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Buffett’s Addiction
© 2013 · Phoenix Capital Research, OmniSans Publish, LLC. All Rights Reserved. Protected by copyright laws of the United States and international treaties. This newsletter may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of OmniSans Publishing, LLC. · All Rights Reserved.
Disclaimer: The information contained on this newsletter is for marketing purposes only. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice by Phoenix Capital Research or any of its affiliates, nor is it to be relied upon in making any investment or other decision. Neither the information nor any opinion expressed on this newsletter constitutes and offer to buy or sell any security or instrument or participate in any particular trading strategy. The information in the newsletter is not a complete description of the securities, markets or developments discussed. Information and opinions regarding individual securities do not mean that a security is recommended or suitable for a particular investor. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Opinions and estimates expressed on this newsletter constitute Phoenix Capital Research's judgment as of the date appearing on the opinion or estimate and are subject to change without notice. This information may not reflect events occurring after the date or time of publication. Phoenix Capital Research is not obligated to continue to offer information or opinions regarding any security, instrument or service. Information has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. Phoenix Capital Research and its officers, directors, employees, agents and/or affiliates may have executed, or may in the future execute, transactions in any of the securities or derivatives of any securities discussed on this newsletter. Past performance is not necessarily a guide to future performance and is no guarantee of future results. Securities products are not FDIC insured, are not guaranteed by any bank and involve investment risk, including possible loss of entire value. Phoenix Capital Research, OmniSans Publishing LLC and Graham Summers shall not be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided. Phoenix Capital Research is not responsible for the content of other newsletters to which this one may be linked and reserves the right to remove such links. OmniSans Publishing LLC and the Phoenix Capital Research Logo are registered trademarks of Phoenix Capital Research. OmniSans Publishing LLC -‐ PO BOX 6369, Charlottesville, VA 22906
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The old man paused to lift his drink. “I can understand this,” he said pointing at the can. “I mean, you can understand this, anyone can understand this… This is a product that hasn’t been changed much since 1886. It’s a simple business…” In front of him, the audience of MBA graduates sat dead silent, hanging on his every word. These young men and women had spent most of their lives sitting in classrooms listening to lectures. And yet, instead of rushing to the nearest bar to celebrate their graduation, they sat and listened to the old man for nearly an hour. No one interrupted. No one yawned or got up to leave even when the old man rambled about castles and dragons. Instead, they listened as though their livelihood depended on it. In many ways it did… When it comes to investing, book learning and actual experience are wholly different. These students of business and investing had just spent tens of thousands of dollars learning the former. The man in front of them, Warren Buffett, specialized in the latter. And few things are as educational to an investor as hearing Buffett explain how he became the richest man in the world by investing in “simple” businesses like Coke.
Buffett’s Addiction August 28, 2013
In This Issue
• Reagan’s Tax Reform created a unique investment vehicle.
• The only dividend when
investor keep more than the tax man.
• A clean energy empire with a
6% yield. • Where the super-rich park
their capital.
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According to Amazon.com, there are over 3,500 books on or about Warren Buffett. An entire industry has sprung up around trying to understand how he does what he does. There are even investment newsletters whose entire strategy is to follow his actions. However, hearing Buffett explain himself in his own words, it’s clear than 99% of what’s written about him is wrong. For Buffett, there is no model or formula for investing. Instead he focuses exclusively understanding the business he is buying and buying it at a reasonable price. During his entire 50-‐minute lecture to Florida’s MBA graduates, Buffett didn’t mention P/E ratios once. In fact, very little of his talk even involved financial metrics. Anyone who wasn’t familiar with his track record would have thought they were listening to a very successful businessman, not a guy who picks stocks for a living. And they would be right. A stock picker would have sold Coke at its peak in the late ‘90s. In fact, a stock picker probably wouldn’t have invested in Coke in the first place, since the business is not particularly glamorous or exciting. However, Buffett, as one of Coke’s largest business owners, would note the following:
• Based on his purchase price ($3-‐$4 per share) he is recouping 50% a year on dividends alone.
