Warren Buffett Lesson on Franchise Investing–The Qualitative Difference

I have excerpted the conclusion of a Tweedy Browne research study on A Great 10-Year Track Record; Great Future Performance Right? because it illustrates the importance of assessing the qualitative information that drives financial numbers.  If financial numbers alone predicted future growth, then, as Warren Buffett has said, all librarians would be rich.  …..And that, folks, is why we will spend time on studying franchises and their competitive advantages.

Interesting investment research articles on Value Investing from Tweedy Browne: http://www.tweedy.com/research/papers_speeches.php

Research paper on the predictability of long-term earnings and intrinsic value growth: Great 10-Year Record = Great Future, Right?

http://www.legend-financial.com/files/Great%2010-Year%20Record%20Great%20Future,%20Right.pdf

The conclusion of this study explains why an investor must focus on the qualitative aspects of a business–what drives the financial performance?

Thoughts/Observations:

The easy-to-calculate Implied Growth Rate (i.e., return on equity times the percentage of earnings that is reinvested in the business and not paid out to stockholders as a dividend) did not predict future earnings growth, on average, for companies that had been highly profitable over the last ten years. Return on equity for these companies, as a group, tended to decline over the next seven years. Financial pasts were not related to financial futures for the companies as a group.

Similarly, companies that experienced the highest growth in e.p.s. over the 12/31/90–12/31/97 seven-year period had prior 10-year average profitability, as measured by average return on equity, that ranged all over the map. The pattern looked random to us. The financial future, as measured by seven-year e.p.s. growth, was unrelated to the financial past. Many companies with poor return on equity track records perked up and produced significant earnings increases, and many companies with excellent return on equity track records stumbled and experienced a large decline in earnings.

The previously described study by Patricia Dechow and Richard Sloan suggests that when the average company experiences a growth spurt in sales per share over a five-year period, the growth in sales per share over the next five years will tend to revert to about the mean average for most companies. Similarly, the Dechow and Sloan study suggests that the average company that has had five years of exceptional earnings per share growth will tend to have e.p.s. growth over the next five years that is about equal to the average for all companies.

The drivers of growth in intrinsic value (as measured by 10x EBIT (i.e., earnings before deducting interest and taxes), plus cash, minus debt and preferred stock, divided by shares outstanding) are growth in EBIT and cash generation (that results in an increase in cash or a decrease in debt). Aside from increases in EBIT that can be generated by price increases or cost cuts, which are often one-time turnaround type changes, the engine that drives EBIT growth over the long-term is sales growth. And more sales generally require more operating assets such as inventory and property, plant and equipment. A company that experiences significant growth in unleveraged intrinsic value of, say, 18% per year, over a long period of time, such as 10–20 years, has to have a high return on the capital that is being reinvested in the business to support the 18% growth rate. Just look at Walmart’s or Coca-Cola’s long-term record as examples of sustained high returns on equity and high reinvestment in the business. Companies that grow a lot over a long, long period of time, have to have sufficient opportunities to reinvest earnings at high rates of return in order to generate more sales and earnings. The math is easy.

Not only do investors have to understand growth but also what the expectations of growth imply for future returns.

This is an important article for understanding how to invest in growth companies and franchises. One conclusion of the research is financial numbers. Isn’t it a paradox that most of what is written about investment analysis in textbooks and journals is about quantitative information, and so little is written about digging up and analyzing the qualitative information that ultimately drives the financial numbers? Customers drive sales, sales drive profits and, ultimately, a company’s competitive standing, or advantage, its “franchise”, determines the sustainability of sales and profits. If long-term growth can be predicted at all, it would appear that the prediction must rely upon insights relating to qualitative information that has been used to assess the sustainability of a competitive edge. When Warren Buffett is considering an investment, he doesn’t just study the company that he is considering. He studies the company’s competitors as well. Historical financial numbers alone do not predict growth. If financial numbers alone predicted future growth, then, as Warren Buffett has said, all librarians would be rich.

In recent years, Warren Buffett has said that you shouldn’t consider buying an interest in a business unless you are willing to own it for at least ten years. He and Charles Munger have also mentioned that the futures (and future growth) of very, very few businesses are predictable with certainty. As a corollary, they believe that the competitive landscape in ten years can only be predicted with certainty for a few businesses. They like a business that they can “understand”, and they don’t like a lot of change in a business. Warren Buffett and Charles Munger classify Coca-Cola as an “inevitable” that they believe is certain to grow. As a corollary, they must believe that Pepsi Cola, Cott, Virgin Cola and other competitors’ future actions and responses over the next ten years will not impair Coca-Cola’s future profitability or dent its 15%+ growth prospects, and that customers’ choices among many competing beverages will continue to favor Coca-Cola’s offerings. Similarly, in emphasizing the rareness of businesses that are “certain” to grow at 15%+ rates over a long period of time, Warren Buffett and Charles Munger describe having an opportunity ticket that may only be punched ten or fewer times in a lifetime. Because there are so few businesses that are certain to grow at high rates that are also available at an attractive price, Warren Buffett and Charles Munger believe that you should load up and concentrate your portfolio on that “opportunity of a lifetime” when you find it. How many businesses are you certain about ten years from now?

