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Rupert Hargreaves
Rupert Hargreaves
Articles (205)  | Author's Website |

Why You Should Pay More for Quality Stocks

Warren Buffett’s Coca-Cola trade is a great example

March 16, 2017 | About:

If you ask investors how Warren Buffett (Trades, Portfolio) made his money, most of them will reply that he built the fortune he has today by value investing.

While this is true to some degree, Buffett only followed a strict value strategy during the first quarter of his career. After the Buffett partnerships had been closed, the Oracle of Omaha’s strategy changed significantly, moving away from a value strategy to a more quality-oriented approach, and the results have been fantastic.

A change of strategy

One of the big differences between the approach Buffett used after he closed the partnerships and before is valuation. Where Buffett used to look for stocks trading at a deep discount to net asset value, he started to buy equities that were reasonably priced but not cheap. This slant away from deep value toward quality at a reasonable price is the reason why he is so wealthy today.

Coca-Cola (NYSE:KO) is perhaps Buffett’s most famous investment, and this is one of the businesses he acquired at a relatively high price, compared to value securities.

The Coke trade

In 1989 Buffett bought $1 billion of Coca-Cola stock. At the time the shares were trading at around 16× 1988 profits. Buffett was willing to pay such a high multiple because he believed in the outlook for the business. He wasn’t paying for Coca-Cola’s past earnings; he was paying a premium for future potential.

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Throughout the 1980s, Coca-Cola grew net income at around 12% per annum. Net margins were consistently in the 10% area, and the firm also had a consistent track record of capital light operations. Without a need to reinvest profits in expensive capital equipment allowed Coca-Cola to return a huge amount of cash to shareholders. Between 1983 and 1988 the company retired 11% of its outstanding shares and between 1970 and 1988 Coca-Cola’s dividend grew at a rate of 9.4% per annum.

Even in 1988, Coca-Cola was the world’s leading beverage brand, and it didn’t take much to realize that if the business continued to grow at the rate it did throughout the '80s and return capital to shareholders at the same rate, the stock would be worth significantly more in three or four decades than it was at the time Buffett was buying.

Even if you assume the company’s revenue only grows in line with the world’s population, Coke’s share repurchases and dividend increases would have still produced impressive returns for shareholders.

Pay more for quality

This is a perfect lesson on why sometimes it is worth paying for quality. Shares in Coke have never really been cheap; it has always been about the company’s future potential. Even if Buffett had bought Coke stock at 20 times historic earnings, the shares still would have produced an impressive return over the next few decades thanks to the company’s steady growth and capital return. What’s more, there is almost no risk of the company going out of business. With over 200 billion servings of the group’s soft drinks being served in 1988, it would have taken a massive scandal to undermine the business around the world. Even then, the breadth of Coke’s brand portfolio likely would have saved the business from destruction.

If Buffett had waited to buy into Coke’s growth story, it’s likely he never would have been offered the chance. Even in the financial crisis shares in Coke never traded for less than 15 times trailing earnings so the stock would never have been cheap enough for the most die-hard value investors.

The interesting thing is Coke’s returns have not been that spectacular. Over the three decades since Buffett began buying the shares have returned 11.9% CAGR including dividends. This return won’t change your life overnight, but over the long term, as Buffett realized, such slow, steady and predictable returns with limited downside are worth paying for. The long term returns add up.

Disclosure: The author owns no share mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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