Lessons from Warren Buffett - XIX - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Lessons from Warren Buffett - XIX

Nov 22, 2007

Last week, through the master's 1991 letter to shareholders, we threw some light on his concept of 'look-through' earnings and how one should build a long-term portfolio based on it. This week, let us see what further investment insight the master has up his sleeves in the remainder of the letter from the same year. In the 1991 letter, while discussing his investments in the media sector, the master delivers yet another gem of an advice that can go a long way towards helping conduct a very good qualitative analyses of companies. Based on his enormous experience in analysing companies, Warren Buffett classifies firms broadly into two main types, a business and a franchise and believes that many operations fall in some middle ground and can best be described as weak franchises or strong businesses. This is what he has to say on the characteristics of each of them:

"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, and (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.

FREE REPLAY: Discover What Richa Revealed in Her Smallcaps Summit

In contrast, "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."

We believe equity investors can do themselves a world of good by taking the above advice to heart and using them in their analysis. If one were to visualise the financials of a company possessing characteristics of a 'franchise', the company that emerges is the one with a consistent long-term growth in revenues (the master says that a 'franchise' should have a product or a service that is needed or desired with no close substitutes) and high and stable margins, arising from the pricing power that the master mentioned, thus leading to a similar rise in earnings as the topline.

On the other hand, a 'business' would be an operation with erratic growth in earnings owing to frequent demand-supply imbalances or a company with a continuous decline after a period of strong growth owing to the competition playing catching up.

Thus, if an investor approaches the analysis of a firm armed with these tools or with the characteristics firmly ingrained into their brains, then we believe he should be able to weed out a lot of bad companies by simply glancing through their financials of the past few years and save considerable time in the process. Further, as the master has said that since a bad management cannot permanently dent the profitability of a franchise, turbulent times in such firms could be used as an opportunity for entering at attractive levels. It should, however, be borne in mind that the master is also of the opinion that most companies lie between the two definitions and hence, one needs to exercise utmost caution before committing a substantial sum towards a so-called 'franchise'.

Lessons from Warren Buffett Series - Previous article | Next article | All Articles
Try the Warren Buffett Quiz

Equitymaster requests your view! Post a comment on "Lessons from Warren Buffett - XIX". Click here!

  

More Views on News

6 Popular Stocks that Turned into Penny Stocks (Views On News)

Nov 27, 2021

A look at popular stocks that crashed big time and never recovered, i.e. which went from 'Multibaggers to Multibeggers'.

ONGC to NMDC: Here are 5 Stocks Value Investors Should Closely Track (Views On News)

Nov 26, 2021

Before investing in value stocks, research the company and gain insight into why the market is discounting it.

Infosys vs TCS: Which is Better? (Views On News)

Nov 26, 2021

In the post pandemic era, the top two IT companies in India are fighting to capture the growing demand for IT.

Is this India's 'Reliance Power' Moment? Here's How to Prepare for it (Profit Hunter)

Dec 1, 2021

Investors forget that market cycles are inevitable and there's no such thing as a free lunch.

Dollar Index (DXY) Headed to 100 (Fast Profits Daily)

Nov 30, 2021

This is why I think the dollar is about to get stronger.

More Views on News

Most Popular

Infosys vs TCS: Which is Better? (Views On News)

Nov 26, 2021

In the post pandemic era, the top two IT companies in India are fighting to capture the growing demand for IT.

This Multibagger Stock Zooms 20% After Dolly Khanna Buys Stake (Views On News)

Nov 24, 2021

Shares of this edible oil company zoomed over 50% in three days after ace investor bought around 1% stake.

6 Popular Stocks that Turned into Penny Stocks (Views On News)

Nov 27, 2021

A look at popular stocks that crashed big time and never recovered, i.e. which went from 'Multibaggers to Multibeggers'.

How to Find Your Next 10-Bagger in this Market (Profit Hunter)

Nov 19, 2021

The #1 make or break factor in your portfolio you shouldn't ignore.

MobiKwik IPO Opens for Subscription Soon. Key Things to Know Before Subscribing. (Views On News)

Nov 20, 2021

The Rs 19 bn issue is set to hit the market soon.

More

Become A Smarter Investor
In Just 5 Minutes

Multibagger Stock Guide 2022
Get our special report Multibagger Stocks Guide (2022 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Dec 1, 2021 10:59 AM

MARKET STATS