Strong Franchises Make Strong Investments

By Sham Gad | November 19, 2009 AAA

Despite recent market optimism, we are entering into a period of uncertainty and significant consequence as a result of the massive monetary and fiscal policy being used today. While another massive macro shock to the economy will spare no stocks, looking at dominantly entrenched companies with strong franchises offers a very sound investment strategy going forward.

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The Power of a Franchise
The best thing about franchises is that they have pricing power that can be passed along during periods of inflation. Furthermore, franchise businesses have very little competition, unlike other big industries like autos. As a result, franchise-type companies give you much more control on the downside. Downside protection is a huge plus in general, but it's much more important today in this market. In referring to franchise business, one should not confuse it with companies that solely franchise out stores. A company that has a dominant franchise usually has a strong brand or entrenched position in its respective industry that provide the business with unique competitive advantages.

No Franchise Runs Like A ...
So if you look at a company like Deere (NYSE:DE), its earnings declined by around 35% over the past year. That sounds awful, but it's actually quite good when you look at other companies, like the autos, who were crushed. Many companies went from making money to losing money, so to only lose 35% of your profits in what is now considered the most difficult economic environment since the 1930s is phenomenal. And it attests to the value of a franchise. And Deere has very little competition besides Caterpillar (NYSE:CAT). Deere not only sells its products, but it services them. That equipment must be serviced and Deere has a wide network of locations to get that business. (For more, see The Value Investor's Handbook.)

See Any Similarities
So what other names would be considered franchise-type businesses? The obvious names would include American Express (NYSE:AXP), Coca-Cola (NYSE: KO), and even Microsoft (Nasdaq:MSFT). Commodity businesses certainly have pricing power in inflationary environments, but they have lots of competition, so the key is to be the low cost producer. In this case zinc producer Horsehead (Nasdaq:ZINC), is such an example. (For related reading, check out The 3 Most Timeless Investment Principles.)

What Matters Most
Franchise or no franchise, the quickest way to lose money is to pay too much for something. Paying below a company's value is the most important type of downside protection. After that, look at companies that possess dominant franchises. It just so happens today that many franchise-type companies are actually trading at sensible prices. (For more, see Spotting Cash Cows.)

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