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Collection: Mohnish Pabrai - #109 'Buffett's Investment In Coca-Cola, Part 1 Models'



How do you make investments? You know, how do you know something is a great idea or not? And I think – what I do is take the example of one investment that Warren Buffett and Charlie Munger made which was the investment with Coca-Cola. And I wanted to go through the models they used when they made this investment.

So, there was no spreadsheet ever created when they did the Coke investment from then till today, it is about almost 30 years since they made the investment. They have no analysts or associates or anyone who helps them. I don’t even believe they make much in terms of notes when they make the investment, but they thought very deeply about it.

And for most investments, if you can't do the math in your head, then it should be an automatic pass. So there was no DCF model run for Coke, there was no numbers based models. I mean they had some numbers in their mind, but they never – I don’t think they ever deduce them into paper.

But they did have I think – And I may be missing some of them, but I think there were dozens upon dozens of models that they used in making the investment. And what happened is that when you have an overlay between models, that's when you get what Charlie Munger called “lollapalooza effect," you know, 1 plus 1 becomes 11. And so it's really kind of the interplay between the models that lead to kind of the “aha” moment and such.

So Charlie Munger had given a speech to a group that basically elected to be secret, they told them not to disclose the name of the group that he gave that speech to. And after he had the speech – where part of the speech covered the Coke investment – they told him, it was a useless speech. That you know and so – they didn’t appreciate it. And the – and I actually think it was one of his more brilliant speeches and it actually gives a window into how they think. So, I think it is useful.

So anyway, the Coke investment that Berkshire Hathaway made, was made between 1988 to 1990 about a three years period when they bought the stock. And at that time, they invested about $1.3 billion into Coke, and $1.3 billion at that time was approximately 1/4 of the book value of Berkshire Hathaway. So they made a very significant bet.

I mean you think about an insurance company taking 1/4 of their equity into a single stock. And that's what they did at that time. And so – And the last bit of Coke that Warren bought in 1990 was bought at about 25 times trailing earnings. So it wasn’t cheap by traditional metric that you might use.

But on many front, they considered a no brainer and obviously, they have now not touched that position for almost like you know, approaching 30 years. And I don’t think they are going to touch that position even well after Warren and Charlie are gone from the scenes. So I don’t think the Coke position is going to be touched at Berkshire for a very long time.

So, why did they make the investment, right? And what went through their minds to make the investments?

And so one of the things that Warren and Charlie has said is that, if they had not invested in See’s Candy, they would have never ever invested in Coke. So, to understand the Coke investment, we should go back to the See’s Candy investment, because that would give us some clues.

[Mohnish Pabrai on See's Candies -]

So when the Coke idea came in front of them, there were couple of things that were different about Coke from See's. The first thing was that Coke travel really well and they could see that. So they have repeatedly try to take this brand (See's Candies) into even the neighbouring states, they couldn't do that.

There are only two countries today in the world, where you cannot get Coke. And I forget there is – North Korea is one of them but I forget what – Pardon?

Yeah, Cuba that's right. So Cuba and North Korea are the only two countries where you cannot get Coke today, right? But what they noticed is that even in these two countries, if Coke tomorrow started selling in these countries with no advertisement, it will take off in quite a significant way.

Because it's – you know, that brand has meaning even to people who have never drank Coke before and never seen an ad because it's so much part of our pop culture and movies and what not, that is entrenched. So basically, what they found is that unlike See's, Coke travels really well.

And Warren studied this phenomena about the difficulty of traveling with See's very carefully because he was very interested in making See's, global. He would love for See's to become a global company and with all the brain power they had, they could never do that. And but here has a company that was naturally a global company.

The second thing he noticed that were different between See's and Coke – So you know, he has been drinking 5 Coke a day since he was 6 years old. And so, you know, Coke has been regular part of his diet for like 80 years or something.

And so the second thing he noticed was that there was a limit to the amount of fudge you could eat. You know, so, as you eat more fudge of See's Candies, your ability to eat more of it declines. And but with Coke, you know, the lack of an after taste means that the ability to consume Coke is quite significantly higher than the ability to consume candies.

In fact, the – a person could consume 5 or 6 Coke a day pretty much for their whole life without really feeling like they were having something monotonous. And many of us do that. How many of you have 1 or more Coke products daily? No one admits to having Coke?

So actually you are having other Coke products you just don't recognise they are made by the company. They got like over a 100 brands. So the second thing they recognised was that unlike fudge and peanut butter brittle and such that – peanut brittle, I'm sorry – that you couldn't – Coke, you had no after taste and so the volume you could consume and the frequency that you consume it was quite different.

And in fact, even if you compared it to something like McDonald's, which is a very good model. But if you were eating at McDonald's everyday that will – could probably get to you much faster than consuming Coke everyday. So they noticed that this particular product had this nuance of recurring consumption, not really being an issue in terms of purchase. So these were some of the models that they knew about before they started to research Coke.

And the third thing, they also recognised different between See's and Coke, was with See's, you needed retail space, right? So they had to have a See's store and you know, pay rent and all these things to sell it. But Coke got sold in all these places where the company didn't pay any rent, you know, it was just sold all over the place.

So it had – And I will go through a little more details about the – kind of the capital-lite model of Coke. So there were a number of reasons why Coke was very capital efficient, far more capital efficient than even See's was.

So even though, See's in 1984 was producing $13 million on $20 million invested capital. I mean, that's a very high return, you know, 65% return on invested capital, really good business. Coke was even better than that, it was a truly remarkable business.

