Tag Archives: Franchises

TIME OUT: Franchise Investing (Pat Dorsey)

Thanks to www.santangelsreview.com

Slides here:pat-dorsey-talks-at-google

A franchise-type company does not often become a distressed, deep value investment. But since we will next be discussing Buffett and his development from cigar-butt investing to buying See’s Candies, I thought a review of franchises by this money manager would interest you.

One mistake investors make is confusing an average company with a franchise. Not to pick on anyone but when Monish Pabrai said Pinnacle Airlines had a moat due to the type of aircraft the airline was flying or Excide Batteries had a brand, he thought he was investing in a franchise. Yes, Excide batteries may be well-known but it doesn’t change a consumer’s behavior.

Punch card Investing: Case Studies on Franchise Investing


http://punchcardblog.wordpress.com/ Dedicated to the Exploration of Moats and High Quality Businesses

Please check out the new blog. Your time is better spent learning about franchises and case studies than debating gold or any macro picture/forecast.


Mental Models, The Franchise of Legos (plastic blocks)


But why should we learn about the world and its history, why bother trying to live in harmony with others? What is the point of all this effort? And does it have to make sense? These questions, and some others of a similar nature, bring us to the third dimension of philosophy, which touches upon the ultimate question of salvation or wisdom. If philosophy is the ‘love’ (philo) of ‘wisdom’ (sophia), it is at this point that it must make way for wisdom, which surpasses all philosophical understanding. To be a sage, by definition, is neither to aspire to wisdom or seek the condition of being a sage, but simply to live wisely, contentedly and as freely as possible, having finally overcome the fears sparked in use by our own finiteness. –Luc Ferry in A Brief History of Thought

Mental Models: http://www.farnamstreetblog.com/mental-models/

Why Legos Are So Expensive — And So Popular? Hint—it is a FRANCHISE!   (I hope readers who have children that play with Legos can add their input–Why did you shell out those big bucks for plastic blocks?)


January 16, 2013

A lot of people wonder how Lego, selling a now un-patented product, can command both massive market share and sell at twice the price of the nearest competitor: Megablocks.

pm-gr-legomega-616Mega blocks are much cheaper than Legos yet Legos dominates in sales.

Rhett Allain, in his WIRED article addressing why lego sets are so expensive, unsatisfyingly concludes “Honestly, I don’t know much about plastic manufacturing – but the LEGO blocks appear to be created from harder plastic. Maybe this would lead them to maintain their size over a long period of time.”

While lego offers a superior product, that doesn’t wholly account for why they sell so well.

Chana Joffe-Walt offers a much better explanation in her NPR Planet Money article: (click on link to hear the radio show on Legos)

Lego did find a successful way to do something Mega Bloks could not copy: It bought the exclusive rights to Star Wars. If you want to build a Death Star out of plastic blocks, Lego is now your only option.

The Star Wars blocks were wildly successful. So Lego kept going — it licensed Indiana Jones, Winnie the Pooh, Toy Story and Harry Potter.

Sales of these products have been huge for Lego. More important, the experience has taught the company that what kids wanted to do with the blocks was tell stories. Lego makes or licenses the stories they want to tell.

Lego isn’t just selling a product, they are selling a story. Still, I doubt that alone fully explains the difference.

I think Warren Buffett offers the best explanation. Talking about the brand power of See’s Candies, he comments:

What we did know was that they had share of mind in California. There was something special. Every person in Ca. has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn’t take any capital.

… It is a good business. Think about it a little. Most people do not buy boxed chocolate to consume themselves, they buy them as gifts—somebody’s birthday or more likely it is a holiday. Valentine’s Day is the single biggest day of the year. Christmas is the biggest season by far. Women buy for Christmas and they plan ahead and buy over a two or three-week period. Men buy on Valentine’s Day. They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of Chocolates by the time we get through with them on our radio ads. So that Valentine’s Day is the biggest day.

Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, “Honey, this year I took the low bid.” And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent.

The reason Lego is awesome and Megablocks is not has as much to do with what’s in the consumers’ mind as the product on the shelf. It’s the experience you have with Lego that makes it so amazing.

Remember the first time you played with Lego? You want to pass that experience off to someone else. No one wants to show up to a kid’s birthday party and announce to everyone they took the ‘low bid’ on a relatively cheap children’s toy.

Lego is a safe bet and we want to reduce uncertainty.

Read more posts on Farnam Street on:
Association biasLegoWarren Buffett

I went to Toys R Us recently to buy my son a Lego set for Hanukkah. Did you know a small box of Legos costs $60? Sixty bucks for 102 plastic blocks!

