Warren Buffett loves drinking Coca-Cola (KO), and has been publicly advocating buying Coca-Cola Company stock at least since he purchased over $1 billion of it in 1988. While Buffett is perhaps the quintessential fundamental analyst, he bases his approach to investing on that of his mentor, Ben Graham, who taught investing based, as he put it, “not on optimism, but on arithmetic.” Graham applied a rules-based, quantitative style to his investing decisions that is sometimes at odds with the Buffett approach.
Here at Turnkey Analyst, we wanted to apply some current, academically-proven quantitative methodologies (of which Ben Graham likely would have approved) to Mr. Buffett’s KO investment, in order to explore how Ben Graham might have viewed an investment today in his protégé’s favorite soft drink company.
The Coca-Cola Company is the world’s largest manufacturer, marketer and distributor of non-alcoholic beverages. Coke has been sold in the U.S. since 1886, is currently sold in over 200 countries, and is perhaps the most recognizable brand in the world. Below is the summary output for our fundamental and quality quantitative factors:
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KO generates an overall Turnkey Score of 56.4%, consisting of the average of a Quality Measures score of 70.1%, and a Pricing Measures score of 42.7%. At first glance, the quality score looks strong, as might be expected from a Buffett investment, yet the pricing score is below average. Let’s take a closer look at the makeup of these numbers and see what we can learn about the company.
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Based on our output, KO’s economic moat looks very strong indeed. Normalized (8 yr average) return on assets of 14.9%, and return on capital of 21.5%, place the company in the top 3%-4% of our screening universe which includes even very small companies (>$250mm). This is nothing short of astonishing for a company with a $150 billion market capitalization. Margin stability is rock solid at 54.7%, placing the company in the 94th percentile. If you look at the gross profit graph, above left, you will see that margins remained essentially unchanged through the great recession of the late 2000s. The company is also a cash cow, generating a normalized (8 yr average) cash from operations – capex / assets return of 56.5%, which puts it in the 84th percentile. Finally, the company has not lost money in any of the past eight years. Clearly, as Mr. Buffett can tell you, KO has a wide economic moat, which will serve to protect its cash flow and market share for many years to come.
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In reviewing our Recent Operation Improvements screen, above, we see a few items impacting the company in the short run that could merit additional scrutiny. Notwithstanding KO’s overall margin strength, we see that gross margins have declined this year by 3.4%. The asset turnover ratio has decreased by 12.9% over the past year, suggesting the company is using it assets with less efficiency. There are signs liquidity is getting squeezed; the quick ratio fell by 15.8%, and receivable turnover fell by 1.2%, which means the company has to tie up cash as it awaits payment. Additionally, the debt to capital ratio has increased by 13.7%. KO scores a 44% in our overall recent improvement assessment, so a fundamental analyst would probably want to review some of these trends to assess whether they could evolve into more significant issues in the future.
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The output from our Earnings Quality screen was frankly puzzling to me. The ratio of operating accruals to assets was abysmal at 4.6%, landing KO in the 6th percentile of our universe. Operating accruals / net income was also high at 29.2%, leaving KO in the bottom quartile. Net operating assets / total assets of 16.6% is also below average. This would be an area where an analyst could dig in and figure out why these accruals seem to be creeping into the financials. Companies with a lot of accruals tend to underperform the market, and the condition is not sustainable in the long run.
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Turning to our Shareholder Yields output, we can see in the graph above how net income has recently shot up above unlevered FCF, reflecting the accrual issue. It makes sense then that the net income yield on market cap of 8.1% is the company’s best score across our screening metrics. Normalized (8yr average) net income is about average at 4.2%.
Normalized (8yr average) EBIT and FCF yields of 4.8% and 4.5% are both below average in our universe, while TTM EBIT and FCF to TEV yields, at 5.9% and 3.3%, are even worse, and put the company in the 36th and 37th percentiles. Finally, book to market is also low at 22.6%, which is the bottom quartile of our universe. Overall, it would be hard to argue that the company is especially cheap.
Turnkey tends to overweight the value of the economic moat, versus other quality metrics, which is why KO’s overall quality score remains high at 70.1%, despite some questions around recent improvements in operations and the accruals issue. So the output suggests KO undoubtedly continues to be a very high quality company, but in particular the low Earnings Quality score of 24% would be worth some further review. Additionally, our Shareholder Yields score of 42.7% means the market requests that you pay up if you want to own KO’s powerful brand, and the hefty long run returns on capital and assets its economic moat generates.
What is a brand worth? In the case of KO’s brand, it can be worth a lot. Many questioned in 1988 why Warren Buffett would pay such high P/E and cash flow multiples for KO, but since then his investment has compounded at high rates. Yet KO is not infallible; it has underperformed the S&P for significant stretches. Ben Graham probably would have struggled to assess KO’s intrinsic value, and might have had questions about the accruals issue. His rigorous, detail-oriented methodology lends itself better to identifying and purchasing companies that are extremely cheap versus their liquid cash value or an earnings stream. KO is not necessarily cheap on either of these dimensions.
Graham recognized that his approach was not for everyone; he believed that some investors, with less time to devote to analysis, should opt for a passive approach, and put their capital into stable and reliable long-term businesses. KO definitely qualifies in this respect, and maybe this was part of Buffett’s thinking when he bought KO.
So at the end of day, perhaps an investment in KO boils down to a question of style. If you buy KO you will probably have a satisfactory outcome, but if you are dyed-in-the-wool Grahamite, ready to roll up your sleeves and do the hard work to find deep value, there are better statistical bargains out there, waiting to be uncovered.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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