My Big Investing Mistake of Omission

One of my favorite speeches of Charlie Munger, which Warren Buffett co-opted when he spoke at Florida University, was the story of how to turn $40 into $5 million. It was a story about Coca-Cola stock, and the conditions that can lead to super large financial rewards based on modest financial investments. The premise is this—you need a product that is super cheap to make and possesses enough brand equity that people will buy it deliberately on a regular basis.

Even before I encountered this story, I knew that the beverage industry has been a very lucrative place to make money if you want to make an initial investment and then grow richer in the coming years without having to do anything. Diageo, Anheuser Busch, and Brown Forman all have long records of growing profits per share and dividend payouts that are significantly higher each decade than the previous.

Pepsi and Coca-Cola have legendary long-term reputations with their shareholders, and Dr. Pepper beat both of them over the second half of the 20th century although most people don’t know that because Dr. Pepper is so much smaller and went through a couple ownership switches in the past 50 years such as going private with Ted Forstmann (the man who coined the term junk bonds) and becoming part of Snapple. It also merged with 7UP, and this is why Dr. Pepper did so well—the stock was perpetually undervalued because it sold off international distribution rights to Coca-Cola and Pepsi got distribution rights to the 7UP brands and Wall Street investors were rarely interested in the stock due to the perception it was “stuck” in the United States.

This logic, incidentally, is why I don’t mind seeing BP stay in the low $40s for so long. Those reinvested dividends into BP will be associated with great long-term wealth eventually, and you might as well enjoy the fertile soil as long as it lasts. It worked out well for Dr. Pepper in the 1990s, Abbott Labs in the 2000s, and I see no reason why an oil company making $7 billion in net profits during a period of low commodity prices can’t be the latest installment in the “Extended Undervaluation With Reinvested Dividends Makes A Lot of Long-Term Wealth” series.

Anyway, despite my knowledge of how lucrative the beverage sector can be, I had never given Starbucks its proper due. It was a significant error of omission in my thought process. That has been foolish of me because I know how great beverage investments are, and the morning routine of buying a Starbucks-branded coffee that gives the company 21% operating margins explains why the company is a better investment than almost anything else I talk about.

Over just about any measuring period, the results have been excellent. If you got in on the 1992 IPO, even in a small way, the results would have changed your life. It has been compounding at 25% annualized over the past 23 years. Someone with a $7,500 investment in Starbucks stock at the IPO day would have $1,200,000 in wealth today.

Even since becoming a large company, the results have still been nice enough that Starbucks would still fall into the category of best investments you could ever make in your life. Every $10,000 put into Starbucks ten years ago would be worth $42,000 today for a compounding rate of 15.82% per year. The ten-year earnings per share annual growth rate is 20%, and the five-year annual earnings per share growth rate is 23%.

It is still rolling out about 600 new Starbucks coffee shops per year around the globe, and that explains why Starbucks grew earnings per share by 18% in the recent year. What catches my eye about the growth figure is that same store sales have been great. Already existing Starbucks locations are making 7% more in annual profits in the first quarter of 2015 compared to the first quarter of 2014. That is important because it means that Starbucks doesn’t have to constantly roll out new stores to deliver returns. It could buy back some stock, pay out the dividend, and grow earnings per share organically by 7% if the globe ever reached its maximum Starbucks tipping point (although that won’t come soon, as Starbucks is planning to double its China store count from 1,500 to 3,000 in the next four years.)

I wouldn’t normally use a 2014-2015 comparison of one quarter of data to make a point, but the 7% same-store growth actually understates the excellence of Starbucks’ same store sales because Starbucks has averaged 8.5% annual growth from same-store sales over the past decade (err, technically, 2005 through 2014).

It does currently benefit from low prices on coffee beans. But even when prices were high, Starbucks still reported 15% operating margins rather than 21% operating margins. The earnings per share growth at Starbucks was still over 13% annually during the first half of the 2000s when coffee prices were not as favorable to Starbucks.

It passes the Benjamin Graham test for companies with strong balance sheets. There is no preferred stock or pensions, and only $2.0 billion in entire debt. It makes $2.4 billion in profit per year, so the entire debt burden could theoretically be wiped out with around 9 months of the company’s profits. The dividend payout is manageable and likely to grow, as Starbucks didn’t begin paying out dividends until 2010 and the current dividend only takes up 38% of annual profits.

This ignorance regarding Starbucks is a big error on my part because I should have known better. The beverage sector has been in my wheelhouse, and I have developed such a huge respect for the business model of how modifying water creates a whole lot of money for people on the ownership side. This isn’t like missing out on Intel’s recovery or something like that, when there is no reason to feel guilty about missing out on something you don’t have the skill set to properly evaluate. But I knew how lucrative beverage investing can be, and yet, I have ignored the superior growth of Starbucks all along. Shame on me.