In fact, I learned, Lego sets can sell for thousands of dollars. And despite these prices, Lego has about 70 percent of the construction-toy market. Why? Why doesn’t some competitor sell plastic blocks for less? Lego’s patents expired a while ago. How hard could it be to make a cheap knockoff?

Luke, a 9-year-old Lego expert, set me straight.

“They pay attention to so much detail,” he said. “I never saw a Lego piece … that couldn’t go together with another one.”

Lego goes to great lengths to make its pieces really, really well, says David Robertson, who is working on a book about Lego.

Inside every Lego brick, there are three numbers, which identify exactly which mold the brick came from and what position it was in in that mold. That way, if there’s a bad brick somewhere, the company can go back and fix the mold.

For decades this is what kept Lego ahead. It’s actually pretty hard to make millions of plastic blocks that all fit together.

But over the past several years, a competitor has emerged: Mega Bloks. Plastic blocks that look just like Legos, snap onto Legos and are often half the price.

So Lego has tried other ways to stay ahead.

The company tried to argue in court that no other company had the legal right to make stacking blocks that look like Legos.

“That didn’t fly,” Robertson says. “Every single country that Lego tried to make that argument in decided against Lego.”

But Lego did find a successful way to do something Mega Bloks could not copy: It bought the exclusive rights to Star Wars. If you want to build a Death Star out of plastic blocks, Lego is now your only option.

The Star Wars blocks were wildly successful. So Lego kept going — it licensed Indiana Jones, Winnie the Pooh, Toy Story and Harry Potter.

Sales of these products have been huge for Lego. More important, the experience has taught the company that what kids wanted to do with the blocks was tell stories. Lego makes or licenses the stories they want to tell.

And kids know the difference.

“If you were talking to a friend you wouldn’t say, ‘Oh my God, I just got a big set of Mega Bloks,’ ” Luke says. “When you say Legos they would probably be like, ‘Awesome can we go to your house and play?’ ”

Lego made almost $3.5 billion in revenue last year. Mega made a tenth of that.

But Mega Bloks may yet gain on Lego.

Mega now owns the rights to Thomas the Tank Engine, Hello Kitty, and the video game Halo. And, on shelves for the first time ever this week: Mega Bloks Barbies.

PS: I will post shortly on a Reader’s Question: What besides an Index would you recommend for a person who seeks safety and return on his/her capital?


Buffett’s Investments in Franchises

A long-term durable competitive advantage in a stable industry is what we seek in a business.

I look for businesses in which I think I can predict what they are going to be like in ten to fifteen years’ time. Take Wrigley’s chewing gum. I don’t think the Internet is going to change how people chew gum.

—Warren E. Buffett

Old, established and Predictable

Predictable products equal predictable profits. It seems Buffett loves OLD, ESTABLISHED companies. Note the proclivity in his private life to repeat what he likes—burgers and Cherry Coke with Sees’ Candies frenzy as desert.

(Read/listen to Buffett discuss Coke and P&G during his lecture at the University of Florida: http://wp.me/p1PgpH-1N and the videos start: http://www.youtube.com/watch?v=ogAxzPaU5H4

Note the difference between Buffett’s style and Venture Capital investing:
Two VC’s explain their company: http://www.youtube.com/watch?v=3iQTvJIGArc&feature=related

We are studying competitive analysis in case studies to help us determine the strength and durability of a company’s future cash flows (depth and width of moat). Eventually we will circle back to tie franchise analysis in with valuation.

Warren Buffett selectively buys stocks when others are rushing to sell. And he has cash when others don’t as in 1973/74 thanks to his closing up his investment partnership in 1969. When Berkshire had $37 billion in cash, he pounced during the crash of 2008/2009.

Note the franchise and non-franchise companies

EPS       EPS          EPS              EPS
Year              Coke       JNJ          Ford     Adv. Micro Dev.
2011              $3.85     $4.85       $2.00           $0.55
2010              $3.49     $4.76       $1.66           $0.64
2009              $2.93    $4.63       $0.86            $0.45
2008              $3.02     $4.57     -$6.50          -$4.05
2007               $2.57     $4.15      -$1.43          -$5.09
2006              $2.37    $3.76       -$6.72          -$0.28
2005               $2.17    $3.50       $0.86            $0.37
2004              $2.06     $3.10       $1.59           $0.25
2003               $1.95     $2.70      $0.35          -$0.79
2002               $1.65     $2.23       $0.19           -$3.81
2001               $1.60      $1.91     -$2.95            -$0.18
TOTALS  $27.66  $40.16  -$10.09      -$11.94

Johnson & Johnson http://www.scribd.com/doc/78158910/JNJ-35-Year-Chart

Advanced Micro Devices http://www.scribd.com/doc/78159095/AMD-35-Year-Chart

Ford: http://www.scribd.com/doc/78159068/Ford-35-Year-Chart

Coca-Cola: http://www.scribd.com/doc/78158885/Ko-35-Year-Chart

Now, the charts do not imply that purchasing a franchise company at any price is wise, but look how profitable growth puts time on your side vs. the non-franchse companies.

