Economic moat. According to Warren Buffett, those two words may be the most important quality to look for in a stock. The legendary investor coined and popularized the phrase, which is understood as a competitive advantage through brand strength, pricing power, and other assets that protects the company from rivals.
Among Buffett's favorite stocks and an oft-used example of a company possessing an economic moat happens to be one of Warren Buffett's biggest holdings: Coca-Cola (NYSE:KO). According to Interbrand, the brand is worth $81.6 billion, a value close to half the company's market cap, making it the third most valuable brand in the world. Up until two years ago, it was considered the most valuable brand in the world. That brand strength affords Coke huge profit margins, above 17%, and its massive distribution network provides another advantage and also gives it a unique opportunity when it acquires other beverage brands.
However, the same economic moat that's made Coca-Cola such a successful company also presents a certain risk for investors. Sales of carbonated drinks have been declining in the U.S for nearly a decade due to health concerns and changing tastes, and soda volumes have also recently begun declining in other core markets such as Mexico and Europe. While the company has offset that slide in fizzy drinks with investments in Monster Beverage, Keurig Green Mountain, and other still beverages, the decline of beverage brands like Coca-Cola and Diet Coke pose a major problem for the world's largest beverage maker.
The problem with economic moats
Economic moats are powerful forces, but they only protect companies from competitors within their own industry. If a disruptive innovation comes along or there's a sea change in consumer tastes, those companies with the moats have the most to lose because they are the biggest and are most closely tied to the old model.
Eastman Kodak, for example, was once a great American company with a huge economic moat. At its peak in 1991, the company had about $25 billion in revenue, thanks to being the industry leader in camera film, which was built on a highly profitable razor/blade model. By 2012, Kodak had just $4 billion in sales and was forced to declare bankruptcy. It's no mystery what killed Kodak. The evolution of digital photography eliminated the need for camera film, its cash cow, and the company's income dried up as it was slow to adapt because it did want to lose film sales. A long debate could be had about what Kodak could have done differently to avoid bankruptcy, but the company's success in film was what made it so hard to transition to digital. And that success gave it so much to lose. At its peak, it had a market cap of nearly $30 billion.
Blockbuster Video offers a similar case. Just 10 years ago the video-rental chain had 9,000 stores and $5.9 billion in revenue. Today, it has no stores and no revenue. The company was a victim of Netflix's disruptive innovation, first through its DVD-by-mail service and later through its streaming service. Though Blockbuster offered added a mail-order option, its thousands of stores, once its strength, ended up being dead weight and it couldn't catch up with Netflix in the end.
What this means for Coca-Cola
While Coke isn't at risk from technological changes in the way that Kodak and Blockbuster were -- people will always consume liquids -- the company is facing a threat from changing consumption habits, and the flattening and declining volumes in its most valuable beverages -- Coca-Cola and Diet Coke -- should present serious concerns for investors. Coke may be able to find growth outlets through smaller brands, but none of them will carry the weight of Coca-Cola or Diet Coke.
Coca-Cola is still hugely profitable and the company isn't in danger of going out of business anytime soon, but cracks are emerging. Analysts are projecting essentially no EPS growth for the next two years, but the company still carries a P/E above 20. By comparison, Benjamin Graham, the father of value investing and Buffett's teacher, believed that a no-growth company should trade at a P/E of 8.5. If Coke's revenue growth continues to stall out, the stock could begin to fall. And from a market cap near $200 billion, it's a long way down.
Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola. The Motley Fool has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.