Warren Buffett provided one of the most important valuation lessons in his 1991 letter to shareholders, as he described the differences between a regular business and a franchise. He used the analogy to describe what had started to happen to newspapers, magazines and television in terms of profitability. As we know, these businesses had begun to feel the heat of intense competition but more importantly, their economic moat was eroding due to new ways to consume information.
"The fact is that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior. Let's take a quick look at the characteristics separating these two classes of enterprise, keeping in mind, however, that many operations fall in some middle ground and can best be described as weak franchises or strong businesses.
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 mis-management. 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.
Until recently, media properties possessed the three characteristics of a franchise and consequently could both price aggressively and be managed loosely. Now, however, consumers looking for information and entertainment (their primary interest being the latter) enjoy greatly broadened choices as to where to find them. Unfortunately, demand can't expand in response to this new supply: 500 million American eyeballs and a 24-hour day are all
that's available. The result is that competition has intensified, markets have fragmented, and the media industry has lost some - though far from all - of its franchise strength."
These remarks are critical in understanding not only the approach Buffett has when investing, but also how difficult it is to achieve superior long-term investing results. As Charlie Munger (Trades, Portfolio) has said, capitalism enforces competitive destruction, which translates into less enduring competitive moats and lower profitability. As investors, it is our duty to tailor the franchise value and its size, and be aware that it could be exposed to secular changes that we did not think possible due to technology and changes in demand and/or supply.
While this seems hard, and is of course everlasting, it is what makes investing so intellectually challenging and rewarding. We get paid for our thinking (and being right in that thinking), and being right in an environment that changes all the time is hard. However, there are principles and tenets such as the ones Buffett provided that stand the passage of time. If we apply them, we will be able to reduce uncertainty and identify the potential winners with a greater degree of ease.
What do you think?