When the market crashes, Buffett isn’t buying the Grahamian bargain he cut his investing teeth on. Instead, he is focusing on the exceptional businesses–the ones with a durable competitive advantage (DCA).


A few readers preface their remarks with an apology for disagreeing with my comments. Don’t. The purpose is to learn not be right.  If you reason with logic and facts you will convince like this: http://www.youtube.com/watch?feature=fvwp&NR=1&v=1jQP0Y2T2OQ

There is no point in discussing an opposing view with a person who acts on blind faith or belief rather than reason: Frailty: http://www.youtube.com/watch?v=Y_rVU40BTw4&feature=relmfu

Please feel free to disagree, but I warn you the last person to do so met this fate: http://www.youtube.com/watch?v=QHH9EYZHoVU  And I want….. http://www.youtube.com/watch?v=WcxiEOqk_w4

Remember today is Friday the 13th; be careful.

Buffett’s Split Personality?

“Do I contradict myself? Very well then I contradict myself, (I am large, I contain multitudes.)
Walt Whitman, “Song of Myself” ―   Walt Whitman

Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong. — Ayn Rand

Below is an unusual article (from www.marktier.com) on the split between Buffett’s private and public beliefs.  Interestingly, when Buffett was growing up his father, Howard Buffett, was an advocate for the gold standard, low taxes and extremely limited government.  Thoughts on this article?

6 January 2012     Warren Buffett’s “Split Personality”

How Warren Buffett’s investment and political philosophies just don’t get along with each other.

Economic Franchise

Warren Buffett became the world’s richest investor by following a clear and straightforward investment philosophy. Intriguingly, though, his political convictions contradict the investment principles that made his fortune. For example, he refused to invest in companies which can’t control their prices; he looks for what he calls “an economic franchise.” His definition, from his 1991 Letter to Shareholders:

“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.” [emphasis added] This produces what he calls a “moat” — a barrier that hinders competitors who want to invade their turf.

Nebraska Furniture Mart — probably the world’s biggest furniture store located in, of all places, Omaha, Nebraska, and 100% owned by Buffett’s company, Berkshire Hathaway — keeps its costs and prices so low that national furniture chains simply avoid Omaha entirely. Coca-Cola, of which Buffett is the biggest shareholder, has such a powerful brand name that only Pepsi is in the race for second place.

By the same token, Buffett avoids “commodity businesses” like agricultural products, where producers are at the mercy of the market. And (until 1999) he shunned businesses whose retail prices are regulated.

An Energy Czar for California

In 2000-2001, California suffered severe rolling blackouts across the state. Pacific Gas and Electric Company went bankrupt and Southern California Edison almost did as well.

The cause? The state had deregulated wholesale prices, but left retail prices fixed (This is an example of a HAMPERED or price-controlled market). When wholesale prices zoomed 800%, Californian utilities had to buy power out-of-state to resell in California at the lower, regulated prices. A recipe for financial disaster.

Buffett’s reaction to the California energy crisis is an example of the dichotomy between his investment principles and his political views. When asked for his solution, he replied: “California needs an energy czar.”  (More centralized, bureaucratic control? How would Buffett’s company managers like to be micro managed from a person/group without aligned profit motives?)

California already had one — the reason there was an energy crisis!

And…with an energy czar regulating and dictating every aspect of the energy business, how much money do you think Buffett would invest in utilities in California?

Quite clearly, none.

What’s more, in a world where every investor acted like Buffett, nobody would have invested in Californian utilities.

Logically then, it follows from Buffett’s investment principles that the solution to California’s energy crisis was the deregulation of retail prices as well (politically impossible at the time). Only then would Buffett and investors like him be willing to put up the money needed to resuscitate California’s ailing utilities.

By rooting for an energy czar, obviously Buffett hadn’t connected the dots.

Interestingly, when Buffett made this “recommendation,” he’d recently added the gas and electric utility, Mid American (with zero exposure to California at the time), to Berkshire’s portfolio of “outstanding companies.”

Had he changed his spots? No, he’d lowered his standards. He had to. With billions of dollars to invest, gone were the days when a See’s Candies or Nebraska Furniture Mart could make a difference to Berkshire’s net worth. He now needed to find “elephants” where he could sink billions of dollars at a time. When he only had millions at his disposal, he’d never have looked twice at companies like Mid American or Burlington Northern.

