The Secret to Warren Buffett's Investment in Coca-Cola and Heinz

Interested in finding the next great investment idea? It might not be as complicated as you think. Consider Warren Buffett, the folksy Midwesterner who also happens to be the most successful long-term investor in American history. His holding company, Berkshire Hathaway (NYSE: BRK-B  ) , built a fortune buying and holding shares of great American companies like Heinz and Coca-Cola (NYSE: KO  ) , among other brands you and I encounter on a daily basis.

While Buffett's investing abilities are extraordinary, his rationale for Heinz and Coca-Cola was quite elementary: He identified a deep connection between the product and customer, based primarily on taste. The science behind this unique attraction is complex, but it's also one of one of the simplest investment ideas I've ever come across.

A Heinz Ketchup container and Coca-Cola PlantBottle. Source: Heinz Press Room.

What's in a Coke and a condiment?
Any investor familiar with the Oracle of Omaha knows he has a soft spot for hamburgers and cherry Cokes, and he's not the only one. Hamburgers are about as American as apple pie (though no better for our waistlines), and a dab of Heinz ketchup and side of Coca-Cola improves the overall experience.

From Buffett's perspective, these products will resonate with customers for a century to come, and his optimism following a $28 billion takeover of Heinz in February was evident: "We hope to own Heinz 100 years from now. If you own great brands and you take care of them, they're terrific assets." Or, as his investing partner, Charlie Munger, says more colloquially, "[I]f you can buy a few great companies, then you can sit on your ass."

Buffett and Munger believe that time is on your side when you own a great business, but what is it that makes Heinz and Coca-Cola so compelling? Few specific brands have staying power of over a century, and we're talking about a vinegar-tomato concoction and coca-infused sugar water. Quite frankly, could these products be any easier to rip off?

Apparently not, as they share a secret attribute that has ensured their success over the years. It's not the only reason these companies have thrived, but it's perhaps the one that matters most.

Heinz's and Coke's secret sauce
For starters, Buffett's familiarity level with the food and beverage industry is higher than many investors realize. One of his first jobs as a young boy in Omaha was selling bottles of Coca-Cola door-to-door in his neighborhood. Since then, Buffett's dabbled in the food industry quite frequently throughout his investing career. Today, Berkshire has built a deep roster of familiar brands, including ownership stakes in Kraft FoodsMondelez, See's Candies, and Dairy Queen in addition to Coke and Heinz.

With the latter two, however, Buffett identified something special. He realized that the early success of Coke and Heinz back in the 1900s depended entirely on their signature product's near-perfect recipes. Lacking well-established brand names, Coke and Heinz attracted new customers based on taste, and the secret to their success was an optimal "flavor amplitude."

In 2004, Malcolm Gladwell dissected the concept of amplitude in great detail in his article, "The Ketchup Conundrum." Gladwell discovered that amplitude was "the word sensory experts use to describe flavors that are well blended and balanced, that 'bloom' in the mouth." No single element of the product's flavor outweighs the rest; instead, they work together in perfect harmony with our taste buds.

As it turns out, Coca-Cola-brand sodas and Heinz ketchup have incredibly high levels of amplitude. Coke's close competitor, PepsiCo (NYSE: PEP  ) , also achieves high marks in this category. As taste expert Judy Heylmun pointed out to Gladwell, "The thing about Coke and Pepsi is that they are absolutely gorgeous. They have beautiful notes -- all flavors are in balance. It's very hard to do that well." In fact, very few cola competitors even come close, which is one reason that the top three colas in terms of American market share are Coke at 17%, Diet Coke at 9.4%, and Pepsi at 8.9%, according to Beverage Digest.

Coca-Cola's secret formula vault. Source: Coca-Cola Press Center.

The market share figure for Heinz is even more impressive, as it controls 60% of sales for the U.S. ketchup industry. Its nearest competitor, ConAgra's Hunt's ketchup, controls less than 20%. Heinz vaulted to the top of the industry with a formula for success that's quite similar to Coke's. Heinz delivers an array of perfectly balanced flavors in its ketchup, making it a condiment that can be irresistible on many levels.

