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1998 - When 'Buy and Hold the Greatest Business' Did Not Work

December 18, 2013 | About:

Here is a question: If you had bought equity ownership interest in the Coca-Cola Company (KO) on July 15, 1998, what would your return be for the next 13 years excluding dividends?

Many readers may have guessed the answer: not much. In fact, the return from price appreciation is almost negligible if you bought KO at the high point in July 1998.

This is a discovery I was lucky enough to stumble on when speaking to Stephen Yacktman and Jason Subotky from Yacktman Asset Management.

[www.gurufocus.com]

Although I am not surprised by the fact that an investor could lose money in a wonderful business like Coca-Cola, I have been pondering the implication of stagnant KO’s share price during that 13 year period. After all, Coca-Cola probably has the widest moat among all wonderful businesses. We all know that Warren Buffett has repeatedly said, “Buying a wonderful business at a fair price is far better than a fair business at a wonderful price.” However, the Oracle did not disclose what his definition of fair price is.

Obviously in this case, the market was not offering Coca-Cola at a fair price during July 1998. And no one knows for sure what the exact fair price for Coca-Cola was in 1997, but that’s probably out of my current circle of competence anyway. Instead, to practice reverse thinking advocated by Charlie Munger, I would like to analyze the reasons why one should not buy Coca-Cola during July 1998.

Let’s look at the reported numbers first. Here is the five-year summary up until 1997. These are numbers from audited financial statements.

392944255.jpg

The average closing price for Coca-Cola during July 1998 is about $85 per share. Assuming an investor purchased KO at the average closing price, he or she was paying a hefty 51 times unadjusted earnings. And if we refresh our memories from the Yacktman Asset Management interview, Jason and Stephen had said that the earnings in 1997 were of lower quality compared to previous years. Shrewd readers may have already observed from the above table, 1996 and 1997 earnings include unusually large other incomes. A careful read of the 1997 annual form 10-K shows that these are mostly made up of gain on sales of non-core assets and gain on issuance of stock by equity investees, both non-recurring in nature. The details are disclosed in the footnotes:

300282206.jpg

1637035390.jpg

Furthermore, the 1996 income tax rate includes a one-off settlement benefit that lowered the tax rate to 24% for 1996 only. Without this benefit, Coke’s 1996 income tax rate should have been 31%. This is also disclosed in the footnote:

1343664280.jpg

After adjusting for the non-recurring items and tax rates, Coca-Cola’s earnings in 1996 and 1997 are much worse than they appear to be. The following table summarizes the result of the adjustments.

1996 1997
Reported Pre Tax Income $ 4,596.00 $ 6,055.00
Adjustments for Non-Recurring Item -

Gain on Sales of Non-Core Assets

(508.00)
Adjustments for Non-Recurring Item -

Gain on Issuance of Stock by Equity Investee

(413.00) (343.00)
Adjusted Pre Tax Income 4,183.00 5,204.00
Adjusted Tax Rate 31% 31.80%
Adjusted Net Income $ 2,886.27 $ 3,549.13
Shares Outstanding- Diluted 2,523 2,515
Adjusted Diluted EPS $ 1.14 $ 1.41
Reported Diluted EPS $ 1.40 $ 1.67
Difference% -18% -15%

If we use the adjusted EPS for 1997, Coca-Cola was trading at more than 60 times trailing 12 months' earnings at $85 per share. This is almost priced into perfection.

Out of curiosity, I pulled a few sell-side analyst reports on Coca-Cola from June 1998 to July 1998. Not surprisingly, almost all the analyst reports have buy ratings on KO:

“Our 12-month target price range is of $88-90. We feel that it is important to note that our confidence and conviction in The Coca-Cola business model and its long-term growth opportunities have never been stronger.” -July 1998 Donaldson, Lufkin & Jenrette Analyst Report

“The long-term story for Coke remains a very strong one. Coke appears capable of achieving a high-teens rate of EPS growth longer term, driven by 8-10% annual volume growth overseas, a 5% increase in weighted concentrate price overseas, a 2-3 percentage point increase in volume driven unit profitability, and continued share repurchase (another 1-2 percentage points). Our 12-month target price for Coke is $90. Coke’s P/E multiple is at approximately 47x this year’s earnings, and holding that multiple would result in a $90 price by next year.” –June 1998 Paine Webber Analyst Report

"We continue to believe KO shares could trade to the $85–86 level over that next 12–18 months, or at roughly 46–47 times our 1999 EPS estimate of $1.84." - June Morgan Stanley Analyst Report

None of the analyst report I read adjusted 1997’s earnings for the non-recurring items, let alone the 1996 earnings for the tax rate effect. Interestingly enough, almost all the analyst whose reports I read did a good job compiling the fundamental information and business updates of Coca-Cola. It is the almost-ridiculous multiples they used and the EPS figure that left unadjusted reflect poor and shallow thinking, albeit likely caused by institutional imperative.

Now I have a much better understanding of the situation of Coke in 1998. Low quality earnings combined with a high multiple and human euphoria created a classic example of “don’t just buy a wonderful business and hold it.”

The lesson is pretty clear. History rhymes. There are a few times in Coca-Cola’s history where an investor can get stuck with a stagnant stock price for an extended period of time. Human nature guarantees that this will be a repeating theme in the future as well. How to avoid the mistake of paying too much for a wonderful business? Fortunately, Warren Buffett has laid out the ground rule for us:

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”

And I have nothing to add.

