In search of 'bulletproof' franchises

All stock investment decisions should ideally start with identifying good companies/businesses. In this note, we discuss what Mr. Buffett has to say on which companies/businesses make the best investments.

In his 1991 letter to shareholders, Mr. Warren Buffett delivered a gem of an advice that can do a great job in helping you analyze a business. Based on his enormous experience in analyzing companies, Mr. Buffett classifies them into two main types -

1. a business, or
2. a franchise

Mr. Buffett believes that many companies fall in some middle ground between the two and can at best be described as weak franchises or strong businesses. This is what he has to say on the characteristics of each of them:

Drawing the line

Mr Buffett says, "An economic franchise arises from a product or service that:

1. is needed or desired,
2. is thought by its customers to have no close substitute, and
3. is not subject to price regulation.

The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mismanagement. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage".

He further goes on to add, "In contrast, a 'business' earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management."

We believe investors can do themselves a world of good by applying the above advice as they go about selecting stocks to invest in. If one were to visualise the financials of a company possessing characteristics of a 'franchise', the company that emerges is the one with a consistent long-term growth in revenues and high and stable margins, which arise from the pricing power the franchise enjoys.

On the other hand, a 'business' would be one with erratic growth in earnings owing to frequent demand-supply imbalances or one with a continuous decline after a period of strong growth owing to the competition having caught up.

Mr. Buffett further says that since a bad management cannot permanently dent the profitability of a franchise, turbulent times in such firms could be looked upon as opportunities. It should, however, be borne in mind that Mr. Buffett is also of the opinion that most companies lie between the two definitions and hence, one needs to exercise utmost caution before investing in a so-called 'franchise'.

Of meaty moats

Mr. Buffett calls 'franchises' as 'companies with wide moats'. Moats are indicative of the strong walls built around a castle in pre-historic times that offered stiff resistance to enemies looking to attack them. Thus, Mr. Buffett has likened 'moats' to the competitive advantages that a company enjoys in the market place and which in turn enable it to command higher profit margins and superior return on capital. The stronger these advantages are, the more difficult it is for competitors to take the market share away from the company and put pressure on prices. Hence, any investor looking to invest in a company should ideally look at those businesses, which have consistent history of higher margins and superior return on capital. Please remember the word 'consistent', as a year or two of great performance does not qualify a company as a 'franchise'.

The Indian context- Colgate's moat as wide as the smile from it

While there are indeed a few Indian companies that possess 'wide moats', the one that we would like to discuss here is Colgate, the maker of the ubiquitous oral care products. In India, the name Colgate has been synonymous with toothpaste and toothbrushes and no other brand commands the same recall in this segment as 'Colgate'. But having a strong brand is one thing and performing consistently year after year is another. So, how does the company fare in terms of its financial performance? We would say not bad at all!

Between 2002 and 2012, a period long enough to test a company's 'moat', Colgate has had just one year of a marginal drop in profitability. Otherwise, the company has managed to grow its revenues and profits at compounded annual growth rates (CAGR) of close to 10% and 20% respectively over this time period. Even the return ratios have been remarkably consistent with return on net worth (RONW - an indicator of the kind of returns a company is generating for its shareholders. It is defined as PAT upon the net worth of the company) not dropping below 30% at any point in time.

Indeed, not many companies in the Indian corporate landscape can boast of such a record over such a long period of time.

Hence, this is the type of businesses that one should look at and this is the kind of companies that we believe could be called as a 'franchise' or a company with 'wide moat'.

Kingfisher Airlines - Moat always under turbulence

As far as companies with 'narrow moats' are concerned, we would mostly find such companies in commodity sectors like textiles, airlines and the like. Let us take Kingfisher Airlines as an example. The company perhaps represents the best in customer service and flying experience. But does it have the financial numbers to show for it? Certainly not. It has recorded losses at the bottomline level for eight of the past ten years. And thanks to these losses, it had a negative equity at last count, implying that all these years of losses had completely wiped away its equity. This is clearly an indication of how even the most customer centric companies can run into trouble if the moat is not present.

» Next: Of price and value and the great divide.

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