To Tax or Not to Tax

Buffett calls taxes a “drag” that Berkshire must overcome to “justify its existence.”

This has been his attitude since he started his first investment partnership in 1956. Indeed, back then, one way he persuaded doctors and other professionals to invest with him was by stressing the tax benefits they’d get.

Today, he says he likes to hold his investments “forever” … so capital gains tax, payable only when an investment is sold, is also delayed “forever.” In his 1989 Letter to Shareholders he gave an example showing how just delaying capital gains could multiply Berkshire’s returns 27-fold, concluding that the government would gain in exactly the same ratio when capital gains taxes were ultimately paid, “though admittedly, it would have to wait for its money.”

He also prefers companies to distribute money to shareholders by buying back stock rather than paying dividends. Shareholders must pay taxes on dividends, which are paid from profits that have already been taxed at the corporate level. Stock buy-backs, by raising the value of the remaining shares, increase the shareholders’ wealth free of the dividend tax.

That double taxation is one reason Berkshire Hathaway doesn’t pay dividends. It’s also a reason why, when Buffett buys a company, he wants a minimum of 80%. Then, dividends to Berkshire are taxed at a lower rate.

If taxes are a drag on Buffett’s investments, surely they’re a drag on everyone’s? If Buffett and Berkshire are better off with minimal tax rates, wouldn’t everyone else be too? So you’d expect Buffett to support pretty much any proposal to cut taxes, right?

If you did, you’d be wrong.

“Voodoo Economics”

Buffett’s underlying political belief is that the rich should pay more tax than the poor, both absolutely and as a percentage of their income.

Indeed, in an op-ed for the New York Times Buffett complained that the previous year he’d paid only 17.4% of his income in tax, compared to an average of 36% for the 20 staff in his office in Omaha. He recommended the government raise his taxes, and those of the other super-rich.

He does not, however, put this belief into practice by voluntarily making up the difference between the tax he must pay and the amount which, according to his beliefs, he would deem “fair.” Indeed, his personal affairs are arranged the same way as Berkshire’s: to pay the least tax possible.

A case of “do as I say, not as I do.”

Shortly after becoming president, George W. Bush proposed slashing the tax on dividends. Buffett’s reaction? “Voodoo economics” that uses “Enron-style accounting,” saying it further tilts the scales towards the rich.

Maybe. But the widespread ownership of stocks in America today (through mutual funds and pension plans) means that the rich are not the only beneficiaries of a lower dividend tax.

And by opposing such a tax cut, he clearly contradicts a significant element of his investment philosophy, which implies it is iniquitous to tax corporate profits again when they’re paid out to shareholders as dividends. Indeed, if every company followed Berkshire’s lead and paid no dividends, the government wouldn’t collect any taxes on dividends at all.

Buffett also opposes abolishing the estate tax: he believes that you shouldn’t get “a lifetime supply of food stamps just because you came out of the right womb.”

Buffett has arranged his personal affairs accordingly. When he dies, his children certainly won’t be poor. But they will only have enough money so that, as he puts it, they’ll “feel they could do anything, but not so much that they could do nothing.”

Most of his wealth is going to the Bill & Melinda Gates Foundation. As it’s a non-profit organization the bequest will be — guess what? — tax-free!

It is clearly more important to Buffett that Berkshire Hathaway, his creation — his “baby” — survives his death, than remaining true to his political beliefs, no matter how sincerely they are held. After all, Berkshire Hathaway might not live on if a chunk of his controlling shareholdings had to be sold off to pay estate tax.

However, by requiring the Gates foundation to spend his annual donations immediately, he’s practicing what governments do so well: consuming capital, not investing in the future.

And he often ignores the overall context, as he did when he was an advisor to Arnold Schwarzenegger during his campaign to become Governor of California.

Buffett told the Wall Street Journal he thought California’s property taxes were “too low.” He compared the property tax he paid on his home in Laguna Beach, California with the tax on his home in Omaha. He paid twice as much property tax in Nebraska, even though his home there is one-eighth the value of his house in California.

Is that “unfair”? Not when — unlike Buffett — we look at the total context. When you add income tax, sales tax and all the other taxes Californians pay, they’re stung by the state for much more Nebraskans. Californians get a break on property taxes — and absolutely nothing else.

An American Liberal

Politically, Buffett tends to support government action to correct what he sees as society’s inequities.  And he believes that the rich should pay for it.

Yet, he arranges his own affairs to avoid government intervention wherever possible. Indeed, when price controls in New Jersey made it impossible to earn what Buffett considers a decent return of capital, one of his insurance subsidiaries turned in its license and shut down its operations there. With Buffett’s hearty approval.

