CHAPTER 5

Franchises—The Archetype of High Quality

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.

—Warren Buffett, Shareholder Letter, 19911

Warren Buffett likes to buy “franchises,” which are businesses earning high returns on capital with a sustainable competitive advantage. Buffett's ability to identify such high-quality businesses at a discount to their intrinsic value has made him one of the wealthiest men in the world. For Buffett, the prototypical franchise is See's Candies, a U.S. West Coast manufacturer and retailer of boxed chocolates. See's results are so good that Buffett credits his acquisition of See's as teaching him about the importance of franchises and marked a significant departure from his previous investment style. It was an acquisition he almost did not make.

Buffett had previously employed his mentor Benjamin Graham's “cigar butt” approach to investing, so-called because “a cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase' will make that puff all profit.” Under the influence of his partner, Charlie Munger, and Phil Fisher's Common Stocks and Uncommon Profits ...

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