Mohnish Pabrai: Here’s Why Buffett Bought Coke (KO) in 1987

Posted on Posted in Books, Get Better by Reading, Mohnish Pabrai, Superinvestors, Warren Buffett

I was reading a passage from Mohnish Pabrai‘s book Mosaic: Perspectives on Investing. I love reading Pabrai’s thoughts and ideas whenever I can. He’s one of the greatest investors of the last 15 years, establishing a track record that has significantly outperformed the S&P 500, including a remarkable run from 1999-2007 when he averaged around 30% per year. One reason I like Pabrai is because he uses simple logic to explain his investment process. We’re big fans of simplicity here at BHI. Another reason I like him is because he is not your typical hedge fund manager. He never worked on Wall Street, and didn’t climb the usual ranks. He started his own business, sold it, and then started his partnership with $1 million of capital, mostly his own (he now runs about $500 million). I recommend reading both of his books (Mosaic and the Dhando Investor).

Pabrai is a huge Warren Buffett follower, and he frequently talks about how he simply tries to replicate Buffett’s ideas in his own investing. Study everything you can on Buffett, reverse engineer his ideas, understand his theses on his investments, and you’ll learn a lot. In Chapter 13 of Mosaic, called Latticework, Pabrai explains what he thinks are the five main reasons why Buffett bought Coca Cola (KO) in the late 80’s. There are many interesting things about that Coke investment by Buffett.

  • It represented 25% of Berkshire Hathaway’s book value by the time Buffett was done buying it
  • It marked one of the first major investments where Buffett paid much more relative to earnings and assets than he did for most of his other investments. Coke was selling around 15 times earnings and I believe somewhere around 5 times book value at the time.
  • It was a huge company, one of the largest in America (like it is now). How does such a large company become so undervalued relative to its future prospects?? What did Buffett see that the rest of the world didn’t at that time?
  • The investment was a huge success… a “ten-bagger” in Peter Lynch’s terminology (Buffett invested $1 billion into Coke that a decade later was worth around $10 billion)

So it wasn’t a classic Ben Graham cheap stock-not even close. But it was a great investment, and it was incredibly undervalued. And we can learn something by thinking about the logic behind Buffett’s investment. Notice that he looked back 80 years (!!!) to learn about Coke’s history. Wall Street looks back a couple quarters and looks ahead a couple quarters when doing their analysis. That game doesn’t work well.

Here are five reasons Pabrai gives for why Buffett might have liked Coke:

  • Buffett is a huge sugar-addict and had been a lifelong passionate consumer of Pepsi Cola – until 1987. He used to add cherry syrup to his Pepsi before Cherry Coke was concocted. When he was seven years old, he used to count the discarded bottle caps around vending machines and carefully tabulate which drink people were having the most. He remembers being astounded with the overwhelming numbers of Coke caps (over 80%) relative to the numbers for all other drinks.
  • Buffett is rumored to have a subscription to Advertising Age magazine. He asked himself what it would cost to replicate the Coca-Cola brand in a few years. The conclusion Charlie and he reached was that it probably could not be done – even with $100 billion given to the best marketing team on Earth. At the time, one could have bought the entire Coca-Cola company for under $20 billion. So, here was a company whose brand alone was worth well over $100 billion and the entire company could be bought for under $20 billion.
  • Buffett pored over the last 80 years of Coca-Cola annual reports. He found that, like a software company, their gross margin on their syrup sold to bottlers is well over 80%. Coke’s future success was a function of the number of servings of coke sold worldwide. The more the servings, the more the cash flow. He found that over the last 80 years, their syrup volumes sold had risen every single year. The last 80 years included many ugly world events – World War I, the great depression, World War II, The Korean War, The Vietnam War, The Cold War, numerous recessions, being kicked out of India in the 1970s et cetera. Through all of that, Coke has grown every single year. The question Munger and Buffett posed to each other was simple – What volume of syrup might The Coca-Cola Company conservatively be expected to ship in the year 2000…2025…2050? They probably came up with some mouth-watering numbers, then extrapolated free cash flow (about one cent per eight-ounce serving) and finally arrived at a present value of all that future cash flow.
  • In 1886, when Coke was first concocted, it sold for five cents per eight-ounce serving. Today, one can buy eight ounces of Coke on sale for under 17 cents. If Coke’s pricing had moved in lockstep with inflation, we’d be paying several dollars for a single can. This is a very unusual product whose unit price has declined dramatically over the years. Very few consumer products have demonstrated the level of decline in prices that Coke has over the last century.
  • Billions of people around the world have yet to have their first Coke. In addition, the daily per capita consumption of bottled beverages around the world is miniscule compared to that of the United States and Europe. However, it has risen dramatically in various countries as per capita incomes have risen. We are likely to see big increases in per capita incomes in the third world over the coming decades.

The typical hammer-wielding Wall Street analyst is fixated on the next few quarters, not the next half century when trying to figure out any given company. No Wall Street analyst’s mental model of Coke in 1988 was comprised of the latticework that Munger and Buffett fixated upon. Individual investors will do well if they only made investments within their circle of competence based on an independent latticework of mental models. When all your mental models all converge at about the same intrinsic value for a given business, and that value is well above the price of the business, back up the truck.

Makes me want to head over to Food Lion and grab some Cherry Coke for the evening. Have a great weekend!