10 responses to “Warren Buffett Lesson on Franchise Investing–The Qualitative Difference

  1. Excellent material – thanks John. Notwithstanding the emphasis on the qualitative, I did find interesting their observation that an EV / EBIT of 10 is, in their experience, a common price to pay for an acquisition.

  2. Agreed. Excellent as usual. I think if we were only given a ten-ticket punch-card, nearly all of us will still choose the wrong companies.

  3. John,

    I suppose Warren Buffett’s career would be an answer to this question but, if, say, you had 90% confidence that the next ten years would look pretty horrible for business generally, would the criteria of “buy businesses you plan to hold for ten years” still be a reasonable approach to investing?

    It’s seemed to work for Buffett but some have questioned whether Buffett was an unwitting recipient of perpetual inflationary bailouts of the economy over the last 40-50 years. Certainly I don’t think we can completely discount Buffett’s success, but it would be more comforting if, say, his career had begun in 1920 and lasted through the 70s or 80s, maybe.

    Thoughts?

    • Dear Taylor:

      You are asking–I think–several questions. Buffett regrets in his 2003 letter his decision NOT to sell KO, Washington Post, etc. Perhaps it would have been awkward being on the board, etc. but he admits it was a mistake. If you hold a business “forever” say 30 years then you will receive the return equal to the firms average ROE. If you pay over or under eventually the over/under payment will be shaved down to the return of the ROE given a long period of time.

      I do agree that if you are so fortunate to find a compounding machine where a company has a ROIC that is above YOUR cost of capital and it can redeploy that capital for many years at a high rate, I would hold on tight–but WMT or WalGreens or MSFT are EXTREMELY rare. How long can their competitive advantage period run? How far do we veer into speculation to hold if the price begins to discount future growth. You only need one or two compounders to make your fortune. However these cases may not put you in the next early WMT but you can learn about entrant strategies, incumbent responses and competitive advantages to allow you to invest in franchies and better value growth.

      Anything Buffett has EVER said about investing here: http://buffettfaq.com/ (great site).

      You are also talking about the stock market’s nominal returns rising over the periods when he was investing. Inflation really took off when Nixon severed all ties to gold in 1971. Conditions now are ripe for nominal (not real) gains–we are still on a fiat money system backed by nothing but government coersion and implicit promises not to destroy the currency. If Money only grew by the amount of gold or precious metals mind, the stock market as a whole would rise only in real terms. (See Capitalism by Reisman for a detailed explanation).

      I believe your best strategy is to follow Buffett’s advice and invest in inflation pass throughs (franchises) at conservative prices like NVS, AMAT, IFF (if it sells off another 10%), etc. See the best article ever written on investing……….http://www.scribd.com/doc/65198264/Inflation-Swindles-the-Equity-Investor

      Good questions …others can take a shot.

      • John,

        You raise an interesting (couple of) point(s).

        I was reading a McKinsey book on value and one of the points they made is that the best owner of an asset or company changes over time. In that sense, it’s unlikely that once Buffett buys a company, he would necessarily be the “best owner” of that asset indefinitely from that point on. It’s more likely that there is a “peak value” he should watch for at which point the price is sufficiently close to, or has surpassed, his calculation of intrinsic value and he should sell.

        The only reason why he might not, beside sentimental considerations, is that he has painted himself into a corner and taken such a large position that he can not liquidate without shooting himself in the foot.

        What do you think are some considerations Buffett and others need to be making with regards to this potential problem? Does it call for never taking too big of a position? Does it necessitate a different strategy for selling your position once you’re in (go private, private sale, shop your position to a buyer who can take the whole thing at a favorable price, liquidate, sell off pieces of the business until you can be more liquid with what’s left, etc.)?

        What do you do if you are, like Buffett, so successful that you’re becoming a larger and larger % of the total wealth of an economy? Do you periodically give wealth away or voluntarily divest yourself of assets at zero price? I wonder about these “rich man’s problems” quite a bit, not just because I hope with any luck I might have them myself one day 🙂

        • I think when using Buffett as an anology you need to understand his psychology. Read SNOWBALL. He likes to collect, he is loyal to what he likes, he abhors change. His strategy of never selling helps him acquire certain businesses that he otherwise wouldn’t because the sellers feel secure with him.

          You may have to look at YOUR motivation vs. why Buffett does what he does.

          All for now.

          Thanks.

          • John,

            Yes, I’ve read Snowball and understand his psychology. I didn’t mean to analogize, only to use Buffett as an example of a person who is accomplished enough to face those particular problems. Could apply to ANYONE in his shoes, with different personal psychology.

          • Good points and hopefully others reading this blog with more insight can comment on your questions too.

  4. Pingback: The Best 100 Quotations from Warren Buffett on Investing, Leadership, and Life | The Talkative Man

  5. Interesting theory about those companies which experienced high profits between 12/31/90 and 12/31/97. Useful details here, thank you for sharing!

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