There are several typical traits of a classic "Buffett investment." The companies in which Warren Buffett and Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) often invest sport great management, huge economic moats, longtime industry leadership, and stable economics. But I've recently noticed one other common denominator: Many of them are huge advertisers.
Of the 11 stock holdings greater than $700 million listed in Berkshire's 2005 annual report, five also placed on Advertising Age's list of the 100 largest U.S. advertisers. The top advertiser, Procter & Gamble (NYSE:PG), bought former Berkshire holding Gillette several years back. Even Berkshire itself was on the list at No. 42.
Who let Pavlov's dogs out?
One could argue that because these advertisers, such as American Express (NYSE:AXP) and Coca-Cola (NYSE:KO) are some of the world's largest corporations, they would naturally occupy a list of the largest advertisers. However, I believe these companies are able to turn commercials into a competitive advantage.
In a famed study in the 1890s, scientist Ivan Pavlov discovered that dogs could be programmed to associate one stimulus with a completely unrelated stimulus -- for example, a ringing bell with dinnertime. Advertisers can do the same thing. In a speech, Charlie Munger said that "three-fourths of advertising works on pure Pavlov," citing how carefully Coca-Cola's ads associate the company with positive images and events. No matter how sophisticated we humans think we are, we're arguably just as susceptible as Pavlov's dogs to advertising's influence.
A virtuous cycle? Priceless.
If a company has a long-term competitive advantage, it is likely to maintain or grow its market share, as well as its share of the industry's profits. This makes it much, much easier for Buffett to predict the company's future economic earnings within a reasonable range of confidence.
It's almost impossible for a soft-drink competitor to outspend Coca-Cola or PepsiCo (NYSE:PEP) in advertising. New competitors face an insurmountable Catch-22: They need to advertise to attract customers, but they need customers to have the money to spend on advertising. Thus, in these advertising-driven industries barriers to entry are enormous, as Buffett explains:
"When TV advertising first arrived -- when talking color pictures first came into our living rooms -- it was an unbelievably powerful thing. ... [If] you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn't. ... In effect, if you didn't have a big volume, you couldn't use network TV advertising, which was the most effective technique."
Clearly, Buffett believes that advertising economies of scale widen a company's moat.
Always Coca-Cola?
In addition, I believe that Buffett invests in big advertisers because generally accepted accounting principles (GAAP) accounting arguably understates a big advertiser's income. According to GAAP, expenses must be matched to the period in which the benefit occurs. However, according to GAAP, advertising is generally expensed as incurred (when it happens). This implies that a commercial's benefit is limited solely to the period of time in which it airs.
Some advertising is worth exponentially more than its cost. For example, Apple's (NASDAQ:AAPL) 1984 commercial, which aired only once during the 1984 Super Bowl, is still talked about and viewed today. That single commercial had an enormous effect on Apple's future that continues to this day -- but its entire cost was expensed in 1984.
Nike (NYSE: NKE), whose Michael Jordan commercials helped vault it to its current leadership position, is another example. Nike's Air Jordan commercials made its product synonymous with arguably the greatest athlete in history. Those commercials still cast an enormous shadow, and bestow immense pricing power, on Nike's brand today. Effective advertising, although expensed up front, can last a generation.
Perhaps that's why, in the past year, Berkshire-owned GEICO has increased its advertising expenditure 40%. In his 2005 shareholder letter, Buffett remarked that GEICO spent $31 million on advertising in 1996, and $502 million in 2005, a 36% annualized increase. Buffett also mentioned he couldn't wait to spend more on GEICO advertising.
Just follow your eyes
It's not hard to identify great advertising when you see it. Investors might want to keep these advertisers in mind when identifying which companies to invest in. After all, a well-spent advertising budget, although subtracted from current net income, can result in a generation of loyal customers.
For some related Buffett commentary:
Coca-Cola and Berkshire Hathaway are Motley Fool Inside Value recommendations. To discover more of the market's best bargains, try our value-centric newsletter service free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.
