Identifying a Franchise

Someone asked:

“How do you define a growth company? What would you look at that tells you it’s a growth franchise?”

As usual, a great starting place for answering this comes straight from the Bruce Greenwald playbook. He’s not perfect but does offer some recipes for cracking nuts such as these that are invaluable when you have no idea yourself where to start. Let me see if I can do his spiel from memory and tell me if I miss anything.

First, we should define “franchise”. It’s just another word for a company with a durable competitive advantage. A company that has such a thing can charge much more for its products and services (competitive advantage) than it costs to produce them, and can do it for many, many years (durable). Thus if you find one, and don’t pay too much for it, you can basically lock it in your vault and watch it metastasize in value as year after year competitors try, and fail, to bridge its moat.

I think where Bruce usually starts is by saying that franchises have two symptoms that help to identify them: consistently high returns on capital and stable share. Sometimes, like quickly in an interview, that’s all he says. Elsewhere he takes the time to unpack.

Symptom #1: Consistently High Returns on Capital
I don’t think this needs explanation, though it’s technically more correct to say that the company earns returns on its capital that are much greater than its cost of capital, and has a history of doing so through thick and thin. ROC > COC is the only way that growth adds any economic value.

Symptom #2: Stable Share
Here he’s referring to stable (or growing) market share of the company’s industry. If it’s an industry where there’s a big reshuffling of who’s in and who’s out every few years, it’s not an industry that lends itself to anyone having a durable competitive advantage. But if there are just a few players, and the company you’re examining has had roughly 30% of the market for the last several years, that would be “stable share”.

Greenwald then advises to never, never, never think you’ve found a franchise just by finding a company with the two symptoms. Many companies that are not franchises will have a few consecutive years where they hit the curve right and earn high ROC despite not having a durable moat. Thus Bruce will implore you to do the extra work of making sure you can put your finger on what the moat is before paying up for growth, or risk breaking his heart.

Now the go-to methodology in academic circles of examining a firm’s competitive advantages is Porter’s Five Forces. Greenwald loves to butcher sacred cows and will tell you here that the problem with the five forces are that there are four too many. The only thing that ultimately matters is barrier to entry. And don’t waste his time with “first mover” straw men or “strong brand” malarkey. Can you put your finger on something that makes competition near impossible for competitors? Even if they have deep pockets?

There are only a handful of competitive advantages that Greenwald considers real and sustainable barriers to entry: a supply advantage, a demand advantage, or economies of scale.

Competitive Advantage #1: Supply
A supply advantage means the firm can produce something others cannot, and/or at a cost that others cannot. Probably the most common example would be a patent, but you want to also keep your mind open to special cases where companies have some privileged access to an input to their product or service.

Competitive Advantage #2: Demand
This is not a strong brand (!) but customer captivity through habit, switching costs, or search costs. Do people just prefer this company’s product, even if it’s not the cheapest? Or, is it painful to switch once you’re using this company’s product? Greenwald might mention that in some cases with the habit competitive advantage, you can see that it exists but not necessarily know why. When you go out to eat Chinese food, you may very well order a Chinese beer you’ve never heard of also. But you’re never going to order a Great Wall cola.

Competitive Advantage #3: Economies of Scale
Probably every business has some economies of scale as they spread fixed costs out over more units, but here you’re looking for a particular style. Is the industry one where a small player can establish a beach head with 1% of the market share, and survive on that while it grows and makes plans for the next battle? Or is it an industry where any new player would bleed red ink profusely while trying to become viable? That’s the situation you’re looking for.

And in summary, I think Bruce says the holy grail is customer captivity plus economies of scale.

If I may add my 2 cents here, I’d just say that I don’t think all customer captivity is created equal. I believe it’s far more desirable for customers to be willingly captive instead of begrudgingly so. Far better for them to have no incentive to switch, than just no easy way (at the moment).

OK, that’s what I remember. What’d I miss?

2 thoughts on “Identifying a Franchise”

  1. Thanks for the great post. I’ve really enjoyed your analysis of Greenwald’s method. Keep up the great work!

    In addition to the above qualitative criteria, do you think we can also think about it quantitatively? I’ve thought about looking at a company’s historic growth rate and sustainable growth as a proxy. I see many cases where ROIC is higher than cost of capital, there is an identifiable moat, but the growth rate indicates it’s not growing much. They just drive me nuts! How would u categorize these companies? Thanks a lot!

  2. hi herms,

    what i personally like quantitively is a high return on retained earnings (RORE). there are a couple ways you can go about this. one is to add up all EPS’s for the last, say, 5 yrs and subtract all dividends. the result is EPS retained. now divide the difference between EPS now vs. what it was 5 yrs ago by the EPS retained. that is RORE. the extrapolated future growth would be the RORE times the % of EPS it usually retains.

    that is a shortcut but can get you into trouble. for example, the company may be taking on debt and/or spending down their cash and that won’t show up in RORE. you also have to figure out whether or not to use GAAP or adjusted earnings.

    greenwald has a more complete solution and it goes like this.

    (1) add up all the net income they said they made for a long period (e.g. 5 or 10 yrs)
    (2) subtract all they spent on dividends and buybacks
    (3) the remainder is what they said they made but didn’t give to you
    (4) now subtract the increase in net cash (cash minus all debt)
    (5) you now have what they said they made, didn’t give you, and was spent somewhere or somehow since it’s not in the bank
    (6) look at the change in sales over that time period. did they get a good return on that “investment”?

    the interesting thing with the greenwald approach is that he uses line items that are hard to fake or manipulate, at least if the auditor is doing their job. sales, he claims, can be manipulated in the short term but you can’t create big sales growth over a long period purely by playing games with accounts receivable, etc. cash in the bank is a simple phone call from the auditor to check the balance. if they’re lying on the net income or just using what they earn poorly, or borrowing heavily (big decrease in net cash), the result will be the same – a lot of real or apparent money coming into the company that somehow disappears and doesn’t move the needle much on sales growth.

    i still think the qualitative is very important here. you want to do the above steps partly to get your mathematical answer but partly just to see the big picture on what’s happening to the cash flows of the company. you want to see what story it tells and, very importantly, ask yourself if it’s sustainable. you might see good #’s for VRX for example if you did this (i haven’t), but you’d still have to ask yourself how much longer the acquisitions through new debt could last.

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