I did not exactly see off last year in style, now did I? Some readers questioned the sudden disappearance of Mr.B on the eve of the festive season. Well, a few projects shifted into gear towards the end of 2002 and I did not get around to seeing everyone off. Nevertheless, I trust you had a good Christmas and New Year, and that your 2003 is off to a roaring start.

The best thing about one year ending and a new one starting is that you get to think about things a bit. As a wise man once said, ?Staring into empty space is not wasted time?. I suppose most of you think about the deeper things in life - future plans and so on, but I tend to mostly concern myself with stocks. One point in particular that I was mulling over was the franchise value (or lack of it) of a business. When I invest in a business I buy its future cash flows. My return on investment will be determined by the value of those future cash flows and by the discount I receive when I buy them. I find the calculations easy. However, as I have stressed before, the difficult part is to be rational in your expectations of the value of the future cash flows. Whether a business will impress or disappoint over the next five to ten years will largely be determined by its ability to stand its ground in the relevant industry. Of course, the industry itself must also be able to stay competitive.

In a good company, management will have a good handle on costs and the general efficiency of the company. Therefore, the only other major factor that can give the company an edge will be its pricing power. One must focus on this pricing power because it plays a key role in determining a company?s long-term competitiveness.

What you want is a franchise. A franchise is a business with a product or service that is needed or desired by others and which has no close substitutes. The latter point is extremely important. It is also important that the profits of the business must not be regulated. If you have the only gas station in a small town in the Australian Outback, then you have a franchise. Gas is needed and you are the only one selling it. It also helps that your closest competitor is likely to be 200 miles away. The crux of the matter is that you have enormous pricing power (I presume gas prices are not regulated in Australia) - especially over tourists who wake you at 2am on a Sunday morning needing gas. However, if prices are regulated your pricing power is zero! The above is an example of a strong franchise, but they are few and far between.

At the other end of the scale are the commodity businesses. If you farm maize or mine coal you fall into this category. You have zero pricing power. Your pricing power is determined by the supply of all your neighbours and by general demand. Your control over the price is zilch.

Most business are either weak franchises or strong commodity businesses. Gillette is a weak franchise. Although it is not the only company selling razors, it has by far the largest market share. Due to ongoing advertising and extensive R&D consumers consider its product more desirable, which gives it pricing power. Additionally, in a number of markets it is the only razor available and in those markets it will have a strong franchise. One wants to invest in companies with either strong or weak franchises and in most cases you want to avoid commodity businesses.

I visited a long time mentor of mine a few weeks ago. We were discussing the above point when he asked me why I invested in companies like Geico, Progressive Insurance and Mercury General, which are all commodity businesses. The point to remember is that you get strong and weak commodity businesses. A strong commodity business can be a good investment. The companies mentioned above are all strong commodity businesses. The strongest commodity business in an industry will be the lowest cost producer. When a business has no price leverage it can only increase margin by reducing costs. Scale is usually the best way to reduce unit costs relative to competitors. Mercury is the largest auto insurer in California, where it does in excess of 80% of its business. Progressive and Geico are the fourth and sixth largest auto insurers in the U.S., respectively. Size counts when it comes to commodity businesses.

Most businesses go through a cycle. They start off as strong franchises, progressing to weak franchises. Later, they become strong commodity businesses and, finally, end up as weak commodity businesses. Very few businesses can escape this cycle.

It is worth noting that a weak franchise has a far better chance of surviving inept management than a strong commodity business. I can take this one step further by stating that in 90% of cases it is only the quality of management that determines whether a business ends up being a strong or a weak commodity business. Peter Lewis (Progressive), George Joseph (Mercury) and the Simpson/Nicely duo (Geico) are leading the best management teams in their industries.

I have not always fully appreciated the importance of management in a company. For instance, in 2001 I sold a UK company mainly because I did not rate the management, which had changed while I was invested. With hindsight it appears that this was a mistake. Although the market value has remained more or less the same, the business will most likely do very well over the long term. I must add that I am unsympathetic when it comes to bungling management, especially if they forget that they are running somebody else?s company and not their personal fiefdom. Anyway, the point I am trying to make is that the aforementioned company is a weak (maybe even a strong) franchise with mediocre management. Therefore, it has a good chance of doing very well despite the below average quality of management. However, if the new (weak) management team had inherited a strong commodity business, chances are that they would turn it into a weak commodity business in no time, destroying value in the process.

If you invest in a commodity business, you must be highly critical of management and demand a higher margin of safety than when you invest in a franchise. In the same vein, you can be more tolerant of inept management when the business is a franchise.

So, that is what I have been thinking about since the last time you heard from me. A lot of the mulling over of an investment decision centers on the above.

Whatever you are up to, I hope it is profitable and ethical!

Mr. B

mail_mrb@yahoo.com

Posted: 2003/01/29 13:27 View Archive