13 thoughts on “Mohnish Pabrai: Here’s Why Buffett Bought Coke (KO) in 1987

  1. There is really nothing in this article that hasn’t been said before many times over. I don’t know-I think that this investment might only have made sense to someone like Buffett–or at least, an American who drinks lots of Coke. While Coke is a staple in American diets (like any other mass-marketed food product) it is nowhere near as popular in the rest of the world, simply because those people have different habits. My point is even a highly skilled investor, but one who is perhaps European, Middle Eastern, etc., would not really feel so strongly about Coke–it’s a highly subjective choice. I personally don’t understand why the brand is so valuable or why it’s worth any given amount ie $100B. In any case now it is substantially less than 25% of BRK’s book value; it’s maybe 5%

    1. MC,

      I mentioned it was 25% of BRK’s book value when Buffett was done buying it in the late 80’s. Not currently… However, it still represents a large part of BRK’s stock portfolio (around 20% last time I checked).

      I agree with you that Buffett has a unique skillset and that it is difficult to replicate some of his thought processes. He’s an extremely talented business analyst. Value works, and there are many other (simpler) ways to achieve investment success. Buffett’s results are because of his ability to combine common sense value principles with his ability to judge businesses (competitive advantages, business specific risks, management, etc…).

      But if you’re not familiar with Coke, you don’t need to invest in it. But it is a good case study regardless…

      Thanks for reading!

  2. About the 4th reason, “This is a very unusual product whose unit price has declined dramatically over the years. Very few consumer products have demonstrated the level of decline in prices that Coke has over the last century.” It seems contradicted to what you wrote on “The importance of pricing power”. Coca cola not only didn’t increase its price, but decreased its price dramatically. So I think maybe the 4th point means they are able to cut their cost more dramatically? Or they are able to widen the gap between price and cost more dramatically?
    What would one say about Coca cola on its pricing power?

    1. Yes that is an interesting fact from Coke. I haven’t verified Mohnish’s numbers that he used, but if those numbers are accurate, that is an interesting point. Regarding pricing power, it is extremely valuable, but not every company has it or takes advantage of it. In fact, the ideal situations, as I mentioned in the post, are the situations where a business has pricing power but isn’t using it (in other words, their customers are getting a bargain, and would be willing to pay more for the same product). Those situations where a business is underpricing its product are very valuable. I’m not sure if Coke is underpricing their product or not. My guess is, they certainly have the ability to raise prices to offset inflation. Their unit price has declined likely because of economies of scale and the related efficiencies that they’ve established over time. I’m not exactly sure how much real pricing power they have, if any.

      1. Thanks a lot John! I get the point.
        I understand what you said “In fact, the ideal situations, … their customers are getting a bargain, and would be willing to pay more for the same product… Those situations where a business is underpricing its product are very valuable”, Then what enables the company to do so (underpricing) ? about the source of this ideal situations? “Underpricing” this word itself is easy for me to make connection with cost advantage as in Poter’s competitive advantage framework? (i.e. as you mentioned, cost advantage due to economy of scale…) In Poter’s framework, the company’s strategy can only comes from either cost leader or differentiation…

        1. Hi Nina,

          I don’t think the underpricing is something that the company intends to do. In other words, why would a company purposely price a product for less than they could (assuming a given impact on unit volume). They wouldn’t… So I don’t think it’s a matter of what enables a company to do this, I think it’s just a unique situation whereby management doesn’t get the pricing right for whatever reason, and thus the customer gets a bargain. This situation leads to real pricing power, as management has the ability to raise prices in excess of inflation without impacting volume.

          It’s also a temporary situation. There is only so much real pricing power a company has. Once it’s used up, the mispricing disappears and the company is accurately pricing its product.

          It’s like a stock that is undervalued. At some point, the reasons for the underpricing become evident, and the stock appreciates to fair value.

          Note the difference between real and nominal pricing power. A company might always have the ability to offset inflation, but real pricing power is finite.

  3. Hi John! Suddenly I have another question. In the 2nd reason for buying coke, as you stressed “here was a company whose brand alone was worth well over $100 billion” This is significant important for valuation. But how did they come up this brand value over $100bn when no one else did back then?
    (PV of future cash flow seems not yet in this step ( in the next step according to this article))

    1. Hi Nina,

      Yeah I think Buffett viewed everything in terms of the future cash that it would produce. He was interested in cash flow, and the compounding of cash flow (and consequently the compounding of value). Coke’s value came from a few sources, but most of the earning power came not from physical assets, but intangible assets.

      As for how they came up with it, I would recommend reading Charlie Munger’s talk on “How to turn $2 million into $2 trillion”, one of the best pieces of analysis I’ve ever read.

      Valuing the intangible asset that Coke had was an art form, as different people could certainly come up with different values, but the value in the end is derived from the cash flow that the brand could produce. And as Buffett and Munger correctly concluded, the brand was more valuable than even most analysts figured.

      Notice how the writeup doesn’t focus on earnings, next year’s results, quarterly margins, or anything else analysts like to discuss… it focuses on the big picture things that a business owner would want to be concerned about…

      1. Many thanks for the reply and article!
        That’s absolutely true. I have been an analyst on sell side and buy side, on emerging country market and developed capital market, europe. Some problems are the same. Mutual fund industry performance is to beat the benchmark. There are overwhelming pressure from clients if you behind the index for several quarters.
        I think the only way might be to leave mutual fund one day, and find a job in hedge fund.
        Thanks John!

  4. I think the reason why Buffett bought up big in Coke was the insight he gained from owing See’s Candy. Think the other reasons provided are strong supporting reasons but without his ownership and direct experience with See’s (initially via his ownership in Blue Chp Stamps) he may not have invested the same way as he did in Coke.

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