Investment Methodology for Investing in Franchises

“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”

“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.” (1996 Chairman’s Letter–Warren Buffett

Franchise Investing

Many weeks ago I mentioned and posted a book on using clean (taking out the “dirty” stuff like one-time accruals) surplus accounting

The gist of the method is to use clean surplus accounting to calculate the company’s true return on equity that makes it easily comparable to other companies. Then invest (at the right price) in companies with better than average ROEs than the market’s average ROE (13%) if you want to outperform an index of stocks.

Obviously, if a company sports a relatively consistent ROE above 15% without too much debt, then the company probably operates with competitive advantages.

Learn More

For those who wish to learn more: You can listen to radio segments of the promoter of “Buffett and Beyond.” Yes, a bit promotional, but the concept the Professor is explaining is sound.

For a list of companies that fit the investment parameters go here: Parameters_for_Investing_the_Buffett_and_Beyond_way

A consolidation of past articles: Clean surplus article

If you have a method that makes sense, you know how it works, and you have confidence in its LONG RUN performance, then you are better off than 99.9% of all investors in the market.

I am not promoting the above method as THE best way to invest, just suggesting that you develop your own investment philosophy and method that YOU believe in. This post is just an example of how you might go about developing your method.

13 responses to “Investment Methodology for Investing in Franchises

  1. I am not promoting the above method as THE best way to invest, just suggesting that you develop your own investment philosophy and method that YOU believe in : nicely said!

    New Montier GMO letter is out btw…always contains a lot of common sense imho!

  2. John, one thing I had been thinking about lately is return on capital. My understanding is that one thing Greenblatt is trying to do come with in his Magic Formula is an incremental return on capital – that’s why he excludes things like goodwill. He’s arguing that it’s the return he can get on the assets that actually exist that’s important.

    I’ve expressed scepticism about this before, arguing that increases in earnings often come through acquisitions, and therefore goodwill was/is a true capital cost (if the company didn’t need to expend money on goodwill, then why did it?).

    Well, this got me to thinking – if what you’re really trying to ascertain is a company’s incremental return on capital – then why not CALCULATE an incremental return on capital, rather than some surrogate? The formula is simple enough (and nothing new, I didn’t invent the idea):
    (EPS1-EPS0)/(ASSETS1 – ASSETS0).
    There are some nuances, like whether you want to use EBIT figures or net income, adjusting for share issues, and so on. But you could use something like EBIT in the numerator, and total capital in the denominator.

    What are your thoughts on this?

  3. Do we KNOW that Buffett uses clean surplus accounting, or is that just something the author asserts?

    • No, we don’t. The Author doesn’t prove that Buffett used it. But I agree that the method improves comparability. The book, though, is ridiculous in its repetition and wordiness.

      • You’re not wrong! Nearly half way through it now, and I think I’ve gotten through the meat of it. It looks like the whole thing could be summarised in about 10 pages, tops.

  4. Good question and I will post in a few minutes so as to provide more information than here.

  5. I just want to air a few niggles with Farwell’s book. He says that “this is how Warren Buffett became one the richest individuals in the world”.

    Well, yeah, but there’s some simplification there. For starters, during his early career, Buffett was engaged, for a long time, in asset conversion situations. These companies were not good.

    Other criticisms: Buffett would have earned a lot of money through the fee structure of his partnerships. That allowed him leveraged returns, because he was effectively skimming off the top.

    Later on, his insurance businesses gave him a structural advantage through the float.

    And I don’t much like Mary Buffett, whom I consider is just trading off the Buffett name. When I read one of her books a long time ago, there was a lot of IRR stuff. But it’s been said repeatedly that Warren doesn’t use DCF, so why are those types of concepts being spouted by Mary? Grrr!

    Having said that, Farwell’s book has definitely given me food for thought. Thanks for sharing it.

  6. Thanks. Yes, Mary is trading off of Buffett’s name as are about 1000 other individuals. Ignore non-practioners.

    If you are learning from Clean Surplus, perhaps you can write out in four or five pages the essense of his 240 page book. May be a good learning exercise.

    I might do it as a case study.

    • “perhaps you can write out in four or five pages the essense of his 240 page book”

      You must be reading my mind 😉

      Actually, one thing I’m assembling as an ongoing exercise is a “Hacker’s Guide To Investing”, which I like to think of as a pamphlet (“book” sounds too grandiose) on material that I want to assemble for my ongoing review. It’s quite a useful reference material for myself. Farwell’s book looks like it could easily be boiled down to 4/5 pages in order to capture the essence of his argument.

  7. Dear Mcturra 2000:
    If you complete such a write-up and submit it, you would win a date with her:

    As you know, Lindsay Lohan is in recovery so she was not available.

  8. You’ll like this little snippet from Farwell’s book, with a table compiled to 2002. He computed ROEs for Eatman Kodak, and came out with a one-year ROE of 6.31%m and a 10-year averafe of 11.28% – both below the Dow 30 average ROE for 2002 of 13.38%. “From whatever angle you snap this picture; Kodak just can’t earn a good return on its investments”.

    Someone should have leant the book to Bill Miller, and saved him a decade of heartache. 😉

  9. If you read why Miller invested in Kodak–he said it was due to the new management, the free cash flow, the investments in digital, the patent portfolio. In other words, a story of the future. But how is the film business AT ALL like the digital photo market. Like at team of Ballerinas trying to play Pro Hockey.

  10. I’ve done a write-up about Clean Surplus Accounting, and made it available here: . 3 pages – a mere 1% of the original contents. Enjoy.

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