Warren Buffett on the importance of the economics of businesses

​In Warren Buffett’s letter published over the weekend he noted the vital importance of identify companies with good or bad economics. He wrote,
“Over the years, I have made many mistakes. Consequently, our extensive collection of businesses currently consists of a few enterprises that have truly extraordinary economics, many that enjoy very good economic characteristics, and a large group that are marginal. Along the way, other businesses in which I have invested have died, their products unwanted by the public. Capitalism has two sides: The system creates an ever-growing pile of losers while concurrently delivering a gusher of improved goods and services. Schumpeter called this phenomenon “creative destruction.” (Warren Buffett, 2023)
To help us deal with the identification of businesses with “extraordinary economics” or “good economics”, some tools have been developed by those interested in the strategic positioning of firms. I’ll illustrate two today: (1) Porter’s Five Forces and (2) The TRRACK system (for more detail see The Financial Times Guide to Value Investing)
Porter’s Five Forces applied to Coca Cola
We can use Porter’s Five Forces (developed by Michael Porter of Harvard) to consider the competitive position of Coca-Cola’s industry.  Porter emphasises that the average returns to companies in an industry are determined, yes, by the amount of rival between direct competitors in that industry, but also by four other power relationships. It might be that suppliers to that industry have a lot of power allowing them to increase prices and achieve high ROCE; or maybe customers hold a lot of power and so can push down price charged by the industry under consideration.
With that, let’s look at the power relationships in the soft drinks industry:

1. Supplier power? Coca-Cola and other soft drink producers buy commodity products (e.g. sugar) sold in highly competitive markets with many alternative suppliers and so suppliers do not have much of a hold over the prices they can charge.
2. Customer power? Coca-Cola is the leading producer, but there are many others offering to supply retailers. However, demand from the ultimate consumer for Coca-Cola drinks and other leading brands – created by psychological factors – mean that retailers have only limited power, even giant retailers such as the major fast-food restaurants.
3. Substitutes? There are many substitutes for carbonated sugar-based drinks and these are having an impact. Coca-Cola and other giants have responded by buying up many firms offering these alternatives to increase range, from coffee and juice to water and energy drinks. Economies of scope – distributing different products through the same routes – help the big firms stay ahead of the competition. Even with these alternative drinks available many people on many occasions must just have a Coke, or Fanta, or Sprite, etc.
4. Rivalry within the industry? There are many suppliers in theory but in many situations Coca-Cola or Pepsi is usually the dominant firm in a market, e.g. the only vending machine is owned by Coca Cola. Also these firms are, to some extent, protected from rivals by its psychological advantages – consumers affinity with the brand for example.
5. Potential entrants? Warren Buffett commented on the inadvisability of entering Coca-Cola’s territory, “If you gave me $100 billion and said take away the soft drink leadership of Coca-Cola in the world, I’d give it back to you and say it can’t be done.”

This industry structure (power relationships) is likely to be stable in the future.  Technological change may assist the processes of Coca-Cola and its competitors, but won’t change in any significant way the consumption of drink or the competitive dynamics within the industry.
What might change is social acceptability of sugar and caffeine.  But then Coca-Cola has positioned itself to benefit from growth in other types of drinks as well as variants of Coke, e.g. sugar-free.
A price war with Pepsi is a possibility. But this has been tried before to the detriment of both firms, so it may not have a high likelihood.
It’s possible that governments/regulators may clamp down on Coca-Cola given its dominance of markets. But we have yet to see that happen to any great extent.
Applying Porter’s five forces to a UK company in which I own shares – Dewhurst.
Dewhurst mostly manufacture push buttons and various fixtures for lifts. They have a large percentage of the world market.

• Threat of entry to the industry?  The costs of entry are relatively low in terms of factory set-up costs.  However, the extant players have name recognition and relatio......

......Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to [email protected])