the nature of a franchise
The process of entry and the ability of entrants to compete on equal terms with the established firms are critical. If new comers can develop and distribute new products on an equal footing with incumbents (e.g. equal ability to differentiate), then all products effectively are commodities.
Company is usually regarded as high value company or company with strong franchise if, compared to other companies, its both actual and potential earnings are above the average in the industry for a sustained period. (Note: Brand has value actually, but if brand value = brand build cost then brand will not be the source of value in the company)
The nature of a franchise or value is only created when the incumbent has abilities that new entrants cannot match. It comes from competitive advantage (CA) and revenue advantage (RA).
CA can be created by the government when it grants a license to one or several firms to engage in some kind of business, leaving everyone else excluded. For example, cable franchises, Broadcast TV stations, Telephone, electric utilities. Other CA can come from basic profit equation of any business:
Revenue - Costs = Profits, so CA =
- Cost advantage: Production techniques or products that the entrants can not match
- Patents, whether on the products themselves or on the process of producing them can create one kind of cost based CA
- Know-how (downward sloping learning curve)
- Access to cheap resources such as Labor and capital, but this type of CA is hard to find because most resources are mobile and plentifully available on a global basis. Entrants and incumbents can use the same time and efforts to obtain those resources.
- Unionized Labor -> high resources costs
- New comer, they can usually enjoy the benefits from the advancement of technology. But, this is no good to everyone, because technology is constantly advancing. So another round of new comers will enjoy the same type of CA too.
And RA usually means Customer demand, easier access to customers, habit (e.g. coca-cola case) and high cost of searching for an alternative (e.g. residential insurance market, Microsoft and IBM ,etc)
Some argue that Economies of Scale (EOS) is one type of CA. But, greenward et al. has another understanding:
If the scale of operations among all the company is the same, the EOS will be eliminated. It must be combined with customer demand advantages because cost structure advantages are very short-lived. Competition is the rule, not the exception. The conjunction of EOS and demand preferences can provide an important degree of franchise longevity, even in the face of changing technology as it allows the company to be able to spend resources on advertising and marketing. It charges less than its smaller competitors and still remains profitable. But, please don't "size" with CA based on EOS. EOS CAs arise only when a firm enjoys a disproportionate share of the relevant MKT. Relevant here means that the market that determines the level of fixed spending. For retailers like Wal-Mart or any of its competitors, distribution systems and ad programme costs are fixed by geographic region.
In the world where MKT prices already exceed asset values, and the margin of safety by that measure is negative, a contemporary value investor had better be able to identify and understand the sources of a company franchise and the nature of its CAs.
Reference:
Greenwald. B. C. N. & Kiviat. B. (2001). Value Investing: From Graham to Buffett and Beyond. Wiley.
