Last week, through the master's 1991 letter to shareholders, we threw some light on his concept of 'look-through' earnings and how one should build a long-term portfolio based on it. This week, let us see what further investment insight the master has up his sleeves in the remainder of the letter from the same year.



In the 1991 letter, while discussing his investments in the media sector, the master delivers yet another gem of an advice that can go a long way towards helping conduct a very good qualitative analyses of companies. Based on his enormous experience in analysing companies, the master classifies firms broadly into two main types, a business and a franchise and believes that many operations fall in some middle ground and can best be described as weak franchises or strong businesses. This is what he has to say on the characteristics of each of them:



"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.



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 equity investors can do themselves a world of good by taking the above advice to heart and using them in their analysis. 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 (the master says that a 'franchise' should have a product or a service that is needed or desired with no close substitutes) and high and stable margins, arising from the pricing power that the master mentioned, thus leading to a similar rise in earnings as the topline.



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



Thus, if an investor approaches the analysis of a firm armed with these tools or with the characteristics firmly ingrained into their brains, then we believe he should be able to weed out a lot of bad companies by simply glancing through their financials of the past few years and save considerable time in the process. Further, as the master has said that since a bad management cannot permanently dent the profitability of a franchise, turbulent times in such firms could be used as an opportunity for entering at attractive levels. It should, however, be borne in mind that the master is also of the opinion that most companies lie between the two definitions and hence, one needs to exercise utmost caution before committing a substantial sum towards a so-called 'franchise'.



Article Source : http://www.equitymaster.com