What Warren Buffett's Investment In IBM And Coca-Cola Have In Common

Dec. 28, 2011 2:44 AM ETBRK.A, IBM, KO, PEP, DPS-OLD5 Comments

When news that Warren Buffett, the CEO and Chairman of Berkshire Hathaway (BRK.A), had amassed a $10.7 billion stake in IBM came out last month, some commentators scratched their heads and pointed to Warren Buffett's famous aversion to technology stocks to suggest that perhaps Buffett was straying from his circle of competence by entering the tech sector. These concerns are most likely exaggerated-Buffett's longstanding lament about technology companies is that he generally felt uncomfortable predicting where they would be ten years into the future-making it entirely predictable that Buffett would enter the world of technology once he felt confident about finding a company with a durable competitive advantage in the sector. Buffett's decision to buy IBM is reminiscent of when the Berkshire CEO decided to load up on shares of Coca-Cola (KO) from 1988 to the early 1990s. Looking at what Buffett said shortly after buying Coke in 1988 is quite similar to what he said shortly after buying IBM in 2011-both companies sell products in almost every country, have sizable profit margins, and are able to charge a premium due to the reluctance of customers to shift away from their products.

Here is what Buffett had to say in the 1989 Letter to Shareholders of Berkshire Hathaway after he initiated a position in the stock of Coca-Cola:

Of a certainty, it was in 1936 that I started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each. In this excursion into high-margin retailing, I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product. I continued to note these qualities for the next 52 years as Coke blanketed the world. Only in the summer of 1988 did my brain finally establish contact with my eyes…What was already the world's most ubiquitous product gained new momentum, with sales overseas virtually exploding. Of course, we should have started buying Coke much earlier, soon after Roberto and Don began running things. In fact, if I had been thinking straight, I would have persuaded my grandfather to sell the grocery store back in 1936 and put all of the proceeds into Coca-Cola stock. I've learned my lesson: My response time to the next glaringly attractive idea will be slashed to well under 50 years.

That's a strong endorsement-although Buffett was being a bit tongue in cheek when he mentioned convincing his grandfather to sell the grocery store to invest in Coke, the point remains that Buffett identified in Coke a company that draws a regular commitment from customers (that is to say, people buy Coke products on a much, much more regular basis than they would say, cars or refrigerators), and they have a sustainable competitive advantage found in the fact that people are very unlikely to switch away from Coke to a competitor-while it's possible that someone might switch from Coke to PepsiCo (PEP) or Dr. Pepper (DPS), there is an entrenched market share for Coke that is unlikely to go away anytime soon.

This type of "entrenched" competitive nature to Coke's products is something that Buffett also seemed to recognize in IBM. When Buffett went on to disclose his position in IBM during a CNBC interview this past November, he offered this rationale for his large investment in IBM stock:

And if you think about it, I don't want to push the analogy too far because it could be pushed too far. But, you know, we work with a given auditor, we work with a given law firm. This doesn't mean that we're happy every minute of every day about everything they do but it is a big deal for a big company to change auditors, change law firms. The IT departments, I-you know, we've got dozens and dozens of IT departments at Berkshire…And that doesn't-that doesn't mean things won't change but it does mean that there's a lot of continuity to it. And then I think as you go around the world, IBM, in the most recent quarter, reported double-digit gains in 40 countries. Now, I would imagine if you're in some country around the world and you're developing your IT Department, you're probably going to feel more comfortable with IBM than many companies."

Buffett goes on to note than when he was in his 20s, he launched a tech company that tried to compete with IBM, but eventually gave up after realizing that "no techie gets fired for going with IBM", but plenty of guys in the technology department can get fired for choosing an incompetent upstart service provider. Aside from the fact that Buffett had first experiences with Coke and IBM growing up-peddling Coke products and trying to compete with IBM-the real connection between Buffett's investment in Coke and IBM is that both companies have a sustainable competitive advantage defined by the reluctance of competitors to switch away from their products. Buffett has observed that people who drink Coke as a kid and teenager are likely to keep drinking Coke products as an adult, and he has also noted that companies that choose IBM as a service provider have a low likelihood of switching to competitor. These types of decades-long relationships provide exactly the kind of sustainable competitive advantages that make each company an attractive investment in the eyes of the Berkshire Hathaway Chairman and CEO.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

This article was written by

Income-oriented investor with a focus on cumulative income over a multi-generational period. Special interest in buying "Top 20 companies in the world at a fair price" or great businesses selling at a 30% or greater discount while dealing with a problem that will eventually resolve. You can access my library of 1,200+ financial articles written over the past seven years at "The Conservative Income Investor": www.theconservativeincomeinvestor.com.My best ideas regarding what I'm purchasing are covered over on Patreon:http://patreon.com/theconservativeincomeinvestor

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