When evaluating a business, it is critical to understand the power of the business' franchise, according to Warren Buffett (Trades, Portfolio). The Oracle of Omaha talked about this in a the spring of 1991 in a series of lectures to students at the University of Notre Dame.
After a long discussion on the process of valuing a business and the importance of cash flows in analysis, the Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) CEO went on to highlight just how critical a business' franchise is to its long-term success.
Assessing the durability of a business
"The durability and strength of a franchise is the most important thing in figuring out whether it's a good business," Buffett said. He went on to explain that outstanding businesses not only have durable franchises, but they are also able to "price advantageously." To put it another way, the companies with the best business models and most loyal customers can continually increase prices at or above the rate of inflation.
Buffett used the highest-priced daily newspaper in the U.S. at the time, the Daily Racing Form, as an example:
"It sells about 150,000 copies a day, and it has for about 50 years, and it's either $2.00 or $2.25 (they keep raising prices), and it's essential. If you're heading to the racetrack and you've got a choice between betting on your wife's birthday, and Joe's Little Green Sheet and the Daily Racing Form, if you're a serious racing handicapper, you want The Form. You can charge $2.00 for The Form, you can charge $1.50, you can charge $2.50 and people are going to buy it. It's like selling needles to addicts, basically. It's an essential business. It will be an essential business five or 10 years from now."
As he went on to explain, investors looking at this business as an investment only really have to answer two questions if they want to try and understand if it will be around for the next 10 or 20 years.
First, potential investors will want to try and understand if horse racing will still be a sport 10 years from now. And second, these investors will have to decide if there's going to be another way people will get their information about the past performance of horses. Neither of these questions is particularly easy to answer, but there are only two of them, which makes the business much easier to understand than so many other companies on the market:
"You have to decide whether horse racing will be around five or 10 years from now, and you have to decide whether there's any way people will get their information about past performances of different horses from different sources. But you've only got about two questions to answer, and if you answer them, you know the business will make a lot of money. The Form has huge profit margins, incidentally. Wider than any other newspaper. They charge what they want to basically. It's an easy to understand business – so easy to understand."
Keep it simple
Something you might have noticed when you read through all of Buffett's advice on how to to find attractive investments is that he is always trying to keep the process as simple as possible.
Buffett does not like to overcomplicate things and will only invest in a business that he truly understands.
The Daily Racing Form is a great example of this mentality in action. There are only two things investors need to understand before they invest in the business. Once you know and understand the durable competitive advantage, it just takes a few minutes to calculate how much the stream of cash flows from the business is worth, and what you should be willing to pay for it.
When these opportunities come along, it pays to act with conviction.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Buffett: Everyone Has Ideas, but the Best Only Act on 1 or 2
- Looking Back at Warren Buffett and American Express in 1962
- How Would Buffett Invest as a Value Investor Today?
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