Warren Buffett Is Wrong About Whole Foods

By Markets Fool.com

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I think the world of Warren Buffett. That's why I just travelled halfway across the country to soak up his wisdom at the 50thannual Berkshire Hathaway shareholders' meeting. But despite his incredible track record, the Oracle of Omaha occasionally makes an investing mistake and I believe he's making one now with Whole Foods Market .

Let's Go To The Videotape
Towards the beginning of the marathon Q&A session, The New York Times' Andrew Ross Sorkin asked Buffett if he was concerned that shifting consumer preferences toward healthier diets might endanger the economic moats of Coca-Cola and Kraft Foods Group . Here's how Buffett responded:

I don't think there will be anything revolutionary. Food and beverage companies will adjust to the expressed preferences of consumers. No company does well ignoring its consumers. I predict that 20 years from now more Coca-Cola cases will be consumed than today. Back in the late 1930s, Fortune magazine ran an article saying the growth of Coca Cola was over. When we bought stock in the 1980s, people were not enthused about [Coca-Cola's] growth.

I am probably one-quarter Coca-Cola [big laugh from audience].... If I had been having broccoli and brussel sprouts, I wouldn't have lived as long. I would have approached every day like going to jail... Charlie [Munger] and I have enjoyed every meal we've ever had except when my grandfather made me eat those damn greens.

It's amazing how durable [consumer brands are]. Berkshire Hathaway was the largest shareholder of General Foods from 1981 to 1984 that's 30-plus years ago. It was bought by Philip Morris and spun out as Kraft. Those same brands are popular today. Heinz goes back to 1869. The ketchup came out in the 1870s. Coca-Cola dates to 1886. It's a pretty good bet that a lot of people will like the same things.

When I compare drinking Coca-Cola to something they would sell me at Whole Foods, I don't see a lot of smiles on the faces of people at Whole Foods.

Right Answer, Wrong Approach
Buffett's conclusions about the future of Coca-Cola and Kraft are probably correct. While consumer preferences have been shifting toward healthier fare, sugary and processed foods are still very popular and will likely remain so for the foreseeable future. And even if a wholesale change in consumer behavior does occur, Coca-Cola and Kraft are capable of adapting. Both companies have the scale advantages, distribution platforms, and marketing muscle to ensure their brands remain relevant for decades to come.

For me, the real issue was Buffett's rationale. I sensed several behavioral biases that could be causing him to make a suboptimal investment decision.

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Survivorship Bias
It's true that Coca-Cola and Kraft successfully fought off challenges in the 1930s and 1980s. But so did Eastman Kodak, General Motors, and Woolworth's. Competitive conditions are constantly evolving, and a company's success several decades ago may not be a valid predictor of its ability to fend off competitors today. By focusing only on those companies that survived, Buffett may be overestimating Coca-Cola and Kraft's odds of continued success.

Liking Bias
Buffett clearly enjoys Coca-Cola, both as a consumer and a shareholder. Furthermore, he is friends with many of the company's executives, and his son Howard sits on Coca-Cola's board of directors. These favorable feelings may make it challenging for Buffett to view the company objectively. We saw evidence of this phenomenon in action last year, when Buffett abstained from voting against an executive compensation program that he viewed as excessive.

Projection Bias
But for me, the biggest flaw in Buffett's thinking concerned the parting shot he took at Whole Foods.

Because Buffett eats like an unsupervised six-year-old, he incorrectly assumes that most consumers share his eating preferences. This fallacy is probably supported by his choice of dining partners, including Munger, who plowed through an entire box of peanut brittle during the shareholder meeting. But I've been to the Omaha Whole Foods, and I saw a store full of happy customers buying premium-priced organic produce. Buffett's bias against healthy eating is likely causing him to underestimate the appeal of Whole Foods' brand.

So, Should Berkshire Buy Whole Foods?
There are legitimate reasons not to invest in Whole Foods. The grocery business is intensively competitive, with thin margins and no barriers to entry. Buffett knows this firsthand, as his grandfather owned a grocery store in Omaha where Buffett and Munger both worked as young men. Furthermore, Berkshire recently lost $444 million by investing in Tesco, the leading grocer in the U.K.

But Whole Foods is not your typical grocery store. As the largest retailer of natural and organic foods in the U.S., Whole Foods is commonly perceived by consumers as offering healthier and higher-quality fare. Thanks to its strong brand, Whole Foods can charge premium prices for its products, which enables the grocer to post atypically high sales per square foot, gross margins, and return on invested capital.

Whole Foods possesses many of the characteristics that Buffett loves to see when evaluating investments. It has strong and sustainable competitive advantages, a clean balance sheet, a dedicated and shareholder-friendly management team, and attractive growth prospects. With a P/E ratio of 30, shares don't appear especially cheap at the moment, but this strikes me as a reasonable price for such a high-quality business. If Buffett could look past his hatred of healthy eating, I suspect he might agree.

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The article Warren Buffett Is Wrong About Whole Foods originally appeared on Fool.com.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Rich Greifner has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway, Coca-Cola, and Whole Foods Market. The Motley Fool owns shares of Berkshire Hathaway and Whole Foods Market and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.