Why Heinz stands alone
Going further, experts have found that Heinz ketchup is one of the few foods that stimulates all five sensations within the mouth: salty, sweet, sour, bitter, and umami (for those unfamiliar with the latter, umami brings "body" to foods, and is commonly found in cured meats or aged cheeses). Gladwell describes H.J. Heinz's masterpiece -- which took years to perfect -- as follows:

What Heinz had done was come up with a condiment that pushed all five of these primal buttons. The taste of Heinz's ketchup began at the tip of the tongue, where our receptors for sweet and salty first appear, moved along the sides, where sour notes seem the strongest, then hit the back of the tongue, for umami and bitter, in one long crescendo. How many things in the supermarket run the sensory spectrum like this?

There seem to be few foods, in fact, that universally appeal to our taste buds like Heinz -- or Coke, for that matter. They introduce a desirable sensation in a way that competitors have difficulty replicating. For Buffett and Munger, this high amplitude characteristic was critical. They have discussed it at length in essays and speeches as a crucial component of their investment decision.

Creating a competitive advantage
In Coke and Heinz, Buffett found unique products with mass appeal that laid the foundation for a competitive advantage. While it is common for analysts to point to world-class supply chains or brilliant marketing techniques, these strengths play more of a supporting role.

An efficient bottling and distribution process, for example, makes a product more widely available, whereas effective advertising creates positive "association" with the product. Both of these serve to grow market share and enhance profit margins -- especially relative to competitors -- but consumer preference dictates whether the product is worth purchasing in the first place. This deep connection with the flavor and the brand boosts pricing power, and perhaps more important, determines whether a product is worth a repeat purchase. With products like cola and ketchup, sometimes one satisfying experience can mean a customer for life.

Buffett's epiphany
To be sure, Buffett's decision to invest in Coke and Heinz rested on impressive business models as well as flavor amplitude. However, it seems his confidence in their future success stems from the perfect chemistry between the products and their consumers.

With Coke, for example, Buffett has addressed numerous questions over the company's ability to thrive in volatile overseas markets or in the midst of declining domestic consumption. Without missing a beat, Buffett typically points out that more people around the world continue to drink Coke, and this trend will remain. At times, Buffett will provide even more detailed justifications for his confidence in Coke's future:

One thing that people don't understand... cola has no taste memory. You can drink one of these at 9 o'clock, 11 o'clock, 5 o'clock...You can't do that with cream soda, root beer, orange, grape... You get sick of them after a while... There is no taste memory to cola. The average person drinks about 64 ounces of liquid per day, and you can have all 64 ounces of that be Coke... If you do that with almost anything else -- with just one product -- you'll get sick of it. And that's a huge factor.

For Buffett, the emphasis is almost always on the product and the unique characteristic of repeat consumption. Whether it's healthy or not, more and more people outside of the U.S. are consuming Coke in ever-increasing quantities. He believes the same trend will play out with Heinz ketchup.

And what other products, if any, can even aspire to this consumption pattern? If you have one iPhone, for example, there's little reason to purchase another -- there are significant diminishing returns for the consumer. But this law holds less weight with Coke and Heinz.

As a result, Buffett expects that customers in other countries will enjoy Coke and Heinz as much as customers in North America, even with slight flavor modifications. As incomes rise in emerging markets, so will the consumption of these two products, creating a virtuous cycle for these two companies.

My colleague Ted Cooper recently summarized Buffett's thesis on Coke as follows: "Buffett saw that Coca-Cola was an exportable brand. It is something that all people in all countries can enjoy and the company has a massive distribution network that can deliver the product to all parts of the world." My fellow Fool also points out that average consumption worldwide is one-fourth the rate of that in the top 10 markets for Coca-Cola. On paper, that's a vast untapped market for this sweet, fizzy beverage.

A Foolish takeaway
In retrospect, it's quite easy to see why Buffett adores Coke and Heinz. Each present high-amplitude flavor in the form of an inexpensive product that customers could enjoy several times a week -- or even several times a day. Americans love Coke and Heinz ketchup, so there was little reason to believe these time-tested products could not thrive in an even larger global market. Executing on this plan might not be easy, but Buffett recognized that the probability of success seemed high given the risk.

