My recent article “What Is Intrinsic Value?” (here) ended with a question:
“Now, we get into a more difficult conversation: how do we assess the future opportunities to reinvest – and depending on our assessments, how does that impact intrinsic value?”
I think a good way to try and answer this question may be with an example – and Berkshire’s (BRK.B) investment in Coca-Cola (KO) seems like an apt choice.
In the 1988 shareholder letter – the first year that Berkshire owned KO – Warren didn’t have much to say; all he noted was that Berkshire intended to own the stock for a long time.
By the time the 1989 letter rolled around, Berkshire had increased its share ownership in KO by more than 60%. In this letter, Warren took investors through his thought process for the investment; here’s his commentary, in full (with bold sections added for emphasis):
“This Coca-Cola investment provides yet another example of the incredible speed with which your Chairman responds to investment opportunities, no matter how obscure or well-disguised they may be. I believe I had my first Coca-Cola in either 1935 or 1936. Of a certainty, it was in 1936 that I started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each. In this excursion into high-margin retailing, I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product.
I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading-stamp issuers, and the like. (If you think I'm making this up, I can supply the names.) Only in the summer of 1988 did my brain finally establish contact with my eyes.
What I then perceived was both clear and fascinating. After drifting somewhat in the 1970's, Coca-Cola had in 1981 become a new company with the move of Roberto Goizueta to CEO. Roberto, along with Don Keough, once my across-the-street neighbor in Omaha, first rethought and focused the company's policies and then energetically carried them out. What was already the world's most ubiquitous product gained new momentum, with sales overseas virtually exploding.
Through a truly rare blend of marketing and financial skills, Roberto has maximized both the growth of his product and the rewards that this growth brings to shareholders. Normally, the CEO of a consumer products company, drawing on his natural inclinations or experience, will cause either marketing or finance to dominate the business at the expense of the other discipline. With Roberto, the mesh of marketing and finance is perfect and the result is a shareholder's dream.
Of course, we should have started buying Coke much earlier, soon after Roberto and Don began running things. In fact, if I had been thinking straight I would have persuaded my grandfather to sell the grocery store back in 1936 and put all of the proceeds into Coca-Cola stock. I've learned my lesson: My response time to the next glaringly attractive idea will be slashed to well under 50 years.”
Note that Warren took great interest in the company’s ability to expand overseas – and so did management; here’s a notable quote from Coca-Cola’s 1988 shareholder letter:
“In many international markets, low per capita consumption rates for soft drinks offer obvious opportunity that is reinforced by demographic trends, economic development and the expanding reach of the mass media. Last year, international per capita consumption of Company products grew 5 percent to more than 51 drinks per year.”
For the sake of comparison, per capita consumption in the U.S. was 289 (8-oz serving) in 1988 – and growing; to put that number in perspective, reaching U.S. levels over four decades would result in a volume CAGR of 4.4% per annum. That’s before considering population growth, which would grow ~1.4% per annum over the next 25 years (and disproportionately outside the United States). That put us on pace for realistic expectations of mid-single digit volume growth for a long, long time – comparable to the ~7% volume CAGR reported by the company in the prior 50 years.
In 1990, there were more than 5.2 billion people on the planet (we’ve added another 2 billion since), with less than 5% living in the US. Considering Coca-Cola's dominant global lead at that time (45% market share excluding China and the Soviet Union), it’s starting to become clear that there was an opportunity to reinvest in the core business. While soft on specifics, we’re pretty sure of one very important thing: there appears to be a long runway – meaning decades – of pretty strong growth in the company’s competitively advantage core business.
At the time (1988), Coca-Cola had ~$8 billion in total assets and ~$3.3 billion in shareholder’s equity on the books. In the prior decade, KO had generated a mid-teens return on assets, in addition to a 25% - 30% ROE with limited use of leverage (~2.5x in 1988); ROE had fallen below 20% - and just barely - in only two of the fifteen years prior to 1988.
At the end of 1988, the company reported $2.84 in EPS (on Berkshire’s cost, less than 15x earnings); the dividend for the year was $1.20 per share, for a payout ratio of 40% (we know with hindsight that the company would stay in this vicinity in the coming years). In addition, the company was repurchasing stock, and had reduced the number of shares out by ~2% per annum in the previous five years. After accounting for those two factors, KO was retaining ~30% of their earnings.
Let’s look at some calculations based on these figures, with the following assumptions: (1) a level 25% ROE over the 30-year measurement period; (2) a payout ratio of 70% over the 30 years – meaning asset growth of ~7.5% per annum (30% x 25%); (3) a 100% payout ratio in perpetuity from that point on. With those assumptions, approximately three-quarters of the value in the DCF calculation is accounted for by cash flows in the first 30 years.
Under that scenario, with a required 10% return in perpetuity, the justified going-in valuation is just shy of 5x book, or 19x earnings. As I noted a second ago, Berkshire’s purchase price (at year end 1988) was at an average cost of less than 15x earnings – under eighty cents on the dollar.
A quick note is necessary here: unsurprisingly, as the ROE moves higher, the price you can pay in the starting year and still expect returns of 10% p.a. increases materially: at a 30% ROE, for example, P/B crosses 7x. When we consider that Coca-Cola had recently exited non-core businesses like Columbia Pictures and shrimp farming, there was some rationale for expecting improved ROE in the coming years (what Warren alludes to in the 1989 letter when he talks about Coca-Cola drifting in the 1970’s and becoming a “new company” under Goizueta); a glance at the company’s performance in the ensuing five years shows that’s exactly what happened:
As I noted above, Coca-Cola had ~$3.3 billion in shareholder’s equity on the books at year end 1988; the stock was trading around ~$44 per share at year end, with ~370 million shares out – good for a market cap of ~$16.2 billion, and a price-to-book ratio of ~5x.
Over the quarter-century that Berkshire has owned Coca-Cola, their investment has increased from a cost of $1.3 billion to a market value of $14.5 billion at year end 2013, for a 25 year CAGR of 10.1%, before dividends - nearly spot on with our discount rate (each 10% move up or down in the terminal period changes the CAGR by roughly 40 basis points). Over that time, shares out have fallen at a CAGR of ~1% per annum, with the dividend payout ratio just shy of 50% over the quarter century in question; all in, returns have been in the mid-teens (percentage). Paying less than implied in the model and improving ROE’s has resulted in stronger returns.
As importantly, we’re in the final five years of our initial thirty year measurement period – and there’s no reason to believe that the opportunities for reinvestment have disappeared (meaning no need for a 100% payout ratio); the opportunity to drive per capita consumption in places like China and India is still in its early innings (at 40 per cap and 15 per cap, respectively, compared to 400 in the United States and a global average approaching 100).
What’s the takeaway? The ability to reinvest in a competitively advantaged core business generating outsized ROE’s and with a high probability of continued success for a long, long time allows you to pay seemingly high prices (on measures like P/E) and still generate solid returns in the coming years / decades.