His comments on business and investing draw on 55 years of proven and tested knowledge and experience.  His political recommendations have no such pedigree.  They are an expression of his beliefs unalloyed by experience.

Indeed, one would think that his experience in creating, from nothing, a highly successful, almost debt-free Fortune 500 company with outstanding managers and (until recently) one of only eight corporate AAA credit ratings in the United States would lead him to be skeptical of the ability of governments to solve any problem.

After all, in almost every respect governments exhibit qualities 180 degrees opposite to Berkshire Hathaway: they lose money every year; run up more debt every day; hardly ever kill programs that are known failures; and if governments have a higher credit rating than Berkshire Hathaway, it’s not from a gilt-edged reputation but from the knowledge that they can always make repayments by collecting money at the point of a gun — or by printing it.

Something else often missing from government is a principle central to Buffett’s style of doing business: integrity. “In evaluating people [to hire or work with],” Buffett says, “you look for three qualities: integrity, intelligence and energy. And if you don’t have the first, the other two will kill you.”

While Buffett might enjoy playing golf with politicians like Bill Clinton, he’d have to break one of his fundamental principles to ever put one of them on Berkshire’s payroll. Mark Tier

Have a question or a comment?

Well……I never quite bought the howdy doody act, but I respect Mr. Buffett as an investor and human being.  His public proclamations on economics seem Daffy.

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?


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


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?

Readers’ Questions: Buffett Compunding $1 Mil. and Why Should an Investor Learn Austrian Economics

Readers’ Questions

Rather than email a reply, I thought sharing with other readers might be helpful.

A reader writes: Your emphasis on capital compounders raises a question in my mind. WEB (Buffett) famously said that if he was running a million bucks, he could get returns of 50% per year. If you reverse engineer this statement, you have to think he would be investing in the following: small caps, special situations, and catalysts.

I don’t think you can get those kinds of return with capital compounders. Thoughts?

My response: Good point. By the way, any future questions that you have for Warren can be answered here: http://buffettfaq.com/.  An organized web-site of all of Buffett’s articles, writings, and speeches organized by subject, source and date–an excellent resource for Buffaholics.  Buffett said he could compound a small amount of money at 50% as he mentions below:

Interviewer to Buffett: According to a business week report published in 1999, you were quoted as saying “it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Buffett: Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

  • Source: Student Visit 2005
  • URL: http://boards.fool.com/buffettjayhawk-qa-22736469.aspx?sort=whole#22803680
  • Time: May 6, 2005

So the Wizard of Omaha agrees with you that returns are probably to be found in small caps where greater mis-pricing on the downside and upside can occur. The problem you have is paying higher taxes on short-term (less than one year and a day) gains and reinvestment risk.  Once you sell you have to be able to find other attractive opportunities to redeploy capital.  Special situations like liquidations may give you high annualized returns but the positions may only be held for four months until the investment is liquidated.

Investing in a Coca-Cola may give you high risk adjusted returns but not 50% annual returns because of its side and lack of reinvestment opportunities. Unless you find an emerging franchise which is quite difficult, then if you hold Coke for years, you will eventually earn the company’s return on equity.

This writer organizes his investment world into franchises and non-franchises. With non-franchises you are hoping to buy at enough of a discount to asset value and earnings power value to generate attractive returns. A catalyst like a special situation or corporate restructuring may increase the certainty and lessen the time needed to close the gap between price and your estimate of  intrinsic value. Often, with non-franchises you do not have time on your side. You must buy at a huge discount to have a chance at 50% returns.  These opportunities may be limited to micro-caps with large discounts  partially due to illiquidity issues.

By the way, I am a big fan of small cap special situations, and I plan to post my library for readers, but we have to go step-by-step in posting material.

The reasons I want to focus on franchises are the following:

  1. A study of franchises will teach us about investing in growth which is difficult to value.
  2. Studying competitive advantages will hone our skills in business analysis making us better investors.
  3. Knowing that a company is not a franchise is also important, because–then with no competitive advantage–the company must be managed efficiently. We know what to look for in management activity. Diversification would be a warning signal, for example.
  4. Investing in franchises can be quite profitable if bought at the right price. Say 3M (MMM) at $42 back in 2009 was purchased, then you would be receiving today about a 5.5% to 6% dividend with growth in cash flows of 8% to 10% or more, then in a few years you will have a 14% dividend yield leaving out any rise in share price. You compound at a low base while you defer taxes and reinvestment headaches. I think Buffett receives double in dividends each year more than the original purchase price of Washington Post.  MMM_35
  5.  The biggest gap today in industry and company research is the lack of interest or knowledge in analyzing competitive advantage. Rarely do you ever see an analyst focus on barriers to entry in their valuation work. My hat is off to Morningstar, Inc. because their stock research is geared toward franchises. Many managements have no idea what are structural competitive advantages are. Often, they say their company’s competitive advantage stems from “culture.”
  6. Finally, you want to avoid Hell. Hell is paying a premium for growth for a non-franchise company. Look at Salesforce.com (“CRM”) as an example for today. Full disclosure: I have held short positions in CRM.   Thanks again for your question.

