What do Value Investors, like Buffett, mean by “Good” Businesses or “Franchises”?
The successful companies in which Warren Buffett and many other investors have invested have various characteristics that make them attractive over time. What are these features? What attracts the attention of investors?
Almost everyone agrees that good companies are companies that enjoy a viable competitive advantage over their competitors. And while there is unanimity that having a competitive advantage is the key to making a profit, it is not clear what everyone understands by what a competitive advantage is.
The relationship between competitive advantage and prestige brands
Many investors believe that a good business is synonymous with prestige and high-end brands. The table below shows this is not always the case.
As the above table indicates, a strong or even “glamorous” brand is certainly an important asset, but that does not automatically mean that it creates a competitive advantage. Let’s not forget that even the most powerful brands need daily “maintenance” which is usually expensive.
The relationship between competitive advantage and industry leaders
Other investors identify the competitive advantage with the first movers (pioneers). The table below shows that said first movers very rarely prevail in the long run. Indeed, many of the “pioneers” have gone bankrupt.
Πίνακας Πρωτοπόρων και Ανταγωνιστικών επιχειρήσεων.
As it turns out, it is not proven that the pioneers were better companies in creating a competitive advantage.
What is a Competitive Advantage?
The discussion began with Michael Porter3 in 1979 and was finally clarified by Greenwald and Kahn in the book Business Strategy- Competition Demystified4 in 2005. The term competitive advantage was paired with the term Barriers to Entry, which is widely used by investors (Warren Buffett, Mario Gabelli, etc).
Admittedly, a competitive advantage is the ability of a company to do particular things that its competitors cannot do that are translated into extraordinary profits beyond the minimum. The minimum is what companies earn when operating in a highly competitive environment (level playing field) with many competitors.
It is also the company’s ability to block the entry of new competitors into its “fields” (Barriers to Entry). Metaphorically it is the moat around the aristocrats’ towers in the middle Ages, which prevented entrance.
There are many examples of companies that enjoy a competitive advantage and interestingly not all of them are big corporations (Google, Facebook, Coca-Cola, etc.). There are small companies that operate smoothly in their own limited market, which have very significant returns on the capital they employ (over 20%). The market is limited, or if you prefer focused, either geographically or product wise.
Ultimately, if there is consensus on what creates a competitive advantage, it is the points mentioned below or even better a combination of them:
- Ownership of hard to copy technical know-how, or ownership of government contracts
- Existence of a “captive” clientele
- Economies of scale
- Combination of all the above
We will come back to the above in more detail and analysis in another article.
Where would you rank your company? Do you have a competitive advantage over your competitors?
We await your answers, questions or comments you may have in our inbox.
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1,2 Greenwald B.C, Kahn J., Bellissimo E., Cooper M.A., Santos T., (2021), Value Investing- From Graham to Buffett and Beyond, (2nd Edition), Wiley, p.163, p.165
3 Porter M (1998), On Competition, (1st Edition), Harvard Business School Press
4 Greenwald B., Kahn J., (2005), Competition Demystified- A Radically Simplified Approach to Business Strategy, (1st Edition), Portfolio