1991
Click here to read the letter.🧠 Key Takeaways
An economic franchise is what you should be looking for. This type of business has special qualities that give it an edge over regular businesses.
For a regular business to perform well over time, it usually has to do one of two things: it either has to be a lowest-cost provider, or it might also see exceptional profits during times of high demand and limited supply.
The criteria for investing in private businesses shouldn’t be any different from investing in publicly traded companies. Whether you’re looking at a tiki bar in Las Vegas or a publicly traded Fortune 500 company, the fundamentals of good investing don’t change.
You should strive to only invest in the very best, and not every business will live up to that standard. In fact, few do—and the more experienced you become as an investor, the more selective you’ll be.
✍️ Memorable Quotes
“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 mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage. 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.”
Here, Warren makes an important distinction between two types of businesses: the first, which he calls an “economic franchise,” and the second, which is just a regular business.
According to Buffett, an economic franchise is what you should be looking for. This type of business has special qualities that give it an edge, and to qualify as an economic franchise, it has to meet three criteria:
First, people have to want—or better yet, need—its products. This is true for any successful business, but with an economic franchise, demand has to be steady and long-lasting.
I think Procter & Gamble (PG) exemplifies this pretty well. People will always need essentials like toothpaste, diapers, and toilet paper, and it’s nearly impossible to imagine a world where they don’t. This kind of consistent demand makes Proctor & Gamble hard to replace and, at least in my opinion, ensures it will stay relevant well into the future.
The second thing that defines an economic franchise is that customers don’t see other companies’ products as a good substitute. In the mind of the customer, there is no replacement.
Although some will definitely disagree, I think Starbucks (SBUX) checks this box. Even though there are countless other places to get your morning cup of joe (and get it cheaper), many people still choose to make Starbucks a part of their daily routine.
They could go to Dutch Bros. (BROS) or some other purveyor, but they don’t, because only Starbucks can deliver the experience they want. Plus, it’s habitual—and habits are hard to break.
To be fair, the reverse can be true as well. Some people prefer Dutch Bros. over Starbucks for similar reasons. Either way, the point is that customers consider these experiences to be irreplaceable in their routines.
With that, the third and final ingredient for an economic franchise is that the business needs the freedom to adjust its prices without being hindered by regulation. Having this freedom allows the company to raise prices and grow profits, hopefully without losing customers in the process.
Intuit (INTU) is a great example of a company that can pull this off. People rely on Intuit’s software for essential tasks like bookkeeping and filing taxes, and switching to another platform would be a hassle. As a result, if Intuit raises its prices, the great majority of its customers are likely to stick around.
According to Buffett, when a company has all of these qualities, it’s more than just a regular business. There’s something special about it that investors would be wise to investigate.
On the other hand, regular businesses don’t have these advantages. For a regular business to perform well over time, it usually has to do one of two things.
One option is to be the lowest-cost operator. This means being more efficient than competitors so it can charge lower prices and still make a profit.
I think Walmart (WMT) is a shining example of this. It competes by offering the lowest prices possible, which it achieves by keeping its costs low and operating at razor-thin margins.
While that certainly stands to benefit customers, the downside for lowest-cost operators like Walmart is that customer loyalty only goes as far as the low prices. If competitors could get in there and outprice Walmart, many customers would follow.
Alternatively, a regular business might also see exceptional profits during times of high demand and limited supply. This happens quite often with oil and gas companies.
Oil prices can skyrocket when demand is high, but supply is limited. This is when companies like ExxonMobil (XOM) or Chevron (CVX) can see a major boost in profits. But these high-demand periods are typically only temporary, as supply eventually catches up, bringing prices and profits back down to earth.
Overall, it’s clear to see why Buffett would prefer to invest in an economic franchise over a regular business. With their unique strengths and competitive advantages, franchises tend to make more stable, profitable, and resilient investments over a long period of time. Plus, who wants to be regular, anyway?
“If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? (I was tempted to say ‘the real thing.’) Our motto is: ‘If at first you do succeed, quit trying.’”
I think this quote from Warren covers a lot of ground and packs in a ton of great insight for us to learn from.
First, Warren is making a key point: the criteria for investing in private businesses shouldn’t be any different from investing in publicly traded companies. Whether you’re looking at a tiki bar in Las Vegas or a publicly traded Fortune 500 company, the fundamentals of good investing don’t change.
Second, Warren is laying out a roadmap for us on how to evaluate potential investments. He says to start by assessing the long-term qualitative and financial characteristics of the business. Basically, is this a company that can withstand the test of time?
Then, consider the quality of the people running it. Are they capable, honest, and aligned with shareholders?
Finally, if the business checks those boxes, only invest in it if you can do so at a price that makes sense.
This brings us to the deeper lesson here: you don’t have to own every business, even if it’s solid.
You should strive to only invest in the very best, and not every business will live up to that standard. In fact, few do—and the more experienced you become as an investor, the more selective you’ll be.
Over time, your “investable universe” will naturally shrink. At least, this has been my experience so far.
You get better at quickly identifying the businesses worth your attention and filtering out the rest. It’s like you develop a spidey sense that tingles when you find those rare companies with a lot of potential, and that ability to focus on the best is a superpower in investing.
Basically, it keeps you from wasting time on average businesses. There’s nothing wrong with those companies—they might be decent—but there’s also nothing special about them.
You only want to spend time on the special ones, and the longer you invest, the more you’ll develop a sense of what those are.
Memorable quotes and key takeaways from the 2001 Berkshire Hathaway shareholder letter.