And so then the second part of the mental model that come in is that, Warren and Charlie like to go through long histories of these companies that they study. So with Coke, both of them read every annual report since the company was public. So they start – they read every annual report from 1919, which is when Coke went public until the late 1980s, every single annual report. And they got some insights from reading those annual reports.

And one of the insights they got was that from the period of 1919 to, let's say, 1987, they had never been a year when Coke's unit cases sold was lower than the previous year. So through the Great Depression, through the Second World War II, through the Korean War, through all the stagflation of the 1970s, through all of that. Unit case volume just every single year went up over the previous year, non-stop.

And the second thing that they noticed was that Coke which started in Rome, Georgia went through this major international expansion so they were repeatedly over the years, they were first only in the Southern U.S. then they kind of spread out to the U.S. and then Canada, and then they started spreading out.

And in fact, World War II took them to all the places where the U.S. Army went. And so they saw the whole way Coke entered one new country after another and what happened after they enter the country. So they could see that from the read of those reports. And what they concluded was that the runway was really long – and I'll get to the runway.

So the way they define the runway from reading Coke is that humans need to ingest water to survive, right?

So we need to ingest about 64 ounces of water a day to survive and humans prefer to consume flavored water over plain water. So at least some portion of that 64 ounces, they prefer to consume flavored versus plain.

In fact, Warren's daughter said that she has never ever seen her dad drink water, you know, she said she never seen her dad drink a bottle of water or drink a glass of water, never happened. And so, Warren I think what – 40 ounces a day is coming from Coke, I don't know where the other 24 ounces are coming from but she says water is not part of the deal.

And so if you take the 64 ounces that humans have to drink, they figured that at infinity, you probably get to something like, 50% of that volume gets consumed in one way or another in a flavored format. And you can take that today where if you look at something like Dasani which is the Coke's brand for water as part of that. So you know some kind of bottled beverage becomes about half of it.

And they found that could probably take 50% of the – of that flavored portion, so 16 ounces per day per person which is two servings. And so they just look at the unit volume, they look at the number of servings, they look at the number of humans, and they look at that runway and they said that we've got a long ways to go here.

And so you got basically, this distribution engine where you can pump a lot of brands through it, you know, Minute Maid and you know, Monster and all these things. And world population was growing so as world population grew Coke consumption would grow. GDP was growing in countries where GDP were very low, so if you look at a country like Mexico, for example, the per capita Coke consumption in Mexico is the highest in the world, it's above the U.S. And there are other countries in the world where they're at 100 of Mexico's volume.

So Coke would grow as it went into new countries, it would grow as GDP grew, it would grow as per capita consumption grew. And so that was another part of what they learned from reading annual reports.

And then Warren read this Fortune article which was written in 1938 about Coke, and the writer of the Fortune article said that, you know, this is a marvellous company in 1938 has done so well. And then he said well, of course the rides over because the company went public in 1919 at $40 a share, and now that is worth $3,300 per share, if you – you know, go back to the stock split and all that. So, you know, the writer of the article said you know, it's great to know that but, you know, the ride is over.

And Warren said the ride was not over because, if in 1938 you invested a fresh $40 into Coke, by 1993 it was $25,000. So you had – You could have missed the first 20 years and you still had runway after that.

And so they – Another model they used was they didn't have an anchoring bias. A lot of times in investing what happens – In fact, I am very guilty of that is we tend to look at kind of past performance of a security, and that taints the way we look at it.

And actually what you really got to do is ignore the past just focus on the future. And so they were really good at not having this bias about, hey, this company's been growing from 1884 till a hundred plus years. Now, we want to invest in it and a hundred years after this company got formed we are putting 1/4 of our capital in. Have you lost it? They didn't think about it that way.

And then, you know, some of the other things that they realize is that the company was currency proof. It was asteroid proof. It was thermonuclear blast proof. It was anarchy proof. It was pretty much a bulletproof from anywhere you look at it.

So if you think about a situation where you have, let's say, an extinction level event takes place in, let's say, an asteroid comes in and let's say, the asteroid takes out 6.5 out of the 7 billion humans, let's say, we are left with a few hundred million.

Well, the Coca-Cola Company has a trademark and they have the formula, and they will eventually start producing Coke again, and they will probably get back into business and such. And you could not say that about almost any other business when you have that sort of an event takes place.

And so even if currencies change or got devalued or whatever happened, Warren's perspective was that people would be willing to trade 2 minutes of labor for a Coke. And so the trading of labor versus Coke would be independent of currency. So that was another part of the model.

And then, you know, the notion that our mouths are a very personal space right? There is a few spaces humans have, kind of very, you know, are very sensitive about, mouth is one of them. And we are kind of sensitive about what we put into our mouths. And so if you see a Coke and you had it in the past et cetera, you won't think twice, and even if you're in a different country, you will have it, no problem.

But if you see some kind of unknown brand, it's kind of like, you know, you eat Wrigley's chewing gum and then someone presents to you Glock's chewing gum and you know, it say would you like some? You know, you're probably not going to take it. And so our mouth is a very personal space and we are not going to be messing around, we're trying to take the low bid on what goes into our mouths. So they felt that we are creatures of habit once we get these habits formed then we are not going to be willing to change them especially with personal space like our mouths.

And the second is about humans are creatures of habit, you know like we shave everyday on the same side of the face first, or in the case of lady, in the same leg first. We do things in a certain pattern. And again, once we get to those habits and patterns, we are reluctant to make those changes. So, they saw all these things and they saw all of this was kind of coming together from their reading with the annual reports.

And then they looked at the – You know, so I've already probably gone through maybe 20 or 30 different models they used. We still have a lot more to go.



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