In my previous article, I ended with these words:
One of the concepts that I find fascinating is – pick a business and understand it from the "inside out." A lot of times we have the illusion that we understand the business when in reality we don’t. If you don’t think this is the case, ask yourself do you really understand IBM (IBM) and Procter & Gamble (PG). Why would Warren Buffett (Trades, Portfolio) choose Coca-Cola (KO) over Procter & Gamble? You may realize that you may not understand the business as well as you thought you do. This is truly a powerful idea. In my next article, I plan to elaborate on this idea with a concrete example.
I’ve thought a lot about which company to use as an example and in the end, I decided to use Coca-Cola because first of all, it is understandable and secondly, most of us are familiar with its products (not necessarily with its business model though). Moreover, it is a business that I thought I understood very well but in reality I didn’t. Therefore, it is both humbling and exciting to use Coca-Cola as an example for the purpose of this exercise.
Before I proceed, I should clarify that you should not expect to understand Coca-Cola’s business from the inside out after reading this article. My intention is to walk through a process that I think might be useful in terms of understanding the business from another level.
My preparation work involved mainly getting as many of KO’s annual reports as possible. So I downloaded all the annual reports that are available from its website and googled the ones that are available online. I’ve also searched on eBay and Amazon and picked up some of Coca-Cola’s annual reports as early as 1965. Then I gathered quite a bit of articles, past OID issues in which various investors talked about Coca-Cola. Since Coca-Cola is Warren Buffett (Trades, Portfolio)’s favorite business, I figured it wouldn’t hurt to read the parts of his letters to shareholders where Coca-Cola is mentioned. And of course let’s not forget Munger’s talk on Coca-Cola. You will be amazed at what you may find. Below are some examples of what I found:
From Buffett’s 1996 letter
"We look for similar predictability in marketable securities. Take Coca-Cola: The zeal and imagination with which Coke products are sold has burgeoned under Roberto Goizueta, who has done an absolutely incredible job in creating value for his shareholders. Aided by Don Keough and Doug Ivester, Roberto has rethought and improved every aspect of the company. But the fundamentals of the business  – the qualities that underlie Coke's competitive dominance and stunning economics – have remained constant through the years.
I was recently studying the 1896 report of Coke (and you think that you are behind in your reading!). At that time, Coke, though it was already the leading soft drink, had been around for only a decade. But its blueprint for the next 100 years was already drawn. Reporting sales of $148,000 that year, Asa Candler, the company's president, said: "We have not lagged in our efforts to go into all the world teaching that Coca-Cola is the article, par excellence, for the health and good feeling of all people." Though "health" may have been a reach, I love the fact that Coke still relies on Candler's basic theme today –Â a century later. Candler went on to say, just as Roberto could now, "No article of like character has ever so firmly entrenched itself in public favor." Sales of syrup that year, incidentally, were 116,492 gallons versus about 3.2 billion in 1996.
I can't resist one more Candler quote: "Beginning this year about March 1st . . . we employed ten traveling salesmen by means of which, with systematic correspondence from the office, we covered almost the territory of the Union." That's my kind of sales force.
Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer –Â not even these companies' most vigorous competitors, assuming they are assessing the matter honestly –Â questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.
Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables. But I would rather be certain of a good result than hopeful of a great one.
Of course, Charlie and I can identify only a few Inevitables, even after a lifetime of looking for them. Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility. Though some industries or lines of business exhibit characteristics that endow leaders with virtually insurmountable advantages, and that tend to establish Survival of the Fattest as almost a natural law, most do not. Thus, for every Inevitable, there are dozens of Impostors, companies now riding high but vulnerable to competitive attacks. Considering what it takes to be an Inevitable, Charlie and I recognize that we will never be able to come up with a Nifty Fifty or even a Twinkling Twenty. To the Inevitables in our portfolio, therefore, we add a few "Highly Probables."
From OID year-end 2000 edition
Warren Buffett (Trades, Portfolio): In the '30s, I would buy six bottles for a quarter and sell 'em for a nickel each. And that was a 6-1/2 ounce bottle for a nickel. Today you can buy a 12-ounce can at a supermarket sale for not much more than twice per ounce what it was selling for then. Not many products have had that kind of value proposition develop over the years.
From OID December 1998 issue
Warren Buffet: KO’s bottling transactions are incidental to a long term strategy which, has been enormously successful to date and which has more success ahead of it…..But I ignore them in my evaluation of KO.
Charlie Munger (Trades, Portfolio): Well I would personally be that KO will increase its flavoring of the world’s water ingestion from the 2% or so they have now to the 4% its CEO is aiming for….In fact I would consider that overwhelmingly likely to happen.
You can find Charlie Munger (Trades, Portfolio)’s talk on Coca Cola here.
So here I am. Without even reading Coca-Cola’s past annual reports, I’ve already felt that I have learned a lot but there is yet so much that I don’t know about Coca-Cola. In the next part of the article, I will continue with my adventure.
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