Another reader:

First I would like to thank you for the quality work you are doing. I am new to Austrian economics and I would really appreciate if you can walk us on how to get started and how is it different from other Keynesian and mainstream economics. I, also, want to know why Austrian economics would be more valuable to value investors than other schools. I also wonder why we have not been taught about Austrian economics in school and why it’s not taught.

My reply: Oh boy, you are asking for an all-night discussion. I came out of school having studied Keynesian economics (Samuelson’s text-book, http://en.wikipedia.org/wiki/Paul_Samuelson) because that is what American Universities taught back then and still do about economic theory. Imagine studying geography and being told that the world was flat, yet once in the real world ships were circling the globe.  What I experienced in real life (raging inflation with high unemployment in the late 1970s) completely contradicted Keynesian theory.  Also, the conceit of central planning, having the government intervene, made no sense. How could bureaucrats in Washington, DC allocate resources in Alaska better than an entrepreneur, say, in Alaska?  The only economists that predicted the Great Depression and the collapse of the Soviet Union and Eastern Europe BEFORE the events occurred were the Austrians, von Mises and Hayek. So I read, Human Action by von Mises, and became hooked. The world of booms and busts, inflation, deflation and capital formation started to make sense. But I had to UNlearn a lot of nonsense.

See how flawed Keynesian prediction has been vs. American history: http://www.youtube.com/watch?v=6XbG6aIUlog. Bernanke in 2005 discussing housing vs. the Austrian view. http://www.youtube.com/watch?feature=endscreen&NR=1&v=x2qr5cSln3Q. Bernanke’s confident ignorance is terrifying.

As an investor you must understand how man operates in an economy allocating scarce resources to better his condition or lesson his unease. Only Austrians–from what I know–have a coherent theory of the business cycle and the structure of production. But then you may ask, “If Keynesianism is such a repeated failure, then how come it is still prevalent today?” Think of human motivation. If you are a politician, what better cover to weld power than Keynesian theory?   Constant intervention to “help” is your guide.

Successful investors who are considered Austrians because they study/follow the precepts of Austrian Economics): http://www.dailystocks.com/forum/showtopic.php?tid/2623

Noted investors who use Austrian Economics:

George Soros is the legendary investor who started Quantum Fund in the 1960s and is a multi-billionaire as a result of some winning macro trades. Soros’ prescription for healing broken economies cannot be mistaken for Austrian Economics, but Soros’ analysis of markets as expressed in his books seems to borrow a lot of influence from the Austrian Economists.

Jim Rogers is acknowledged as one of the most successful investors of all time. Making an early start when he was in his twenties, he was able to build a huge fortune with an initial investment of just $600 by the time he was 37. A firm believer in Austrian economics, he advocates investing in China, Uruguay and Mongolia.

Marc Faber was born in Switzerland and received his PhD in Economics from the University of Zurich at age 24. He was Managing Director at Drexel Burnham Lambert from 1978-1990, and continues to reside in Hong Kong. He is famed for his insights into the Asian markets, and his timely warning about market crashes earned him the name of Dr.Doom. In 1987 he warned his clients to cash out before Black Monday hit Wall Street. In 1990 he predicted the bursting of the Japanese bubble. In 1993 he anticipated the collapse of U.S. gaming stocks and foretold the Asia Pacific Crisis of 1997-98. A contrarian at heart, his credo has always been: “Follow the course opposite to custom and you will almost always be right.”

James Grant, a newsletter writer who publishes “Grant’s Interest Rate Observer” is also a follower of Austrian Economics. He is a “Graham & Dodder” too. Go to www.grantspub.com

Ron Paul, a Republican Congressman for the Texas State, is also a believer of Austrian Economics.

Interestingly enough, Howard Buffett, the father of Warren Buffett is also an Austrian Economics follower. His son, Warren, however, seems to be more inclined to the Keynesian method of healing broken economies as opposed to the strict and rigid ones espoused by Austrian economists. Warren Buffett did acknowledge in a recent TV interview that one will have a hard time finding a paper based currency that appreciates in value over time. (All fiat currencies have been debased to worthlessness.)

