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Thursday, December 14, 2006
When Warren Buffett first announced his purchase of Coke, people thought he’d lost his mind...
Buffett made his first investment in Coca-Cola (KO) in 1988. He purchased more than $1 billion of Coke stock, equal to 6.2% of the company. The position was so big, it represented 35% of Berkshire Hathaway’s entire common-stock portfolio.
He was supposed to be the steward of Ben Graham’s teachings about value investing yet with a P/E ratio of 15 and a price-to-cash flow ratio of 12 – Coke didn’t come close to meeting any of Ben Graham’s strict criteria for value investing. Buffett actually paid a premium for Coke. He paid a 30% premium for earnings and a 50% premium for cash flow over the average of the sector.
Nor was the stock price depressed. Between 1980 and 1988, Coke stock went up every year. In the five years before Buffett bought Coke, its stock rose an average 18% per year even after you factor in the Great Crash of 1987.
So the question is, if Coke wasn’t cheap, why did Buffett buy it?
“I look for simple businesses, with consistent performance, and favorable long-term prospects,” he said in an interview in 1989.
In Coke, Buffett saw the most consistent long-term growth of perhaps any corporation in history, without making any changes to the core product in 100 years. When Buffett bought in, Coke was enjoying its 25th year of consecutive dividend growth.
In addition, he saw a bargain in Coke’s stock price. The 1970s had been a disaster for Coke. It endured disputes with bottlers, was accused of mistreating migrant workers in the orange groves, and weathered environmental campaigns claiming Coke was responsible for litter and pollution. Overseas, several Arab nations slapped an embargo on Coke after it set up a factory in Israel, and the Japanese dumped thousands of bottles of soda into Tokyo Bay when the contents started fermenting on supermarket shelves.
But diversification was the worst crime. Instead of focusing resources on Coke’s most profitable operation, Coke’s chief, Paul Austin, invested in white elephants like water projects, shrimp farms, and wineries.
Result: Coke underperformed the S&P between 1974 and 1980.
Roberto Goizueta took over Coke in 1980 and immediately turned things around. He refocused the company, divested unproductive businesses, and concentrated capital in Coke’s most profitable operation – selling soda syrup. He also started paying higher dividends and, in 1984, announced Coke’s first stock buyback of 6 million shares. Soon after, Buffett started buying.
Buffett bought Coke in 1988. Between 1989 and 1999, the market value of Coke rose from $25.8 billion to $143.9 billion. The company produced $26.9 billion in profits, paid out $10.5 billion to shareholders and retained $16.4 billion for re-investment. For every dollar Coke retained, it created seven dollars in market value.
By the end of 1999, Buffett’s billion-dollar investment in Coke was worth almost $12 billion.
As editor of a newsletter dedicated to income investing, you might think a stock like Coke – with its measly 2.5% dividend yield – wouldn’t interest me. But check this out:
On November 29, 2006, Coca-Cola paid out 31 cents per share, making a total payout of $1.24 for 2006. Not great for a $50 stock, I understand. But Buffett bought his Coke stock – if you adjust for splits and dividends – closer to $3.75 in 1988.
To Buffett, the $1.24 dividend really feels like a 33% dividend. And that's why, when you get the chance to buy a stock with 25 years of uninterrupted dividend growth at a decent price, you take it.
P.S. The best investment opportunities are always found in the midst of panic. In the December issue of my newsletter, the 12% Letter, I added three crisis plays to my recommended portfolio. They pay 11% dividends, but they're so beaten down I see little price risk.
P.P.S. I got the details of Buffett’s Coca-Cola investment from Robert G. Hagstrom’s The Essential Buffett. It’s an easy read about our generation’s greatest investor. To order a copy, click here.
IS THIS THE “HARD FLOOR” IN CRUDE OIL?
Questions for DailyWealth: Is oil going below $50 a barrel in 2007? Or above $100? And what should I do with the answer?
Frankly, nobody knows for sure where the price of oil is going. We can only say crude oil remains above the “hard floor” provided by the $57-$61 a barrel range.
And here’s our guess for why that floor exists: Most of the world’s cheap oil has already been found... and we’re left searching for petroleum in places where communist idiocy and guerilla warfare rule the day. Venezuela, Sudan, and Nigeria come to mind.