• Coke is an inflation-‐proof business. It can continually raise its prices without damaging sales.
The final point is the ultimate for any Buffett business. Looking over the investments he made in the latter half of his career⎯the ones that made him the richest man in the world ⎯ he almost invariably bought companies that could raise their prices in line with inflation… or better yet, hide inflation through a variety of methods. One of the biggest myths perpetuated by the investment community is the notion that inflation always results in higher prices. Most corporations are aware that they cannot simply raise prices every time their costs go up. If they did, their customers would take their business to a competitor. As a result of this, companies resort to a number of strategies to maintain prices without hurting their sales. One of the most common tactics is to sell less product at the same price by using smaller packages.
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As the article below summarizes, Kellogg’s has reduced 15% of the cereal in its boxes. Snickers has reduced its bars by 11%. Haagen-‐Das has reduced content by 12.5%. Heinz Ketchup has reduced content by 11%, etc.
U.S. Companies Shrink Packages as Food Prices Rise
Large food companies have recently announced that they will raise the prices they charge grocery retailers for commodities-‐based products. For example, a chocolate bar will cost more soon: Hershey last week announced a 10% increase for most of its confectionery goods. Of course, straightforward price hikes could cause consumers to buy less of those products or to choose less costly store brands. So in many cases, food companies are trying a different tactic: Keeping the price of an item the same while decreasing the amount of food in the package. The company recoups the costs of the rise in commodities and hopes consumers don't notice that they're getting less of the product for the same price. http://www.dailyfinance.com/2011/04/04/u-‐s-‐companies-‐shrink-‐packages-‐as-‐food-‐prices-‐rise/
Another policy employed by companies to maintain profits is to swap out higher quality ingredients for lower quality/ lower cost alternatives.
Reuters is reporting that many of America's major brands have been quietly tweaking their coffee blends. While most coffee companies consider their blends trade secrets, and are loath to disclose exactly what goes into them, both circumstantial and direct evidence suggests they're now substituting lower-‐grade Robusta beans for some of their pricier Arabica, and degrading the quality of our coffee…
At least one coffee roaster has admitted it. In November, Massimo Zanetti USA, which roasts for both Chock full o'Nuts and Hills Bros., publicly confirmed upping its Robusta usage by 25% this year. Why the switcheroo? Prepare to not be shocked. The answer is: price. Last year, a shortage of Arabica caused prices of the premium bean to spike as high as $3 a pound -‐-‐ $2 more than what a pound of Robusta would cost. This compares to a five-‐year historical trend of Arabica costing closer to 70 cents more than Robusta. In recent weeks, the trend has reversed, with Arabica prices falling to just a 62-‐cent premium over Robusta.
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http://www.dailyfinance.com/2012/06/19/noticed-‐that-‐your-‐coffee-‐tastes-‐funny-‐heres-‐why/?a_dgi=aolshare_twitter
Warren Buffett made the vast majority of his fortune by focusing on investments that can either raise prices or engage in the above strategies to maintain profits during periods of inflation (between the 1960s when he started investing and today, the US Dollar has lost over 80% of its value). In the case of Coke, a can of Coke cost under 15 cents per can in 1964. Today it costs between 50 cents and 75 cents depending on whether you buy it in a 24-‐pack or from a vending machine. That’s a 233-‐400% price increase. And Coke’s business has only grown throughout that period. Buffett calls this quality “economic goodwill.” The basic notion is that the company has a grip on people’s minds that precludes them from balking at price increases. Gas prices go up to $3.50 and people start driving less. However, when a can of Coke goes from $1.00 to $1.25, people just keep on drinking it by the case. My friends, when you can grow sales while simultaneously raising the price of your product, you will make a ton of money. And few companies can do this better than this month’s pick. As most of you have no doubt guessed by now, I’m talking about Coco-‐Cola (KO). Buffett is the largest single owner of KO’s stock. All told he owns 8% of the company. If you listen to Buffett’s analysis of the company you quickly realize why this is his single favorite investment. Among other things, KO sells a product that
1) Has changed very little if at all in the last 100 years. 2) Is extremely inelastic from a price perspective (meaning if you raise prices, consumers
don’t demand less). 3) Has no taste memory: you can drink six Cokes a day and never get sick of the taste.
