How Do You Build a $2 Trillion-Dollar Company?

“Writing is thinking. To write well is to think clearly. That’s why it’s so hard.” – David McCullough

Inspired by the book summaries written by hedge fund manager, Li Lu, this blog will also be an account of any useful information drawn from any books or texts. I believe that the benefits of writing information in your own words will help assimilate and consolidate knowledge that would otherwise be forgotten. In this blog post, I will recap a chapter from Charlie Munger’s book Poor Charlies Almanack (2005) with some additional inserted notations. The section that I have recapped below is a real gem that Munger has so kindly shared.

In the book Poor Charlies Almanack, Munger included a transcript of an informal talk he made called Practical Thought About Practical Thought? (1996). In this talk, Munger delivered a series of ultrasimple general notions that have helped him solve problems throughout his life. Munger believes that there are five helpful notions.

The first notion revolves around the idea of asking the “no-brainer” questions first to simplify the problem.

The second notion emphasizes the importance of numerical fluency. Munger says that without numerical fluency, “the part of life most us inhabit, you are like a one-legged man in an ass kicking competition.”

The third notion requires you to be able to flexibly think through problems forwards and backwards. Thinking forward is rather mathematical; one must be able to identify and weigh up a number of variables in order to make a prediction. Thinking backwards is rather intuitive and diagnostic.  It is a test which involves looking for patterns, finding theories and causal chains to support or stress-test an argument made thinking forward. Often times, it can help expose any discrepancies and potential errors in rationally arriving at a conclusion.

The fourth notion is that you must draw upon multiple disciplines as a source of practical wisdom. Even the most elementary concepts from each academic discipline can prove sufficient when combined to solve problems. It prevents a psychological defect depicted by the proverb: “To a man with a hammer, every problem looks like a nail.”

The fifth and final notion is that the “lollapalooza effect,” comes from multiple biases, tendencies, specific factors or mental models acting in compound simultaneously. This can result in significant favourable outcomes when specific factors and mental models are applied correctly. Alternatively, it can be dangerous when multiple biases and tendencies work in tandem to create irrationality.

To demonstrate these notions, Munger raised a practical question: how do you take Coca-Cola, a non-alcoholic beverage, from being a $2 million-dollar company in 1884 to a $2-trillion-dollar company in 150 year’s time despite paying a large amount of its earnings in dividends?

Firstly, the “no-brainer” question involves asking and identifying how a $2 trillion-dollar valuation can be achieved. It cannot possibly be done selling a generic beverage and it would be a lot easier if it was globally recognized product. To resolve the components of this “no-brainer” questions, Coca Cola must:

• Create a strong, legally protected trademark.
• Start operations in a particular American city, i.e. Atlanta, succeed in the rest of the America and then the rest of the world.
• To create a product that can be globally recognized, the product needs to be developed in a way which possesses universal appeal.

The next notion, concerning numerical fluency, can be drawn upon to imply targets.

• In 150 years, there will approximately 8 billion people (or beverage consumers) in the world. On average, these people will be leading more prosperous lives.
• Each consumer is composed mostly of water and is required to drink 64 ounces of water per day. That is 8, 8-ounce servings of water a day.
• If Coca-Cola can constitute 25% of the 8, 8-ounce servings per day for half of the global population, that will be a total of 2.92 trillion 8-ounce servings consumed per annum. This is calculated by considering 2 servings per day, half the global population of 4 billion and a 365-day calendar year.
• If the net profit of each serving is 4 cents, that would leave Coca-Cola with an annual net income figure of approximately $117 billion. The $2 trillion-dollar price-tag for the company valuation would imply an approximate P/E of 17 times earnings. If the company can still sustain growth at this point in time, this price-tag can be deemed reasonable.

