Warren Buffett once told investors to think of their investment choices as tethered to a punch-card: over the course of an investment lifetime, the investor would be limited to 20 punches on the card. Given this limitation, individuals would have to think more deeply about their investment choices, taking as much time to make a decision as they would in say, purchasing a new car.
This has not always been the mantra of Buffett, however. He has evolved over time from the influences of Benjamin Graham to that of Phillip Fischer and Charlie Munger. What follows is a picture of that evolution, which ultimately led to his purchases of long-term holdings See's Candies and The Coca-Cola Company (NYSE:KO).
The cigar butts of Benjamin Graham
Originally, Buffett took the approach of his mentor Benjamin Graham and purchased stocks at deep value using the Graham net-net formula: adjusted current assets minus all liabilities. He coined this investing approach as cigar butt-style investing, seeking out discarded cigar butts with one or two good puffs left in them. This method worked well at first for the original Buffett Limited Partnership but over time, the opportunities became fewer and fewer. Buffett eventually shuttered the partnership and began to focus on purchasing quality businesses under the influences of Phillip Fischer and Charlie Munger.
It is much better to buy a wonderful business at a good price than a good business at a wonderful price
Legendary San Francisco-based investor and author Phillip Fischer recommended purchasing quality businesses with rational management in place that could be held over the long haul. The economics of these businesses, he argued, would eventually win out over short-term gyrations and deliver significant returns for the investor. With this mindset and the help of Charlie Munger, Buffett purchased See's Candies in 1972, the first time he paid for quality.
At a purchase price of $25 million, Buffett paid three times book value for See's, something unheard of under the Ben Graham model. However, the purchase represented an investment in a company with a durable economic moat that would prove out over the years: by 2011, the company had sales of $376 million and a profit of $83 million. If Buffett had never invested in See's, he probably never would have bought into Coca-Cola as well.
I would like to buy the world a Cherry Coke
Buffett once opined that if he was given a billion dollars, access to the brightest minds in business, and the the challenge of taking Coca-Cola's market share, he would give the money back, stating that it could not be done.
Charlie Munger put the business model in more practical terms in his 1996 talk, Practical Thought on Practical Thought. He described what it would take for an individual in 1884 to start a globally successful beverage company and what the end result would be:
We can guess reasonably that by 2034, there will be about eight billion beverage consumers in the world. ... Each consumer is composed mostly of water and must ingest about sixty-four ounces of water per day. This is eight, eight-ounce servings. Thus, if our new beverage and other imitative beverages in our market, can flavor and otherwise improve only 25% of ingested water worldwide, and we can occupy half of the new world market, we can sell 2.92 trillion eight ounce servings in 2034. And if we can then net four cents per serving, we will earn $117 billion. This will be enough, if our business is still growing at a good rate, to make it easily worth $2 trillion.
In addition to its brand-equity built upon over 120 years of marketing, the moat of Coca-Cola's business model rests on the fact that the human race is composed mostly of water and must ingest so much water every day -- what better way to enhance the water drinking experience than with a Coca-Cola?
This purchase underlines Buffett's shift to investing for quality, and it represents one of the 20 punches on his punch-card as it is a "permanent holding" of Berkshire Hathaway.
Certainly, the individual investor can still make a go of net-nets -- the Value Line Investment survey even publishes a list of net-nets in its weekly Summary and Index -- but remember the distaste that Buffett developed for this investment style as he likened it to picking up cigar-butts. Price is still important but not as important as the quality of the underlying business whose economics will prevail over the long-term, a business such as Coca-Cola. As Peter Lynch infamously stated, "Go for a business that any idiot can run -- because sooner or later, any idiot probably is going to run it." Or as Buffett has told us, buy a business that even a ham sandwich could run.