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Can a Phase One Stock Make It to the Benchmark Index? A True Story... - Views on News from Equitymaster
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  • Mar 1, 2017 - Can a Phase One Stock Make It to the Benchmark Index? A True Story...

Can a Phase One Stock Make It to the Benchmark Index? A True Story...
Mar 1, 2017

Dear reader,

At Phase One Alert, we always emphasise an important point. The fate of the stocks we recommend is largely in the hands of the company's founders.

Thus, learning what it takes for the founder of a phase one company to succeed is crucial and this interests me a lot.

Which brings me to something I'm excited to share with you today.

Let me begin with a question...

Have you seen the movie, The Founder?

If not, I urge you to do so. It tells the true story of Ray Kroc and the McDonald's brand he created.

For all long-term investors thinking seriously about putting their money in phase one stocks, this is a movie they shouldn't miss. I can honestly say it improved my ability to understand small businesses.

McDonald's is part of the Dow Jones Index. Hollywood has done a big favour for phase one investors. And I am excited to share with you some real-life wisdom from a legend of American business.

So here we go. Lessons for phase one investors from Ray Kroc and The Founder.

  1. Phase One Founders Should Never Be Satisfied
  2. In 1954, Ray Kroc is a salesman. He is good at his work. He perseveres in the face of countless rejections. He makes enough money to lead a comfortable but simple life with his wife.

    But he isn't satisfied. He wants more from his life. Much more.

    He discovers a small drive-in restaurant called McDonald's. It's run by two brothers, Richard and Maurice McDonald. The restaurant is doing great business, with its fast service and high-quality food.

    His desire for more in life drives him to convince the brothers to franchise their restaurant - despite the fact they'd already tried to and failed.

    This time around, Kroc takes the lead in their franchising effort.

  3. Phase One Founders Focus on Quality
  4. Ray Kroc discovers that the brothers have put their heart and soul into the first McDonald's restaurant.

    The place is spotless. It's designed for an extreme level of efficiency. Every burger served is just like the last one. The food is served in clean, disposable packaging.

    The employees are highly motivated. They put the super-efficient design of the restaurant to good use. Service is lightning fast.

    This was also the reason the brothers' franchise effort failed the first time. The franchisors were rich people interested only in a steady income from the franchise. They were not interested in maintaining high quality standards.

  5. Phase One Founders Innovate in the Face of Adversity
  6. Ray Kroc soon faces the same problem as the brothers. His rich friends become franchisors. They are not interested in running the restaurant. He quickly realises that quality standards are dismal. But he can't fire them.

    So what does he do?

    He starts franchising to middle class investors.

    These folks put their life savings into the McDonald's franchise. They work hard and are very hands-on. They readily follow the high quality standards. The new franchises prove successful.

  7. Phase One Founders Focus on Aggressive Growth Once They Have a Winning Formula
  8. Ray Kroc expands the business rapidly across the country. He has a successful formula for the business. He identifies hard-working, family-oriented, conservative, middle-class people who have saved a decent amount of money.

    He hand-holds them through the process of setting up the restaurant. Then, he mostly stays out of their way.

  9. But Aggressive Growth Funded with Debt is Dangerous
  10. Ray Kroc uses debt to fund the expansion. Unfortunately, as per the contract he signed with the brothers, his share of the profits is too small to cover his costs. He starts borrowing to cover his expenses. This soon leads to a debt-trap.

    The brothers refuse to increase his share of the profits.

    The banks refuse to renegotiate his loans.

    The business is in crisis.

  11. Some Luck is Necessary
  12. Fortunately for Ray Kroc, a consultant at the bank, Harry Sonneborn agrees to help him. He soon discovers the company's core problem. What follows is history.

  13. Phase One Founders Must Understand Their Business Inside Out
  14. Sonneborn tells Kroc the business of McDonald's is not burgers but real estate.

    In other words, the land on which the franchises are build, should belong to the owner of the franchise and not the franchisors.

    This would kill two birds with one stone. It would provide him a steady revenue stream (i.e. rents) and would help him break free from the control of the brothers.

  15. Phase One Founders Must Sometimes Make Unpleasant Decisions
  16. Ray Kroc incorporates a new company, Franchise Realty Corporation. He starts attracting investors to the new 'real estate company'.

    It works. The brothers realise they can't stop him legally.

    With fresh funds from new investors, the company takes off like a rocket. The steady rents get him out of his debt trap.

    He renames the company, The McDonald's Corporation. Ray Kroc is now calling all the shots. The brothers are side-lined. They eventually agree to sell their stake to him. He pays them US$ 2.7 million.

  17. Despite Running a Small Company, Phase One Founders Understand the Power of Brands
  18. Towards the end of the movie, one of the brothers asks Kroc why he put in so much effort to take over the business. He could have just stolen their idea instead.

    Kroc explains to him that the value of McDonald's is not the high-quality food or the super-efficient system they had created.

    Rather it was their name, 'McDonalds'.

    People believed it to be a symbol of the American way of life. As his name, 'Kroc', did not appeal to anyone; he could not have stolen their idea.

    This is McDonalds' moat.

    It's not the quality of the burgers or the speed of the service that keeps people (even today) coming back again and again. Every time we bite into a McDonald's burger, we get a taste of America.

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