Wednesday, June 8, 2011

Buffett on Coca-Cola: Berkshire Shareholder Letter Highlights

The excerpt below provides some historical perspective on Coca-Coca (KO).

As a major holding of Berkshire Hathaway (BRKa), Warren Buffett not surprisingly draws from the example of Coca-Cola but, from my perspective, what he says below applies to many other high qualiity franchises.

Which ones? Things like Pepsi: PEP, Heinz: HNZ, Diageo: DEO and Johnson & Johnson: JNJ come to mind among many others (i.e. brands consumed everyday with scale and broad distribution).

From the 1993 Berkshire Hathaway shareholder letter:

Let me add a lesson from history: Coke went public in 1919 at $40 per share. By the end of 1920 the market, coldly reevaluating Coke's future prospects, had battered the stock down by more than 50%, to $19.50. At yearend 1993, that single share, with dividends reinvested, was worth more than $2.1 million. As Ben Graham said: "In the short-run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long-run, the market is a weighing machine."

Later in the letter, Buffett highlights a Fortune article from 1938. The writer of the article implies that it was already too late, back in 1938, to benefit from the ownership of Coca-Cola's stock:

In 1938, more than 50 years after the introduction of Coke, and long after the drink was firmly established as an American icon, Fortune did an excellent story on the company. In the second paragraph the writer reported: "Several times every year a weighty and serious investor looks long and with profound respect at Coca-Cola's record, but comes regretfully to the conclusion that he is looking too late. The specters of saturation and competition rise before him."

Yes, competition there was in 1938 and in 1993 as well. But it's worth noting that in 1938 The Coca-Cola Co. sold 207 million cases of soft drinks (if its gallonage then is converted into the 192-ounce cases used for measurement today) and in 1993 it sold about 10.7 billion cases, a 50-fold increase in physical volume from a company that in 1938 was already dominant in its very major industry. Nor was the party over in 1938 for an investor: Though the $40 invested in 1919 in one share had (with dividends reinvested) turned into $3,277 by the end of 1938, a fresh $40 then invested in Coca-Cola stock would have grown to $25,000 by yearend 1993.

Coca-Cola's potential to compound in value wasn't done in 1938 or 1993 and certainly isn't now. Though a large company, the economics that have propelled Coca-Cola's value upward aren't anywhere near exhausted.

Still, I'm guessing some will judge Coca-Cola's future propects beyond 2011 in a similar manner to that Fortune writer. That, once again, Coca-Cola is a great company with upside limited by sheer size and competition. Basically, that investors too late...again.

With the above in mind, consider how often layers of complexity and cost are added to the investing process when a perfectly sound and straightforward option is right there in front of you.

Below is an example (one of many) of how investing can be made more difficult and expensive than it otherwise needs to be. According to this Wall Street Journal article by Jason Zweig, an e-mail from Action Alerts PLUS, a trading tip service of Jim Cramer, claimed "My portfolio is CRUSHING the S&P 500..." and claims to have more than doubled the return of the S&P 500.

A bar graph showed the following performance comparison from January 1, 2002 to April 1:

S&P 500: 15.5% return
Mr. Cramer's Portfolio: 39.2% return

The above results apparently include dividends for Mr. Cramer's portfolio but does not include dividends for the S&P 500. The Wall Street Journal article says that the return of the S&P 500 with dividends was 38.3%.

So just a bit less than Mr.Cramer's portfolio.

Those returns are before trading costs, taxes, and the subscription fee ($ 299.95 for the first year) for the letter. The article points out that something like an average of 774 trades annually would be required.

774 trades? Yikes.

Let's do some math.

774 trades multiplied by a typical $ 7 per trade commission would cost an investor $ 5,418 per year.

So someone with a $ 100,000 portfolio would with $ 5,418 in commissions obviously be incurring more than 5% in frictional costs each year. Obviously, you'd need a much larger portfolio or lower trading costs so those costs don't substantially reduce total returns.

In fact, going back to 2002, a portfolio with 5% in annual commission costs easily wipes out (and then some) the 39.2% claimed total return. So the target audience for this service would have to be someone with much more money than $ 100k. Even so the math just doesn't work since that portfolio didn't even really outperform in the first place.

From the Wall Street Journal article:

...you could have bought and held an S&P 500 index fund and then done utterly nothing except reinvest your dividends. And you, too, would have more than doubled the market's return—calculated without dividends.

Alternatively, you could just steadily buy something like Coca-Cola (and a few of the other great franchises), whenever market prices seem reasonable*, and go beach.

If nothing else you'll save a whole lot on commissions.

Adam

Long all stocks mentioned except Heinz

* Coca-Cola and many other great consumer franchises became extremely expensive in the late 1990s. At that time they could not be bought at prices that would produce a satisfactory return. Market prices for these stocks were materially higher than intrinsic value. The past decade has mostly corrected this in my view.
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