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!