what to look for in picking a stock to invest

Is Coca-Cola the A Perfect Business?
What does a perfect business look like? For Warren Buffett and his partner Charlie Munger,
vice-chairman of Berkshire Hathaway, Inc., it looks a lot like Coca-Cola. To see why, imagine
going back in time to 1885, to Atlanta, Georgia, and trying to invent from scratch a nonalcoholic
beverage that would make you, your family, and all of your friends rich.
Your beverage would be nonalcoholic to ensure widespread appeal among both
young and old alike. It would be cold rather than hot so as to provide relief from climatic effects.
It must be ordered by nameBa trademarked name. Nobody gets rich selling easy-to-imitate
generic products. It must generate a lot of repeat business through what psychologists call conditioned reflexes. To get the desired positive conditioned reflex, you will want to make it
sweet, rather than bitter, with no after-taste. Without any after-taste, consumers will be able to
drink as much of your product as they like. By adding sugar to make your beverage sweet, it
gains food value in addition to a positive stimulant. To get extra-powerful combinatorial effects,
you may want to add caffeine as an additional stimulant. Both sugar and caffeine work; by
combining them, you get more than a double effect, you get what Munger calls a Alollapalooza@
effect. Additional combinatorial effects could be realized if you design the product to appear
exotic. Coffee is another popular product, so making your beverage dark in color seems like a
safe bet. By adding carbonation, a little fizz can be added to your beverage=s appearance and
its appeal.
To keep the lollapalooza effects coming, you will want to advertise. If people
associate your beverage with happy times, they will tend to reach for it whenever they are happy,
or want to be happy. (Isn=t that always, as in AAlways Coca-Cola@?) Make it available at
sporting events, concerts, the beach, and at theme parksBwherever and whenever people have
fun. Enclose your product in bright, upbeat colors that customers tend to associate with festive
occasions (another combinatorial effect). Red and white packaging would be a good choice.
Also make sure that customers associate your beverage with festive occasions. Well-timed
advertising and price promotions can help in this regardBannual price promotions tied to the
Fourth of July holiday, for example, would be a good idea.
To ensure enormous profits, profit margins and the rate of return on invested capital
must both be high. To ensure a high rate of return on sales, the price charged must be
substantially above unit costs. Because consumers tend to be least price sensitive for moderately
priced items, you would like to have a modest Aprice point,@ say roughly $1-$2 per serving.
This is a big problem for most beverages because water is a key ingredient, and water is very
expensive to ship long distances. To get around this cost-of-delivery difficulty, you will not want
to sell the beverage itself, but a key ingredient, like syrup, to local bottlers. By selling syrup to
independent bottlers, your company can also better safeguard its Asecret ingredients.@ This
also avoids the problem of having to invest a substantial amount in bottling plants, machinery,
delivery trucks, and so on. This minimizes capital requirements and boosts the rate of return on
invested capital. Moreover, if you correctly price the key syrup ingredient, you can ensure that
the enormous profits generated by carefully developed lollapalooza effects accrue to your
company, and not to the bottlers. Of course, you want to offer independent bottlers the potential
for highly satisfactory profits in order to provide the necessary incentive for them to push your
product. You not only want to Aleave something on the table@ for the bottlers in terms of the
bottlers= profit potential, but they in turn must also be encouraged to Aleave something on the
table@ for restaurant and other customers. This means that you must demand that bottlers
deliver a consistently high-quality product at carefully specified prices if they are to maintain
their valuable franchise to sell your beverage in the local area.     If you had indeed gone back to 1885, to Atlanta, Georgia, and followed all of these suggestions, you would have created what you and I know as The Coca-Cola Company. To be sure, there would have been surprises along the way. Take widespread refrigeration, for example. Early on, Coca-Cola management saw the fountain business as the primary driver in cold carbonated beverage sales. They did not foretell that widespread refrigeration would make
grocery store sales and in-home consumption popular. Still, much of Coca-Cola=s success has
been achieved because its management had, and still has, a good grasp of both the economics
and the psychology of the beverage business. By getting into rapidly growing foreign markets
with a winning formula, they hope to create local brand-name recognition, scale economies in
distribution, and achieve other Afirst mover@ advantages like the ones they have nurtured in the
United States for more than 100 years.in a world where the typical company earns 10 percent
rates of return on invested capital, Coca-Cola earns three and four times as much. Typical
profit rates, let alone operating losses, are unheard of at Coca-Cola. It enjoys large and
growing profits, and requires practically no tangible capital investment. Almost its entire value
is derived from brand equity derived from generations of advertising and carefully nurtured
positive lollapalooza effects. On an overall basis, it is easy to see why Buffett and Munger
regard Coca-Cola as a Aperfect@ business.
A. One of the most important skills to learn in managerial economics is the
ability to identify a good business. Discuss at least four characteristics of a
good business.
B. Identify and talk about at least four companies that you regard as having the
characteristics listed here.

