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.
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.
The average closing price for Coca-Cola during July 1998 is about $85 per share. Assuming an investor purchased KO at the average closing price, he or she was paying a hefty 51 times unadjusted earnings. And if we refresh our memories from the Yacktman Asset Management interview, Jason and Stephen had said that the earnings in 1997 were of lower quality compared to previous years. Shrewd readers may have already observed from the above table, 1996 and 1997 earnings include unusually large other incomes. A careful read of the 1997 annual form 10-K shows that these are mostly made up of gain on sales of non-core assets and gain on issuance of stock by equity investees, both non-recurring in nature. The details are disclosed in the footnotes:
Furthermore, the 1996 income tax rate includes a one-off settlement benefit that lowered the tax rate to 24% for 1996 only. Without this benefit, Coke’s 1996 income tax rate should have been 31%. This is also disclosed in the footnote:
After adjusting for the non-recurring items and tax rates, Coca-Cola’s earnings in 1996 and 1997 are much worse than they appear to be. The following table summarizes the result of the adjustments.
|Reported Pre Tax Income||$ 4,596.00||$ 6,055.00|
|Adjustments for Non-Recurring Item -
Gain on Sales of Non-Core Assets
|Adjustments for Non-Recurring Item -
Gain on Issuance of Stock by Equity Investee
|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|
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.