Is the net profit of each servings at 4 cents a sensible estimate? The following 4 arguments address this possibility:

• Only if a beverage with a strong brand is created. This implies pricing power.
• Monetary depreciation will cause the dollar will lose value to inflation. The real purchasing power of a consumer will only increase over time as people, on average, will be leading more prosperous lives. The proclivity to inexpensively improve one’s experience (through food and beverages) will increase even faster over time.
• Technology improvements will reduce the cost of production, resulting in lower unit costs.

 The purchasing power of beverage consumers worldwide will increase at least 40-fold within the next 150 years. This purchasing power is supported by the number of different countries around the world continue to develop and prosper, gaining higher levels of income and proclivity to spend. Based on a global GDP growth figure of approximately 2.50% per year, the 40-fold increase will be achievable in 150 years using compound calculations.

Using Munger’s reverse-thinking notion, the current net profit target per can is only 1-40^th of 4 cents. Again, this is only achievable with the universal brand appeal. How is it possible to build a universal brand appeal? It requires the integration of the following actions:

• Create a product which can become a diet staple for half of the world’s water consumption.
• Gain as much market share as possible – desirably 50% and leaving the rest to competitors.

To produce the highest probability of success, the odds of all favourable outcomes must work in conjunction with each other to create a desirable “lollapalooza” effect.

The “no-brainer” decision to create a strong, legally protected trademark has psychological implications on the consumer. When a business creates a strong brand it is creating and maintaining conditional reflexes. It is an artificially created stimulus to generate and reinforce the desired response in consumers: to purchase and to drink.

To create these conditional reflexes, you will need:

• Operant conditioning: this can be achieved by maximizing the rewards for consuming Coca-Cola and minimizing the consumer desire to switch to a competing beverage brand once they have an acquired taste.
• Conditional / Pavlovian conditioning.

Under the operant conditioning, the categories of practical consumption are:

1. Food value in calories;
2. Flavour, texture and / or aroma as an additional stimulus to consumption;
3. Stimulus, i.e. sugar or caffeine;
4. Cooling effect, when one is too hot or warming effect, when one is too cold.

To generate the “lollapalooza” effect, both conditions and all categories mentioned above need to be present and working in tandem.

Should the beverage be hot or cold? Designing the beverage cold has a multi-faceted advantage over designing the beverage hot. There is significantly less opportunity to counteract excess cold as opposed to excessive heat. In addition, with excessive heat, people are more likely to drink more cold beverages whilst the reverse is not entirely true. People will not drink more hot beverages just because it is cold. 

What is the stimulus? Both sugar and caffeine will be included along with other flavours to create the quintessential beverage to create the maximum pleasure in consumption.

To train the operant condition in consumers globally, awareness and availability is key to developing long-term consumer habits and extinguishing any operant conditions set by competitors.  

The Pavlovian conditioning, on the other hand, draws on the powerful subconscious effects of the mere association tendency. Named after Russian psychology Ivan Pavlov, this condition was discovered in an experiment where Pavlov’s dog learned to salivate at the sound of a bell. This conditioned stimulus relays back to the way the human brain functions on a subconscious level – people can be conditioned to elicit certain behaviours and thoughts on engineered stimuli, i.e. marketing.

Coca-Cola’s beverages are to be promoted by exploiting every dimension of the Pavlovian condition. This includes marketing the beverage with positive associations such as happiness, admiration and desire. Although marketing is particularly expensive, it will be particularly effective in cementing the Pavlovian condition.  It will increase brand awareness in consumers and drive rapid volumes growth that, in turn, creates a cost advantages in product distribution. This is called the volume-creates-power effect.

The mere associations tendency can be further exploited by choosing a brand name which sounds exotic and expensive. Doing so will invoke consumers to subconsciously draw comparisons to other expensive beverages such as wine and champagne. This will give Coca-Cola a point of differentiation that will help the business in obtaining the 50% market share desired to reach the implied target.