Austrian Economics vs. Keynesianism

What is Austrian Economics http://mises.org/etexts/austrian.asp

http://mises.org/daily/4095   Hayek vs. Keynes Rap video and discussion. http://mises.org/daily/3465    The Austrian Recipe vs. Keynesian Fantasy.

A recent civil debate between an Austrian economist and a New Age Keynesian.  http://board.freedomainradio.com/forums/t/32178.aspx

Free School in Austrian Economics

If you REALLY want to learn Austrian economics, the lessons couldn’t be laid out better for you than here: http://www.tomwoods.com/learn-austrian-economics/.   Start with Economics in One Lesson by Hazlitt.

And if you want to interact with professors you can go to the Mises Academy here: http://academy.mises.org/.   Don’t go by what I say, but by what YOU think after delving into the material. Does it make sense? Forget political labels of Right-wing, Democrat, Liberal, and Conservative; think of how the world works.  I hope that helps partially answer your question.

The same reader asks another question:

I have another question related to Bruce Greenwald book, Competition Demystified. In his book he mentioned that if the company has no competitive advantage then strategy is irrelevant and the course of action should be efficiency. However, following this argument, investors would have avoided many companies during the journey to become industry dominant player.

Correct me if mistaken, but I don’t think you have read the entire book yet. Greenwald will talk about entrant strategies from the point of view of the incumbent (crush an entrant) to an entrant (how to gain a foothold profitably against an incumbent). Greenwald will also talk about cooperation between incumbents.

If you want a more detailed description of emerging franchises–though I suggest you read it after Greenwald’s book–read Hidden Champions of the 21st Century by Hermann Simon.

I can promise you that one of the reasons for Buffett’s success is his amazing understanding of competitive advantages in his investments.  As a business person understanding strategy is critical.

Here is a question.  You own a chain of very profitable movie theaters within a 150 mile radius of a major city. These theatres are spread about 5 to 20 miles from each other and are nicely profitable. You have economies of scale in hiring, securing first-run films, buying condiments, etc.  You awake one morning to find that another large regional theater chain from 800 miles away wants to open a theatre near one of your 29 theatres.  What response might you offer to send a strong message not to enter this market?  A paragraph is enough.

Thanks for your questions, you make me work hard.

Greatest Company Analysis, Studying Franchises and More………….

“The average person can’t really trust anybody. They can’t trust a broker, because the broker is interested in churning commissions. They can’t trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now it’s even worse because even the most sophisticated people have no idea what’s going on.” –Seth Klarman

I’m passionate about wisdom. I’m passionate about accuracy and some kinds of curiosity. Perhaps I have some streak of generosity in my nature and a desire to serve values that transcend my brief life. But maybe I’m just here to show off. Who knows? –Charlie Munger

Best Company Analysis

Several experienced investors (including charlie479) have called the lecture in the link below one of the best company analysis ever done. A Charlie Munger speech about worldly wisdom in solving the problem of building a trillion-dollar business almost from scratch.  http://www.scribd.com/doc/76174254/Munger-s-Analysis-to-Build-a-Trillion-Dollar-Business-From-Scratch

Analysis of a Franchise: Linear Technology

An analysis of Linear Technology’s franchise characteristics: http://www.valueinstitute.org/viewarticle.asp?idIssue=1&idStory=109

Do you agree with the above analysis? The five companies below are considered by some to be franchises. Build a database of franchise companies to eventually purchase at the right price for you. Write down what you think are the sources of competitive advantage. Can you arrive at a ball-park value?  If not now, then set aside for future reference. Note the level of ROIC, operating margins, use of excess capital, growth and investment needed for growth and the history of returns.

Linear:                      LLTC 25 Year    LLTC_VL

Balchem:                  BCPC_35 Year   BCPC_VL

Applied Materials: Charts 35 year AMAT  AMAT_VL

Analog Devices:      ADI_35 Year  ADI_VL

Intel:                         INTC_35 Yr   INTC_VL

Now is the time to dig into the Value Vault and read, Competition Demystified by Bruce Greenwald. A study guide is offered here (Thanks Sid): http://competitiondemystified.com/index.htm

Be the Best

To be the best, you will need to have character, be independent and tough like Joker: http://www.youtube.com/watch?v=gYxEIyNA_mk&feature=related

You will need to develop your skill in understanding and recognizing franchises. Eventually you will show skill like this: http://www.youtube.com/watch?v=HwtMPdMFXQA&feature=related or take it to the hoop like Jordan: http://www.youtube.com/watch?v=U17x7gJ33bY&feature=related

I have never held a ball in my hands, but even I know Jordan is practicing magic not basketball–but, then again, he almost didn’t make his high school team.