Other than water, there is no other foodstuff on the planet that can be consumed as frequently as Coke without the consumer becoming sick of the taste. For this reason KO meets almost every criteria Buffett looks for in a company. And this is why he refuses to sell it no matter what its share price is doing. This last point is key.
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Let’s say tomorrow Coke collapsed from $55 to $25 per share. Most investors would panic and sell. I, on the other hand, would be buying greedily. Why? Because Coke’s business has a fundamental value. Even during a Financial Crisis and Depression, people will continue to drink soda. So the opportunity to buy Coke at $25 a share (which would be 7-‐8 times cash flow) would be truly an extraordinary opportunity. Indeed, from an income perspective alone, the opportunity here would be fantastic. Consider that in 2009, Coke paid out $1.76 in dividends. With shares at $55, this means a dividend yield of 3.2% (roughly three times what you’d get by leaving your money in a savings account). However, if Coke shares fell to $25, that $1.76 suddenly becomes a 7% yield ($1.75/ $25.00). That’s a heck of a return from an income perspective. Even if globally the world entered a sharp Depression and Coke’s income fell by 30%, pulling its payouts down to $1.23, you’re still looking at a 5% yield. Indeed, companies like Coke offer the potential of REAL value should their share prices drop. Their fundamentals almost ALWAYS outperform investor sentiment. What I mean by this is that should there be another Collapse, Coke’s share price will almost certainly fall MORE from its current levels than Coke’s cash payouts or income will from theirs. During 2008, Coke shares fell 30% or so. However, Coke actually INCREASED its dividend that year. Anyone who bought Coke in October 2008, now collects a 4% yield on their shares (four times what he or she would get from a bank account). This is why companies like Coke remain so strong during times of Crisis. With the FDIC broke and most US banks insolvent, investors desperately need a place to park cash that will still EXIST in a few years. Companies like Coke are a reasonable alternative to a savings account in the sense that you’re paid a higher yield for your deposit (now 3%, but 5% or higher if Coke shares plunge). Buffett currently collects a Buffett first bought Coke back in 1988. Now, we can't be sure of the exact date because the available SEC filings don't go back that far, but Buffett's 1988 letter to Berkshire Hathaway shareholders announces that he'd purchased $592 million worth of the company by the year's end.
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However, we do know that Coke's 1988 market cap was $16 billion. That same year, Coke had $8 billion in sales and $1 billion in earnings. Using the above market cap numbers, we can determine the following valuation for Coke's business in 1988:
1988 Market Cap $16.3 billion
Sales $8.3 billion P/S 1.9x
Earnings $1.03 billion P/E 15.8x
So investing legend Warren Buffett bought Coke when it was trading a little under two times sales and a little over 15 times earnings. Moreover, KO was growing cash flow at an average of 21% per year.
Coke's Current Buffett's Buy Range P/E 21x 15.8x P/S 4x 1.9X
Today, Coke is more expensive… but it’s also a heck of a lot more profitable. In 1988, Coke had gross margins of 57%. Today, they're 60%. In 1988, net margins were 12%. Today, they're 18%. And Coke continues to grow at an astounding pace. Indeed, the company has more than tripled revenues since Buffett bought the company. Heck, it’s more than DOUBLED revenues in the last 10 years alone! Simply put, Coke is now a larger, more profitable and faster growing company than when Warren Buffett first bought it. In this context, as well as the current liquidity fueled market, KO is going to be more expensive than it was when Buffett bought it. Action to Take: Buy Coco-‐Cola (KO) Good Investing! Graham Summers Chief Market Strategist Phoenix Capital Research