About the author:


Rating: 4.3/5 (35 votes)

Comments

itzarjuna
Itzarjuna premium member - 1 year ago
Good Article..Its very important to look at these one tim income from sale of a particular unit or a tax benefit. operating income should give you clear picture. Thanks for the nice writeup. I like the last line 'nothing to add'   you stole charlie's lines ;-) 
20punches
20punches - 1 year ago
Thanks for commenting Arjun. I've been thinking about Yacktman's comments on Coca-Cola since the interview so decided to take a further look. Also during the research, I was shocked by the lack of earnings quality analysis by the sell side research analysts. It was a good exercise going through the footnotes. A lot of useful information. And yeah, I stole Charlie's line in the end and hopefully he doens't mind:)
AlbertaSunwapta
AlbertaSunwapta - 1 year ago

Buffett was asked back then whether he was considering selling KO. It would be interesting to try to determine his sell price. I believe he hinted at it at the time. I recall him saying something to the effect of; 'If it reaches _____ just watch me."

20punches
20punches - 1 year ago

AlbertaWunwapta: Thanks for your comments. I believe Buffett did indirectly sell KO( and other holdings back then too, to avoid taxes maybe) when he decided to issue Berkshire's shares to acquire Gen Re in June 1998.

chompinchuck
Chompinchuck - 1 year ago
I think I remember that 3 years after Buffett bought Coke the investment ended up being worth as much as all of Berkshire was worth at about the time of the purchase- or something like that.  Then Buffett does in effect sell Coke as mentioned above via shares for GenRe---- in truth he/Berkshire just ran right on by Coke without selling it as Berkshire leaped forward in book value and instrinsic value.  Berkshire has simply run circles around so many companies.  I have the Andrew Bary Barron's front page framed on my wall where Bary compares Buffett to Welch and Greenberg (GE and AIG) in 1999.  Of course AIG collapsed and GE's sales are still $20 billion below back then---- all the while Berkshire's sales have gone from about $33 billion to nearly $200 billion.  Buffett just outsmarts people right-left up and down and countless articles constantly circulate on how he has literally lost it and is going stright to hell in a handbasket.  All by those who have no concept of anything related to Berkshire and Buffett.
drossi
Drossi premium member - 1 year ago
Thank you Ning!This is a lesson worth repeating 1000 times!All the best (returns),Diogo
ebritt120
Ebritt120 premium member - 1 year ago
Great article.  Shows the potential negative consequences for overpaying for any company.
20punches
20punches - 1 year ago
Chompinchuck: Great comments and agreed Buffett just vastly outsmarts people by a wide margin. His timing of purchasing KO and the way he structured the Gen Re deal is just sheer genius and like you said, not a lot of people have a good idea on Berkshire and Buffett. 
20punches
20punches - 1 year ago
Drossi: Thanks for the nice comments and all the best returns to you too. 
20punches
20punches - 1 year ago
Ebritt120: Thanks for commenting. It is true that taking care of the purchase price and you don't have to make a good sale to get good returns:)
ansgarjohn
Ansgarjohn - 1 year ago
Ning, the sell, and buy decision might be different because of capital gains taxes in the United States. A fund like Bestinver in Spain apparently buys and sells more, because the tax system is different. I believe not selling KO when it is slightly over intrinsic value has to do with the "deferred taxes" Buffett refers to in the Owner's Manual: "Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and "float," the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $32 billion. (written in 1996-9....$117b in 2013?)Better yet, this funding to date has been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting - which we have done, on the average, during our 32 years in the business - the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt - an ability to have more assets working for us - but saddle us with none of its drawbacks."
AlbertaSunwapta
AlbertaSunwapta - 1 year ago

Good point on the share exchange for Gen Re. Looking back I wonder if Buffett would have preferred to trade shares for something else. :-). The derivative book was a bit of a downer for him.

You'll see here (link below) that he thought BRK was overvalued when he capitalized on it through the B share issuance.

http://www.sec.gov/Archives/edgar/data/109694/0000898430-96-001695.txt

20punches
20punches - 1 year ago
Ansgarjohn: Thanks for commenting. I'm not sure I get your point. Are you saying that Berkshire didn't sell KO because the money it used to purchase KO was from float? 
20punches
20punches - 1 year ago
AlbertaSunwapta: Agreed the derivative book made him sweat quite a bit. Also Gen Re messed up when 9-11 happened and Buffett specifically mentioned the risk of terrorists attack for the World Trade Center, which Gen Re was involved. Thanks for the link to the B-Share Prospectus. I have never read it but I remember reading Buffett saying the B-share was not undervalued at the time. 
Seanickson
Seanickson - 1 year ago
Interesting that buffett sold wells in 1998 but not coke
20punches
20punches - 1 year ago
Seanickson: In my opinion, coke has a wider moat than wells. Coke is needed almost everywhere on earth and that per capita consumption has beeng growing and will most likely continue to grow. I can't imagian a bank being that dominant globally. 
Stephen
Stephen premium member - 11 months ago
Nice article Ning."And if we refresh our memories from the Yacktman Asset Management interview, "  Can you provide a link to this interview? Thanks
20punches
20punches - 11 months ago

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