In conjunction with the tendency mentioned above, the social-proof tendency will also be readily exploitable. The social-proof tendency triggers people to automatically think and do what they consider as generally accepted by others. It is a “monkey-see, monkey-do” cognitive bias. The act of consuming a beverage can be inviting on the popular sight of others consuming. Once consumed, it is also a reward that reinforces the decision to consume.

We now have the combination of following factors that accelerate the rate of growth:

• Pavlovian conditioning
• Powerful social-proofing effects
• All dimensions of practical consumption that reinforces the operant conditioning: taste, energy, stimulation and cooling effects

From a logistics and the distribution standpoint, there are 2 practical methods:

1. Sell the product as a completely encased carbonated beverage.
2. Sell the product in syrup form.

The latter requires a few syrup-making plants to be set up and has logistical benefits which come in the form of reduced shipment sizes. Bottling plants are therefore required to be set up worldwide to finish the product into its final form as encased carbonated beverages. Whether it is the syrup or encased carbonated beverages being sold overseas to these bottling plants or otherwise, it will be sold at a first-sale price. Simply put, the price that the importer pays will be the price that that Coca-Cola manufacturer’s set on the product. This will help avoid all agency mark-ups that lead to increased import taxes paid by the importer.

The importer's tax savings, which can be passed onto the customer, can be seen in the example below by comparing the total import tax figures.

Figure 1: Second-sale model

Figure 2: First-sale model

Additionally, the bottling companies that are set up globally as subcontractors in order to be profit maximizing. In this arrangement, the subcontractor will only carry out the duties set out by the general contractor: Coca-Cola.

The worldwide distribution system that is built has the ability to provide a moat for the company against competitors and future food-chemical engineers who will be able to replicate the taste of Coca Cola. As the technology improves for these future food-chemical engineers, so does the technology for the Coca Cola company. Technology advances in refrigeration, transportation and flavour science will assist the company in gaining efficiency and to capitalize on any additional opportunities.

Munger often quotes the great algebraist, Carl Jacobi, who often said: “invert, always invert.” To work backwards on this problem, and close to the problem, it is important to explore what must be avoided in order to achieve a $2 trillion-dollar business valuation. The following points make strong arguments:

• Avoid the cloying aftertaste of over-consumption. Naturally, as part of Darwinian evolution, the cloying aftertaste has been developed as part of the standard human physiology to force moderation of intake. To take advantage of the consumption of Coca Cola on hot days, the flavour must be created with no after-taste effects. This can only be done through trial and error.
• Avoid losing parts of the trademarked name, i.e. Coca or Cola. Consumers should only associate those terms with the Coca Cola company. If there is another brand with Coca or Cola, it must be under the Coca Cola brand as one of the subsidiaries.
• Avoid the bad effects of envy. Paying attention to and recognizing one’s own success is the path to avoiding envy. Seeking to maximize internal improvements opportunities related to product quality, product presentation, price sensibility and harmless pleasure provided will be the only thing that matters.
• Avoid sudden and significant changes to flavours. Consumers are psychologically entrenched in their own deep-seeded preferences; any significant changes may unroot the very reason why they choose a particular brand. Old flavours, when consumed over and over again, reinforce the consumer preference for a particular taste. In addition to consumer preferences, a tendency called Deprival Super-Reaction Syndrome (DSRS) may also take place if a significant flavour change occurs. This syndrome, which describes the human tendency to become upset when something that we like is being threatened to be taken away, can impair a consumer’s brand perception in light of a significant flavour change.

And that concludes Munger's solution to a practical problem. This problem walk-through is particularly applicable in the world of investing, especially when you are trying to find companies that can compound at high rates of return over long periods of time. Munger's investment analysis shows that it is a lot more than just number crunching, financial ratios and the like; its a balance of multiple factors. The level of comprehensiveness that Munger depicts in his Coca Cola example will set as a personal benchmark for all research reports written in future. The significant inclusion of elementary ideas across multiple disciplines creates context and stresses the importance of consumer behaviour. At the end of the day, consumer behaviour is the ultimate driver for consumer purchases.