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Learning From Warren Buffett's Decision to Buy Coca-Cola

Coca-Cola (NYSE:KO) is probably one of Warren Buffett (Trades, Portfolio)'s most successful investments. The Oracle of Omaha started to build a position in the soft drinks manufacturer in 1988. He acquired a 6.2% position in the business, paying $1 billion.


Buffett took advantage of the 1987 stock market crash, in which investors dumped stocks of all shapes and sizes without giving thought to their underlying fundamentals. Coke was one of the companies many investors decided to unload. Sensing an opportunity, Buffett started to buy the stock.

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However, what made him decide that the business was worth buying at that point? He gave investors some insight into his thinking in Spring 1991 in a lecture to students at Notre Dame.

Buffett's investment process

Buffett described that at the time, the entire business was only selling for $14 billion in the market. However, if you were to add "a penny to the price of every Coca Cola sold in the world this year, that would add $2 billion to pretax earnings."

This was the genius behind the investor's decision to buy Coca-Cola in 1988. The stock looked relatively expensive compared to previous investments Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) had acquired, and it even looked expensive compared to its past earnings. It was Coke's future earnings potential that interested Buffett.

Buffett explained that the company had a bright future because it could raise prices without consumers leaving the brand. You can only make more money by raising the price of a product if more customers or the same number of customers continue to buy the product. If the price causes consumers to go elsewhere, then the business is going to have problems.

This was Coke's primary advantage. The company could raise prices without losing market share, and it had been doing that for nearly 100 years at the time Buffett started buying the shares:


"When they bought the Coca Cola Company, the Candler family bought it from Pembertons back in 1904 or 1906, they paid $2,000 for the company. If the Pemberton family had reserved a penny a serving royalty a serving, the Coca Cola company would be sending $2 billion to the Pemberton family every year and you wouldn't even see the difference in the figures. It's there."



These numbers suggest that any patient, long term investor would have done exceptionally well buying Coca-Cola stock at any point in the past 100 years. That's even if the stock looked expensive at the time of the acquisition.

The company has extreme pricing power, and this allows it to increase prices every year. That results in steadily growing profits, which means that if you buy the stock at a premium price, it will grow into its valuation over the long run.

That's not to say that investors should ignore valuation when buying Coca-Cola, but it is perhaps less critical than with other businesses that lack the same kind of pricing power. As a counterpoint example, Buffett referenced Berkshire's original textile business:


"Now that's not true when I was selling [men's suit] linings [Berkshire Hathaway's original business]. I sold men's suit linings for 20 years. We tried to raise our price a half a cent a yard, and on an 80-cent-a-yard product, people who'd done business with us for 80 years slammed the door in our face. (garbled) ... "but half a cent a yard"... Nobody ever went into a store and said "I'd like to buy a pinstripe suit with a Hathaway lining." Never. They say "I want a coat" all over the world."



Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.