 A Good Data Source

Accounting, business studies, and data here: http://mgt.gatech.edu/fac_research/centers_initiatives/finlab/index.html

Freedom vs. Tyranny

A satellite view of tyranny vs. freedom: North vs. South Korea    http://mjperry.blogspot.com/2011/12/legacy-of-n-korean-dictator-kim-jong-il.html

Answer to Economic Question Posed in previous post

The European Central Bank (“ECB”) is offering euro zone banks loans of up to 3 years on Dec. 21 at a rate of 1%. A Wall Street/City of London Whiz can buy Spanish paper at plus 2% on money borrowed from the ECB at 1%. Brilliant! This is going to deluge the Euro zone with money and become extremely bullish for the Euro zone markets and price inflationary.  How else do central bankers know how to deal with a financial crisis. Print.

A viewpoint of America’s involvment in the Euro crisis: http://www.thedailybell.com/3379/Ron-Paul-Beware-the-Coming-Bailouts-of-Europe

Have a good evening.

Current Events Economic Question and More……..

Franchise Studies

There are some readers here who are only interested in the nitty-gritty of individual companies. They study the accounting and the competitive advantages of their companies. That is good. Those readers will become good investors.  Later today, I will post the world’s greatest analysis of a company. And we will begin our study of franchises and competitive advantage.

I think we all need to see the mountain top to know what to strive for. I will put the cart before the house by posting 5 franchise companies with a short description of their alleged competitive advantages.   Within four months we will have about 100 companies in our data base.

We will also begin discussing the case studies in Bruce Greenwald’s excellent book, Demystifying Competition.  Please go to the Value Vault (just email aldridge56@aol.com with VALUE VAULT in the subject line, and I will email you a key–please use the materials for your own use) and read this book a few times, take notes and think about the cases.

Economics Question

Now, there may be other readers who are actually interested in Austrian economics and are also value investors.  For you I pose a question, “Why is it NO SURPRISE to see the markets higher this morning and what is the ECB actually doing?  Answer to be posted this afternoon.

Question from a Reader–The Best Way to Improve Your Skill as An Investor

Question from a reader

There seem to be two courses of action in trying to apply the lessons learned via your website to improve your skill as an investor. The first is to do an in-depth study of a single company, its industry and its competitors. The second option is to read as many 10-Ks as possible and do quick and dirty valuation similar to those found in, say, Greenblatt Class #5.

Which option do you see as more valuable? Am I missing a third way?

Great question and I will elaborate more as this blog develops.

Mario Gabelli advises students to pick one industry and study that thoroughly then after 3 to 4 months move on to another industry. Buffett started by pawing his way through Moody’s manuals and Value-Line to find cheap asset stocks like cigar butts. Munger influenced Buffett with Sees Candy to look at high quality businesses.

After you have read the obligatory required materials like Buffett’s shareholder letters, his Buffett Partnership letters, Margin of Safety, The Intelligent Investor, the Greenblatt books and lecture notes, you need to build from there. My interest and suggestion would be to find 6 to 8 compounding machines which can be bought at a discount.  If you can find a few high return on capital companies that are able to redeploy that capital for several years at high rates, you will have outstanding returns. These companies are rare that is why you must be patient to find them and to hold them.  But you must know what to look for.  You should become an expert in how companies develop and maintain competitive advantages. This will help you in searching for great investments and give you confidence to hold them for a while.

For example, if you understand regional (geographic) economies of scale you could focus on service companies like waste hauling and disposal or rock aggregates or health care providers and notice if they dominate their particular regions. Do you see high returns on capital? Study these companies and wait for them to go on sale.  Rather than wait for blow-ups and disasters to study companies, find the best emerging companies you can find, study them regardless of price then wait for your opportunity.

Take a look at the last case study on charlie479.  He epitomizes what I am talking about.  Read broadly and deeply about businesses—10-Ks but books and autobiographies too.  As you learn more about competitive advantages you will see connections in other businesses. You will see companies losing their advantages but look for companies that are successfully entering against incumbents. Look at niche companies that can dominate smaller markets.   Read, read and read.

Next week I will post the best company analysis in the world done by Charlie Munger.  If you can learn how he views business problems then you will grasp what is most important in business analysis.

You can buy cheap assets in special situations where management restructures the debt or assets and you get a nice bump up in price, then you must redeploy your capital like a merchant into another asset play.   This can be profitable and relatively low risk but the big money is made sitting on fantastic businesses that are compounding at high rates.  I would focus there. Few investors study competitive advantages–I mean become an expert at spotting and understanding great companies.

Fire away with more questions.