As Buffett is fond of saying, oftentimes the best investing ideas are the simplest. And, as this case proves, sometimes they're the ones sitting right under your nose.

More wisdom from Buffett

Buffett's investing talent is astounding, but so is his willingness to share insights with aspiring investors. Amateurs like you and I can learn a lot from his incredible success as well as his biggest mistakes. His stories are fascinating -- and numerous -- so we decided to consolidate the best of Warren Buffett's wisdom in a new special report from The Motley Fool. To gain access to this invaluable insight, click here now for a free copy.


Read/Post Comments (8) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 04, 2013, at 4:00 PM, midnightmoney wrote:

    "a condiment that can be irresistible on many levels."

    quote of the day:)

  • Report this Comment On December 04, 2013, at 7:32 PM, AnsgarJohn wrote:

    uh, the Brazilians called him and said do you want 9% dividend on preferred shares ? He sold bonds at 4-5?% to finance it.

    It's always about the math.

    Heinz and Coca-Cola are nice because earnings are predictable, but not at any buying price.

  • Report this Comment On December 04, 2013, at 8:44 PM, hiddenflem wrote:

    I thought he was dumping coke...

  • Report this Comment On December 04, 2013, at 8:46 PM, hiddenflem wrote:

    Interesting quote about all flavors in balance. Do you know why a can of coke has the equivalent of 10 cubes of sugar in it? Because without that about of sweetener, the bitterness of the drink would make it repulsive.

  • Report this Comment On December 07, 2013, at 10:08 AM, PaulPignataro wrote:

    I wrote a book on the Heinz Leveraged Buyout. Interestingly enough it's difficult to justify typical "LBO" returns on this investment unless major cost cutting is in place. It is about the math in many respects. On the other hand, Warren Buffet receiving $720MM per year dividend is not bad.

  • Report this Comment On December 07, 2013, at 1:15 PM, jrj90620 wrote:

    So,Buffett figures out that people like junk food and buys these providers.Makes sense to me.Just wish Buffett's thoughts on economics made sense.

  • Report this Comment On December 07, 2013, at 7:34 PM, Oceana wrote:

    As couple of you have pointed out, the author completely forgot to talk about the price Buffet bought these. To me, the purchase price is even more important than the product. As Buffet said it 'What is smart at one price is dumb at another'

  • Report this Comment On December 09, 2013, at 2:58 PM, TMFBoomer wrote:

    @AnsgarJohn and @Oceana

    I should point out that the article is based on what I believe to be the most important aspect of Buffett's thesis for Coca Cola and Heinz, and not about whether the companies are a buy today. I think Munger's and Buffett's understanding of the appeal of Coke and Heinz ketchup to a wide audience served as the foundation for their investments. The recipe was key to an 'enduring economic moat' in the form of a difficult-to-replicate intangible asset. They realized what sold in America could sell around the world (even though some countries, like France, have banned ketchup ;), and I don't believe it can be simplified to selling a warm, fuzzy feeling created by the brands. Lots of products have brand loyalty (even Twinkies!) but the market share and margins driven by repeat consumption patterns are something witnessed by few other consumer goods companies. And, to be frank, it's not simply the brand, because Coca-Cola's success in brand extension is limited to Diet Coke. Numerous other "Coke" products have come and gone over the years and ultimately failed. So, it's a lot more than just the brand and selling "happiness" in my opinion (although that top-of-mind characteristic helps enormously).

    Further, I'll point out that I think the product, the brand, the distribution network, the management - all of these things add up to a 'wonderful' business for Buffett. And, as he's pointed out "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

    The price matters, though, and my colleague Adam Levine-Weinberg points out that Coke's been lackluster for the past 15 years or so (http://www.fool.com/investing/general/2013/04/13/coke-stock-...

    But, at the time of Buffett's investment, the price was not the determinant factor, in my opinion.

    Isaac

    TMFBoomer

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