How to identify great companies to invest in – Part ll

Business franchise

Freedom from ‘cutthroat competition’

This week’s post looks at how we can identify companies with really superb business franchises. This second hallmark of great companies will be followed in subsequent posts by a discussion of the third and fourth qualities, which are superior management and superior business operations. My previous post dealt with the first quality, the ability of a company to generate what Warren Buffett calls Owner Earnings. See here.

It might be thought that five years of peer-beating high margins or high ROC numbers is all we need to identify a company with an exceptional business franchise; not so. First off, high ROC numbers are increasingly suspect. See here. Secondly, and of more importance, there’s a lot more to understanding a company’s business franchise than looking at raw numbers. As Buffett puts it: “When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett/Cunningham 1998) p.63.

Our assessment of the business franchise need not be too precise. To paraphrase Buffett: A basketball coach doesn’t check to see if a prospect is six foot one or six foot two; he looks for seven-footers. We aren’t interested in those prospects that are six foot ten. They may be close but they don’t measure up.

As well, Buffett says to stick to companies within our circle of competence. We need to remind ourselves that this is not the same as liking the product or service. We may love Ford cars or Apple smartphones but that is not the same as understanding the business. This included understanding the business sector or industry the company operates in, understanding its competitive position, understanding the market for its products or services, understanding its capital needs and understanding its prospects.

Inherent characteristics of a business

I often refer to Philip Fisher. Along with Ben Graham, he had the most influence on the development of Warren Buffett’s investment philosophy. Fisher says what he was looking for was: “the degree to which there does or does not exist within the nature of the business itself certain inherent characteristics that make possible an above-average profitability for as long as can be foreseen into the future.” (Fisher, 1958, 1974, 1996)p.198

Buffett says: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, 1998, p.93)

Fisher writes: “Some companies are in the seemingly fortunate position that they can maintain profit margins simply by raising prices. This is usually because they are in industries in which the demand for their products is abnormally strong or because the selling prices of competitive products have gone up even more than their own.” (Fisher, 1958, 1974, 1996) p.64. Fisher would add, some companies are of a type that is ‘fortunate because it is able’. (Fisher, 1958, 1974, 1996) p.50.

Characteristics of an attractive business include growth from existing products and from new ones; a high profit margin and return on capital, together with favorable trends for both; effective research; a superior sales organization; a leading industry position giving advantages of scale; and a valid ”franchise” – proprietary product or services.

This leads directly to Warren Buffett’s concept of ‘moats’, a term he coined about fifty years ago. The term is in common use. The metaphor is a bit stark. Moats in business are sometimes stark and sometime subtle.

I can do no better than quote Morningstar’s discussion of moats:

“Morningstar has identified five potential sources of an economic moat, which are described below. Every company with an economic moat rating of wide or narrow exhibits at least one of these sources of advantage, and in some cases more than one.

Network Effect. The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. For example, millions of buyers and sellers on eBay (EBAY) give the company an advantage over other online marketplaces. The more sellers there are on eBay, the more likely buyers are to find what they’re looking for at a decent price. The more buyers there are, the easier it is to sell things.

Intangible Assets. Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products, or allow the company to charge a significant price premium. For example, patents protect the excess returns of pharmaceutical manufacturers such as Novartis (NVS). When patents expire, generic competition can quickly push the prices of drugs down 80% or more.

Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, Express Scripts (ESRX) controls such a large percentage of U.S. pharmaceutical spending that it can negotiate favorable terms with suppliers like drug manufacturers and retail pharmacies.

Switching Costs. When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power. Architects, engineers, and designers spend entire careers mastering Autodesk’s (ADSK) software packages, creating very high switching costs.

Efficient Scale. When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. For example, midstream energy companies such as Enterprise Products Partners (EPD) enjoy a natural geographic monopoly. It would be too expensive to build a second set of pipes to serve the same routes; if a competitor tried this, it would cause returns for all participants to fall well below the cost of capital.”

Moats of the future

Morningstar’s list is not exhaustive. Companies are constantly coming up with novel sustainable competitive advantages. As well, I am always on the lookout for companies that are on the verge of establishing strong business franchises. They typically are smaller to mid-size companies in which management has a major stake. They are run in an entrepreneurial fashion. They are managed for the long term. It will be evident that if they build the business they seem capable of they will have substantial franchises.

Such companies may not have a broad moat when the initial investment is made so long as the investor is convinced a substantial moat is in the making. There is room for a small number of these companies in an investor’s portfolio.

Conclusion

As I’ve written before, we only invest in superb companies, and then only at very attractive prices. An investor will identify very few companies that meet all their requirements to be thought of as a superb company.

Thinking about a company’s business franchise and whether the company has a defensible moat might be thought as a second step (after Owner Earnings) in identifying companies whose earnings will march upward year after year. In future posts I will look at management competence and alignment of interest and the quality of superior business operations.

The first post in this series is How to identify great companies to invest in – Part l

The next post in this series is How to identify great companies to invest in – Part lll

For readers wanting to dig deeper into the subject of how to identify great companies, take a look at Part 6: The Hallmarks of Superb Businesses

In particular, see Chapter 31. General approach to choosing common stocks

And specifically, Sections:

31.18 Owner earnings

31.20 Management

31.21 Understandable and superior business operations

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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