How Buffett separates the good from the great

They say there's more than one way to skin a cat, and the investing legend Warren Buffett would likely agree. For decades, Buffett produced one market-beating performance after another at Berkshire Hathaway (Ticker: BRK-A ) ( BRK-B ) , but he took a variety of paths to get where he is today. At times, he relied on the virtuous economic characteristics of what he calls a "wonderful" business; in other instances, however, it was his operating managers alone who were responsible for Berkshire's profits.

The year 1990 was a prime example of the latter scenario. In Buffett's letter to shareholders, he commended Berkshire's astute managers who delivered impressive results in spite of otherwise challenging industry economics:

[O]ur return was not earned from industries, such as cigarettes or network television stations, possessing spectacular economics for all participating in them. Instead it came from a group of businesses operating in such prosaic fields as furniture retailing, candy, vacuum cleaners, and even steel warehousing. The explanation is clear: Our extraordinary returns flow from outstanding operating managers, not fortuitous industry economics.

For investors, incidentally, there's more than one way to unpack this particular Buffett quote. A knee-jerk reaction would be to snatch up shares of tobacco and TV conglomerates like Altria (NYSE: MO ) or Disney (NYSE: DIS ) , but that would probably just make you 25 years late to the party (timing is critical).

On second thought, you might dig deeper into Buffett's thoughts on identifying great managers. That would probably be a more fruitful activity, but it would nonetheless miss the core of this concept.

What Buffett meant to convey was an idea that had only recently crystallized in his mind: To evaluate a company, one of the most critical skills for an investor to master is the ability to differentiate between a "franchise" and a mere "business." In his eyes, the former is virtually "bulletproof," whereas the latter is considered simply "ordinary." This particular train of thought led to some of his greatest investments over time, including those in the standout franchises of Coca-Cola (NYSE: KO ) and Gillette.

But what exactly separates a bulletproof franchise from an ordinary business? In Berkshire's 1991 letter to shareholders, Buffett describes the three characteristics of a franchises that make them so durable:

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,

(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 short, a franchise sells a product or service that is highly differentiated. A prime example of a franchise would be a company like Coca-Cola, which generates 18% profit margins on sales of well-branded flavored water. Coke has created a product that appeals to consumers' taste buds and carries emotional appeal; it's nearly the opposite of what we might call a "commodity."

A Coke bottle tower at Turner Field in Atlanta. Source: Coca-Cola.

A commodity business, on the flipside, engages in the sale of generic products, ranging from raw materials like steel or lumber to retail goods like many groceries. In those respective industries, customers do not perceive the products as particularly unique, and therefore managers can only differentiate on price. Often, it becomes a race to rock-bottom prices in an extremely competitive environment. The result is less-than-fortuitous industry economics for everyone, managers and investors included.

As a result, a lowly commodity business faces persistent and severe headwinds. In this realm, think of grocers with razor thin margins like Safeway (NYSE: SWY ) or Kroger (NYSE: KR ) . As Buffett points out, businesses like these can ultimately prosper, but it requires an exceedingly smart and agile management team:

[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.

What Buffett realized over the years is that an appropriate symbol for a franchise is a castle, and its lucrative economic traits are the moat that protects the castle. In some cases, that moat provides such a formidable buffer that franchises can prosper in spite of poor decisions by the defenders of the castle, e.g. the management team. Companies with wide moats, however, are rare, as are those with no moat whatsoever. At the end of the day, most companies fall along a continuum with a true franchise on one end of the spectrum and a pure commodity business on the other.

For individual investors, this continuum is a tool developed by Buffett that can be applied to any business to better understand its economics. The determination will not always be cut and dry, but it can provide valuable context. In 1990, for instance, Berkshire's great managers overshadowed the great franchises, a feat the Oracle of Omaha was eager to point out to shareholders.

Buffett's lesson shows that buying stock in a company resembles buying a horse in an attempt to win the Triple Crown. In either case, an owner can employ one of two basic strategies: Identify the best all-around thoroughbred (a franchise) and ride it to victory; or, find an average horse (a business) and hire the best trainer and jockey in the industry.

In the first scenario, as Buffett has said about businesses, you only have to be smart once, when selecting the absolute best horse for the race. In the second scenario, however, you and your team have to be smart forever.

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