liquor giant, invested its profits in china, crystal, silver, and luggage businesses, all with very low returns. Seagram, a global spirits and wine merchant, bought Universal Studios. PepsiCo (Coca-Cola's biggest competitor) bought snack food company Frito-Lay and restaurants, including Taco Bell, KFC, and Pizza Hut. More importantly, not only did Goizueta's actions focus on the company's largest and most important product, but the entire company's resources were tilted toward the most profitable business. Because selling beverages was far more profitable than other businesses, the company reinvested surplus into the highest-return business. Determining Value When Buffett first bought Coca-Cola in 1988, people couldn't help asking, "Where is the value in Coca-Cola?" At the time, the P/E was 15 times, and the stock price was 12 times cash flow, 30% and 50% above market averages, respectively. Buffett paid 5 times book value, giving a yield of only 6.6%, which seemed unattractive compared to the 9% yield on long-term government bonds. Buffett was willing to do this because of Coca-Cola's unparalleled goodwill; the company achieved a 31% return on equity with relatively little capital expenditure. Buffett explained that stock price doesn't indicate value. Coca-Cola's value, like any other business, depends on the discounted value of all expected owner earnings over the life of the company. In 1988, Coca-Cola's owner earnings were $828 million, and the yield on 30-year U.S. Treasury bonds (the risk-free rate) was 9%. Using the 1988 earnings and a 9% discount rate, the company's value would be $9.2 billion. When Buffett bought Coca-Cola, the company's total market value was $14.8 billion. At first glance, Buffett overpaid. But remember, the $9.2 billion valuation was based on current earnings. If a buyer is willing to pay a 60% premium, it must be because they see future growth opportunities for Coca-Cola. Analyzing Coca-Cola, we find that from 1981 to 1988, the company's owner earnings grew at a compound annual rate of 17.8%, higher than the risk-free rate. In such cases, analysts use a two-stage discounted cash flow model, assuming high growth for a period, then slower growth, using different discount rates for each stage, and summing to arrive at the company's valuation. We can use the two-stage method to calculate the present value of future cash flows in 1988. Coca-Cola's owner earnings in 1988 were $828 million. If we estimate it can maintain 15% growth over the next decade (a reasonable estimate, as it's below its average growth rate over the past seven years), owner earnings would reach $3.349 billion. Let's continue: from the 11th year, growth drops to 5% annually. Using a 9% discount rate (the then long-term Treasury yield), we can calculate that Coca-Cola's intrinsic value in 1988 was $48.377 billion. We can repeat the calculation with different growth assumptions. If we assume Coca-Cola's owner earnings grow at 12% for the next decade, then 5% thereafter, with a 9% discount rate, the current intrinsic value would be $38.163 billion. If growth is 10% for the next decade, then 5%, the value would be $32.497 billion. Even if we assume Coca-Cola's growth rate is only 5% forever, the company is worth at least $20.7 billion. Buying at an Attractive Price In June 1988, Coca-Cola's stock price was about $10 per share (adjusted for splits). Over the next 10 months, Buffett invested a total of $1.023 billion to buy 93.4 million shares, with an average cost of $10.96 per share. By the end of 1989, the investment in Coca-Cola accounted for 35% of Berkshire's portfolio, making it a heavyweight position. Since Goizueta took over in the 1980s, Coca-Cola's stock price had risen every year. In the five years before Buffett's first purchase, the stock price rose an average of 18% annually. The company's prospects were so bright that Buffett couldn't buy at a lower price. He tells us that price and value are two different things. During Buffett's buying period in 1988 and 1989, Coca-Cola's valuation averaged around $15.1 billion, but Buffett's valuation was $20.7 billion (assuming 5% owner earnings growth), or $38.1 billion (assuming 12% growth), or $48.3 billion (assuming 15% growth). Buffett's margin of safety—the discount to intrinsic value—ranged from a conservative 27% to an optimistic 70%. Buffett said the best businesses are those that, over the long term, require no large additional capital investments but can maintain stable high returns. In his mind, Coca-Cola was a perfect example of this standard. Ten years after Berkshire's purchase, Coca-Cola's market value rose from $25.8 billion to $143 billion. During this period, the company generated $26.9 billion in profits, paid $10.5 billion in dividends to shareholders, and retained $16.4 billion for reinvestment. Every dollar retained by the company created $7.20 in market value. By the end of 1999, Berkshire's initial $1.023 billion investment in Coca-Cola stock had a market value of $11.6 billion; the same investment in the S&P 500 would have grown to only $3 billion. Source: i投资 (ID: itouzi8) -END-