Thursday, 24 May 2012

Did Buffett indeed make a mistake by not selling Coke?

Lessons from Buffett’s Decision not to Sell Coke: “I talked when I should have walked”
Written by Greg Speicher on August 2, 2010

In his 2004 letter to the shareholders of Berkshire Hathaway, Warren Buffett admitted that he made a mistake by not selling certain stocks that were “priced ahead of themselves.” The episode contains some powerful lesson that we can use to improve our investment results. 

Let’s look at how the businesses of our “Big Four” – American Express, Coca-Cola, Gillette and Wells Fargo – have fared since we bought into these companies. As the table shows, we invested $3.83 billion in the four, by way of multiple transactions between May 1988 and October 2003. On a composite basis, our dollar-weighted purchase date is July 1992. By yearend 2004, therefore, we had held these “business interests,” on a weighted basis, about 12½ years.
In 2004, Berkshire’s share of the group’s earnings amounted to $1.2 billion. These earnings might legitimately be considered “normal.” True, they were swelled because Gillette and Wells Fargo omitted option costs in their presentation of earnings; but on the other hand they were reduced because Coke had a non-recurring write-off.
Our share of the earnings of these four companies has grown almost every year, and now amounts to about 31.3% of our cost. Their cash distributions to us have also grown consistently, totaling $434 million in 2004, or about 11.3% of cost. All in all, the Big Four have delivered us a satisfactory, though far from spectacular, business result.
That’s true as well of our experience in the market with the group. Since our original purchases, valuation gains have somewhat exceeded earnings growth because price/earnings ratios have increased. On a year-to-year basis, however, the business and market performances have often diverged, sometimes to an extraordinary degree. During The Great Bubble, market-value gains far outstripped the performance of the businesses. In the aftermath of the Bubble, the reverse was true.
Clearly, Berkshire’s results would have been far better if I had caught this swing of the pendulum. That may seem easy to do when one looks through an always-clean, rear-view mirror. Unfortunately, however, it’s the windshield through which investors must peer, and that glass is invariably fogged. Our huge positions add to the difficulty of our nimbly dancing in and out of holdings as valuations swing.
Nevertheless, I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked.
As the following charts show, of the big four, Coke and Procter & Gamble reached the most extreme levels of over-valuation. According to Value Line, Coke sold at an average P/E ratio of 47.5 during 1999, its peak being considerably higher.  Procter & Gamble sold at an average P/E of 30.8 during 1999.

(all graphs show quarterly prices and P/E ranges from 1/1/1996 to 7/30/2010)
American Express
Procter & Gamble
Wells Fargo
(click images to enlarge)
What lessons can be learned from this?
If you’ve read my investing blueprint you know that I am a strong proponent of patient business-like investing for the long-term. This is a proven way to create wealth. However, at a sufficiently high price, all assets – no matter what their level of quality – should be sold.
What is sufficiently high? When the price clearly exceeds all reasonable estimates of the Net Present Value of the business’s earnings after taking taxes into consideration. 

What can make this difficult is that the intrinsic value – the net present value of all future cash flows – of a truly great business may be strikingly high in relation to its current earnings. Consider that a 50-year bond with economics similar to those of Coke (ROE of 30% and a payout ratio of 66.67%) would have a net present value of 46x earnings, assuming a discount rate of 8%. (Here’s the data.) 
However, unlike a bond where the coupon is set and contractually obligated, a holder of equity has no future guarantee other than his judgment about the competitive advantages of the business.  At the peak of the bubble, Coke’s price appeared to more than fully reflect the next 50 years of earnings and then some.
Plus, the proceeds of the sale could have been redeployed in cheaper assets, thereby raising the intrinsic value of Berkshire Hathaway. The challenge is that, unless you have a specific immediate purchase in mind, you never know how long you will need to wait to re-invest the funds of a sale.
If you buy or hold an overvalued security it will materially impact your future performance. Many stocks purchased during the Internet Bubble have shown a large increase in earnings with no progress in the price of the stock.
Consider an example. In 1999, Microsoft earned $.70 a share, sold for an average P/E of 49.8 and traded between $34 and $60 per share. Ten years later during 2009, it earned $1.62 per share, more than doubling its earnings, but sold for an average P/E of 13.4 and traded no higher than 31.5. Lesson: don’t overpay – it’s costly!
Confirmation Bias
Beware of confirmation bias, which Wikipedia defines as, “a tendency for people to favor information that confirms their preconceptions or hypotheses whether or not it is true.” Buffett was long on record as saying that his favorite holding period was forever, going so far in his 1990 shareholder letter as to call Capital Cities/ABC, Coca-Cola, GEICO, and Washington Post his “permanent four”. The risk with confirmation bias is that you are liable to act irrationally even at the expense of your own interests.
How Much Cash Will You Get Back?
If you are a businesslike investor, you should actually expect that a business in which you invest will deliver more cash than you put in. This is how Buffett operates as is evident from the comments about how much of his cost for purchasing shares in the “Big Four” he had already received. This is a lesson in how to think in a businesslike fashion about investing.
“The glass is invariably fogged”
Investing – whether deciding on a new purchase or whether to hold an existing investment – is always a business of judgment fraught with many uncertainties: “the glass is invariably fogged.” Accept this and get on with it by putting a premium on hard work, exceptional research, and following a rational investing process with great discipline.
What are your thoughts? Did Buffett indeed make a mistake by not selling Coke?


Read below or add a comment...
  1. M. Ofenheim
    I don’t believe he did make a mistake by selling Coke. I one thing I learned reading and listening to Buffett is that all currencies are a race to the bottom. A dollar will simply buy less in 20 years than it does today.
    I doubt Coke will outperform the S&P during the next 5-10 years, however a business like Coke is one of the few franchises in the world that possesses true pricing power. Coke will sell just as many cans, bottles and syrup, if not more and at a higher price due to natural inflation. As result the value of the business reflected in the total market cap should be preserved.
    Of course we need to add the following caveats:
    1. Is there Competant management?
    2. Are they enhancing the existing brands?
    3. Are they adding brands either thru internal development or fair valued purchases of outside businesses (i.e. Vitamin Water)?
    4. Are they increasing shareholder value (share buybacks, increasing dividends)?
  2. Drew Kennedy
    Consider capital gains taxes before selling.
    Imagine you bought a company for $500, thinking its fair value is $1000. If the company is currently trading at $1500, you would say it is overvalued and might consider selling. If you sold, and the capital gains tax rate was 30%, then you would owe $450 in taxes and have $1050 after tax.
    By selling you gain the ability to invest the cash elsewhere. But if the business you are selling is Coca-Cola, Gillette, or American Express, it will be hard if not impossible to find a better business. Even if you know of similarly great businesses, there is no guarantee that they will be cheap.
    On the other hand, by selling you lose out on any dividends, and real business growth. You will also be losing purchasing power due to inflation (should you hold cash). Finally there is no guarantee the price will fall sufficiently to make the business a bargain once again.
    If the business is terribly overpriced, your taxes will be low, and you have better companies at cheaper prices to invest in, then the decision is that much easier.
  3. Drew Kennedy
    My math was wrong.
    The tax of $450 was based on 1500-(1500*.30). I incorrectly included the total sales price and didn’t take into account the purchase cost.

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