Is Coca-Cola the “Perfect” Business? (Case Study)
Interesting perspective on the characteristics of wonderful businesses has been given by legendary Wall Street investors T. Rowe Price and Warren E. Buffett. The late T. Rowe Price was the founder of Baltimore-based T. Rowe Price and Associates, Inc., one of the largest no-load mutual fund organizations in the United States, and the father of the "growth stock" theory of investing. According to Price, attractive growth stocks have low labor costs, superior research to develop products and new markets, a high rate of return on stockholder's equity (ROE), elevated profit margins, rapid earnings per share (EPS) growth, lack cutthroat competition and are comparatively immune from regulation.
Omaha's Warren E. Buffett, the billionaire
head of Berkshire Hathaway, Inc., also looks for companies that have strong
franchises and enjoy pricing flexibility, high ROE, high cash flow,
owner-oriented management, and predictable earnings that are not natural
targets of regulation. Like Price, Buffett has profited enormously through his
To apply Price's and Buffett's investment criteria successfully, business managers and investors must be sensitive to fundamental economic and demographic trends. Perhaps the most obvious of these is the aging of the population. Health-care demands will continue to soar. In recognition of this fact, investors have bid up the shares of companies offering prescription drugs, health care, and health-care cost containment (e.g., home health agencies). Perhaps less obvious is that an aging and increasingly wealthy population will save growing amounts for their children's education and retirement. This bodes well for mutual fund operators, insurance companies, and other firms that offer distinctive financial services.
As the overall population continues to enjoy growing income, spending on leisure activities is apt to grow; companies that offer distinctive goods and services in this area will do well. Helping well-heeled customers have fun has always been a good business. Productivity enhancement to combat economic stagnation is also likely to be a major thrust during the coming decade. In this area, it is perhaps easier to pick likely beneficiaries of emerging technologies than it is to chart the future course of technical advance. For example, catalog retailers, long-distance and cellular phone companies, and credit card providers are all major beneficiaries of the rapid pace of advance in computer and information technology. Similarly, major broadcasters, cable TV companies, movie makers, and software providers are all prone to benefit from increasingly user-friendly technology for leisure-time activities.
The American Express Company, Coca-Cola, Procter & Gamble, and Wells Fargo are well-known examples of major common stock holdings of Warren Buffett's Berkshire Hathaway, Inc. Each of
major holdings are large capital-intensive companies with long operating
histories of above-average rates of return.
Like any really good business, they display a wise use of assets as
indicated by an average ROE that is well above typical norms. Enhancing the attractiveness of these
companies is the fact that they also display above-average annual rates of growth
in stockholders’ equity. Thus, they can
all be described as beneficiaries of high-margin growth. As is often the case, attractive financial
and operating statistics reflect essentially attractive economic
characteristics of each company.
The American Express Company is a premier travel and financial services firm that is strategically positioned to benefit from aging baby boomers. The Coca-Cola Company, one of
Berkshire's biggest and most successful holdings,
typifies the concept of a wonderful business.
Coca-Cola enjoys perhaps the world's strongest franchise, owner-oriented
management, and both predictable and growing returns. Also, the company is not subject to price or
profit regulation. From the standpoint
of being a wonderful business, Coca-Cola is clearly the "real thing." Newspapers, banks, and cable TV companies,
such as The Washington Post Company and Wells Fargo & Company, translate
immense economies of scale in production into dominating competitive
advantages. They also fit Buffett's
criteria for wonderful businesses. In the
case of Gillette, above-normal returns stem from unique products that are
designed and executed by extraordinarily capable management.
The late T. Rowe Price was prone to invest in high-tech companies that produced distinctive products. On the other hand, Buffett is fond of saying that he doesn’t “understand” high-tech and doesn’t want to be blown out of business by a few guys “working in a garage somewhere.” Of course, Buffett’s thinly-veiled reference to Hewlett-Packard and the
Valley revolution that was started by “two guys in a simple
garage” means that Buffett clearly does understand the problems of investing in
hard-to-project high-tech companies.
Thus, while Buffett avoids high-tech stocks, T. Rowe Price, if he were
alive today, might find compelling the advantages of high-tech companies such
as Microsoft, Intel, and Cisco Systems, among others.
Above-normal returns from investing in wonderful businesses are only possible to the extent that such advantages are not fully recognized by other investors. In the case of T. Rowe Price, early investments in Avon Products, Xerox, and IBM generated fantastic returns because Price saw their awesome potential far in advance of other investors. On the other hand, Buffett has profited by taking major positions in wonderful companies that suffer from some significant, but curable, malady. In 1991, for example, Buffett made a large investment in American Express when the company suffered unexpected credit card and real estate loan losses. When the company absorbed these losses without any lasting damage to its intrinsic profit-making ability, its stock price soared and Buffett cleaned up. Companies that are conservatively financed enjoy a similar ability to profit when an unexpected business downturn causes financially distressed rivals to sell valuable assets at bargain-basement prices.
Therefore, while above-average stock-market returns provide the clearest evidence of having picked good businesses for investment, short-term results can be disappointingly average or below-average if the virtues of these good businesses are clearly recognized in the marketplace. More frustrating still is the problem of finding and investing in good businesses at attractive prices and then having to wait while conventional wisdom comes around to recognizing them as such. The overall stock market is extremely efficient at ferreting out bargains and adjusting prices so that subsequent investors earn only a risk-adjusted normal rate of return. For individual investors seeking above-average returns, finding good businesses is a necessary first step, but they must also be incorrectly priced (too cheap). Buffett succeeds because he is unusually adept at finding high-quality bargains.