C. Suppose you bought common stock in each of the four companies identified
here. Three years from now, how would you know if your analysis was
correct? What would convince you that your analysis was wrong?
CASE STUDY SOLUTION
A. Interesting perspective on the characteristics of wonderful businesses has been given
by legendary Wall Street investors T. Rowe Price and Warren E. Buffett. The late T.
Rowe Price was founder of Baltimore-based T. Rowe Price and Associates, Inc., one
of the largest no-load mutual fund organizations in the United States, and the father
of the "growth stock" theory of investing. According to Price, attractive growth
stocks have low labor costs, superior research to develop products and new markets,
a high rate of return on stockholder's equity (ROE), elevated profit margins, rapid
earnings per share (EPS) growth, lack cutthroat competition, and are comparatively
immune from regulation. Omaha's Warren E. Buffett, the billionaire head of Berkshire Hathaway, Inc., also looks for companies that have strong franchises and
enjoy pricing flexibility, high ROE, high cash flow, owner-oriented management,
and predictable earnings that are not natural targets of regulation. Like Price, Buffett
has profited enormously through his investments.
To apply Price's and Buffett's investment criteria successfully, business
managers and investors must be sensitive to fundamental economic and demographic
trends. Perhaps the most obvious of these is the aging of the population. Healthcare
demands will continue to soar. In recognition of this fact, investors have bid up
the shares of companies offering prescription drugs, health care, and health-care cost
containment (e.g., home health agencies). Perhaps less obvious is that an aging and
increasingly wealthy population will save growing amounts for their children's
education and retirement. This bodes well for mutual fund operators, insurance
companies, and other firms that offer distinctive financial services.
As the overall population continues to enjoy growing income, spending on
leisure activities is apt to grow; companies that offer distinctive goods and services
in this area will do well. Helping well-heeled customers have fun has always been a
good business. Productivity enhancement to combat economic stagnation is also
likely to be a major thrust during the coming decade. In this area, it is perhaps easier
to pick likely beneficiaries of emerging technologies than it is to chart the future
course of technical advance. For example, catalog retailers, long-distance and
cellular phone companies, and credit card providers are all major beneficiaries of the
rapid pace of advance in computer and information technology. Similarly, major
broadcasters, cable TV companies, movie makers, and software providers are all
prone to benefit from increasingly user-friendly technology for leisure-time activities.   


B. The American Express Company, Coca-Cola Company, Gillette and Wells Fargo &
Company are well-known examples of major common stock holdings of Warren
Buffett's Berkshire Hathaway, Inc. Each of Berkshire's major holdings are large
capital-intensive companies with long operating histories of above-average rates of
return. Like any really good business, they display a wise use of assets as indicated
by an average ROE that is well above typical norms. Enhancing the attractiveness of
these companies is the fact that they also display above-average annual rates of
growth in stockholders= equity. Thus, they can all be described as beneficiaries of
high-margin growth. As is often the case, attractive financial and operating statistics
reflect essentially attractive economic characteristics of each company.
The American Express Company is a premier travel and financial services
firm that is strategically positioned to benefit from aging baby boomers. The Coca-
Cola Company, one of Berkshire's biggest and most successful holdings, typifies the
concept of a wonderful business. Coca-Cola enjoys perhaps the world's strongest
franchise, owner-oriented management, and both predictable and growing returns. Also, the company is not subject to price or profit regulation. From the standpoint of
being a wonderful business, Coca-Cola is clearly the "real thing." Newspapers,
banks, and cable TV companies, such as The Washington Post Company and Wells
Fargo & Company, translate immense economies of scale in production into
dominating competitive advantages. They also fit Buffett's criteria for wonderful
businesses. In the case of Gillette, above-normal returns stem from unique products
that are designed and executed by extraordinarily capable management.
The late T. Rowe Price was prone to invest in high-tech companies that
produced distinctive products. On the other hand, Buffett is fond of saying that he
doesn=t Aunderstand@ high-tech and doesn=t want to be blown out of business by a
few guys Aworking in a garage somewhere.@ Of course, Buffett=s thinly veiled
reference to Hewlett-Packard and the Silicon Valley revolution that was started by
Atwo guys in a simple garage@ means that Buffett clearly does understand the
problems of investing in hard-to-project high-tech companies. Thus, while Buffett
avoids high-tech stocks, T. Rowe Price, if he were alive today, might find
compelling the advantages of high-tech companies such as Microsoft, Intel, and
Cisco Systems, among others. 


C. Above-normal returns from investing in wonderful businesses are only possible to
the extent that such advantages are not fully recognized by other investors. In the
case of T. Rowe Price, early investments in Avon Products, Xerox, and IBM
generated fantastic returns because Price saw their awesome potential far in advance
of other investors. On the other hand, Buffett has profited by taking major positions
in wonderful companies that suffer from some significant, but curable, malady. In
1991, for example, Buffett made a large investment in American Express when the
company suffered unexpected credit card and real estate loan losses. When the
company absorbed these losses without any lasting damage to its intrinsic profitmaking
ability, its stock price soared and Buffett cleaned up. Companies that are
conservatively financed enjoy a similar ability to profit when an unexpected business
downturn causes financially distressed rivals to sell valuable assets at bargain basement
prices.
Therefore, while above-average stock-market returns provide the clearest
evidence of having picked good businesses for investment, short-term results can be
disappointingly average or below-average if the virtues of these good businesses are
clearly recognized in the marketplace. More frustrating still is the problem of
finding and investing in good businesses at attractive prices and then having to wait
while conventional wisdom comes around to recognizing them as such. The overall
stock market is extremely efficient at ferreting out bargains and adjusting prices so
that subsequent investors earn only a risk-adjusted normal rate of return. For
individual investors seeking above-average returns, finding good businesses is a necessary first step, but they must also be incorrectly priced (too cheap). Buffett succeeds because he is unusually adept at finding high-quality bargains.