Warren Buffett loves to invest in "franchises." He buys shares in a business, not just pieces of paper called "stock."
The term "franchise" has different meanings for different people. Most investors think of franchises as giant retail operations with brand names we all recognize: Coca-Cola (NYSE:KO), Wal-Mart (NYSE:WMT), General Motors (NYSE:GM), etc. A franchised business can also work like McDonald's (NYSE:MCD), where most restaurants are owned by independent operators who serve you a menu determined by the national company, complete with the national corporate logo.
Investing in franchises
For investing purposes, a "franchise" is a strong corporate identity backed by long-term proven management, products, and markets. It can be a retailer, an airline, a cell phone provider, or a less well-known company in oil service or industrial equipment. You are looking for consistent quality and performance from your franchise, not cyclical results or big ups and downs with each new product it introduces.
Investing in franchises isn't as simple as going to your neighborhood mall, finding the brightest neon signs, and buying stock in the company names you see on them. Sometimes a big national retail franchise is a great investment, if it's growing, making money, and the share price isn't too expensive yet. Other times it's a total washout.
McDonald's was a good buy when its stock dipped into the teens on fears that its future growth was uncertain. I didn't buy then because I shared those fears. Management fixed the problems and restored investor confidence. The stock price shot up.
But Wal-Mart stock has gone nowhere since 2000, along with Coke, and General Motors is a shaky national franchise. Coke and Wal-Mart both sported price-to-earnings ratios higher than 50 in the 2000 stock market bubble, a ridiculous level for megacap stocks. They spent the last seven years just matching their P/Es to their long-term growth rates. GM undermined its franchise by drowning in labor and health-care costs, and falling behind international competitors like Toyota.
Management, products, and markets
If a company is run by managers who can't produce consistent results, investing in it is a waste of time. If its products or services don't sell -- or they succeed for a while, then fall victim to obsolescence -- company profits will stagnate. And a successful long-term franchise needs a reliable market for what's being sold.
I am not saying you should restrict your portfolio only to companies that excel on all three fronts. You will rarely find such perfect stocks at a good price, and you would miss out on up-and-coming companies that haven't proven themselves yet. But you have to stick to your strategy: Look for consistent management and performance in young, growing companies with products that hold up in good markets and bad. They are the solid franchises of tomorrow.
The top holdings in your portfolio should be proven franchise stars, or up-and-comers well on their way to proven franchise status. One example of the latter is MTN (OTCBB: MTNOY.PK). As the second-largest cell phone operator in Africa, MTN has a product in strong demand (since most fixed-line phone service in Africa is terrible), an eager market ready to spend its limited disposable income on cell phones, and management that grew the company from nothing to a major player.
I never worry that I will wake up to a headline saying MTN didn't meet its growth targets, or costs were out of control, or an acquisition went sour. MTN management has proven what they can do. And the company still has fantastic growth prospects, if a bigger fish doesn't buy it out first.
A big franchise move I missed in the U.S. was the rise of E*Trade (NASDAQ:ETFC) and Ameritrade. I owned both stocks in the low teens for three reasons: Management executed well; demand for online trading and financial services settled down to reasonable growth after the 2000 stock market crash; and both companies had proven management.
In franchise terms, both online brokers were on their way to proven franchise status when I sold too soon. Building a proven franchise doesn't happen overnight; some of the greatest rewards in franchise investing can come when the contenders are just reaching a plateau of success. Stick to your guns if management is executing well every quarter.
Sometimes I do buy stocks based on products or services I have used and liked. Easyjet is one of the top two discount airlines in Europe. I flew them often from Amsterdam to various destinations. When I heard the stock was cheap based on doubts about future growth, I was happy to buy some at $3.65. The growth doubts faded, and the stock has almost quadrupled since then. Management is executing and building a great franchise.
State-owned companies can also be great franchise investments, if the government that controls them lets them function as profitable companies. Keppel (OTCBB: KPELY.PK) is one of the world's top manufacturers of offshore drilling rigs. I knew the product was in high demand; I also knew that the Singaporean government is a conservative, pro-business majority owner. That's the kind of stock you can buy and hold for years if demand holds up.
Always remember the key factors -- management, products, and markets -- and stick with the companies that execute well, quarter after quarter. In the long run, you will find your portfolio full of quality franchises that build your wealth while you sit back and enjoy the ride.
For more on some of the great franchises mentioned above, check out:
Coca-Cola and Wal-Mart are two great franchises. It should be no surprise they are both Inside Value recommendations as well. To see what other great franchises lead analyst Philip Durell recommends, click here for your free 30-day trial to the newsletter.
Fool contributor Dale Baker, a private client portfolio manager and former U.S. diplomat with extensive experience in Europe and Africa, owns shares in MTN, Easyjet, E*Trade, and Keppel for himself and his clients. He welcomes your questions or comments. The Fool's disclosure policy is a global citizen.
