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Warren Buffett Lesson on Franchise InvestingThe Qualitative Difference

Be aware of the fragility of companies no matter how powerful today.

Fortune 500 Firms in 1955 vs. 2011; 87% Are Gone.

What do the companies in these three groups have in common?

Group A.American Motors, Studebaker, Detroit Steel, Maytag and National Sugar Refining.

Group B.Boeing, Campbell Soup, Deere, IBM and Whirlpool.

Group C.Cisco, eBay, McDonalds, Microsoft and Yahoo.

All the companies inGroup Awere in the Fortune 500 in 1955, but not in 2011.

All the companies inGroup Bwere in the Fortune 500 in both 1955 and 2011.

All the companies inGroup Cwere in the Fortune 500 in 2011, but not 1955.

Comparing theFortune 500 companies in 1955 and 2011, there are only 67 companies that appear in both lists. In other words, only 13.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011, and almost 87% of the companies have either gone bankrupt, merged, gone private, or still exist but have fallen from the top Fortune 500 companies (ranked by gross revenue). Most of the companies on the list in 1955 are unrecognizable, forgotten companies today. Thats a lot of churning and creative destruction, and its probably safe to say that many of todays Fortune 500 companies will be replaced by new companies in new industries over the next 56 years.

Update:Heres arelated articlefrom Steve Denning in Forbes, featuring some insights from Steve Jobs about what causes great companies to decline (power gradually shifts from engineers and designers to the sales staff) and how the life expectancy of firms in the Fortune 500 and S&P500 has been declining over time.

Also, the impending death of a big-box retailer, Best Buy:

Peggy Noonan On Steve Jobs And Why Big Companies Die

There is an arresting moment in Walter Isaacsons biography ofSteve Jobsin which Jobs speaks at length about his philosophy of business. Hes at the end of his life and is summing things up. His mission, he says, was plain: to build an enduring company where people were motivated to make great products. Then he turned to the rise and fall of various businesses. He has a theory about why decline happens at great companies: The company does a great job, innovates and becomes a monopoly or close to it in some field, and then the quality of the product becomes less important. The company starts valuing the great salesman, because theyre the ones who can move the needle on revenues. So salesmen are put in charge, and product engineers and designers feel demoted: Their efforts are no longer at the white-hot center of the companys daily life. They turn off.IBM[IBM] and Xerox [XRX], Jobs said, faltered in precisely this way. The salesmen who led the companies were smart and eloquent, but they didnt know anything about the product. In the end this can doom a great company, because what consumers want is good products.

This isnt quite the whole story. Its not just the salesmen. Its also the accountants and the money men who search the firm high and low to find new and ingenious ways to cut costs or eveneliminate paying taxes. The activities of these people further dispirit the creators, the product engineers and designers, and also crimp the firms ability to add value to its customers. But because the accountants appear to be adding to the firms short-term profitability, as a class they are also celebrated and well-rewarded, even as their activities systematically kill the firms future.

In this mode, the firm is basically playing defense. Because its easier to milk the cash cow than to add new value, the firm not only stops playing offense: it even forgets how to play offense. The firm starts to die.

If the firm is in a quasi-monopoly position, this mode of running the company can sometimes keep on making money for extended periods of time. But basically, the firm is dying, as it continues to dispirit those doing the work and to frustrate its customers.

As the managers find it steadily more difficult to make money playing solely defense, they become progressively more desperate and start doing ever more perilous things, likelooting the firms pension fundorcutting back on worker benefitsoroutsourcing production to a foreign countryin ways that further destroy the firms ability to innovate and compete.

Whats interesting is that Steve Jobs lived long enough to show us atApple[AAPL], in the period 1997-2011: what would happen if the firm opted to keep playing offense and focus totally on adding value for customers? The result? The firm makes tons and tons of money. In fact, much more money than the companies that are milking their cash cows and focused on making money. Other companies likeAmazon[AMZN],Salesforce[CRM] andIntuit[INTU] have demonstrated the same phenomenon and shown us that its something that any firm can learn. Its not rocket science. Its calledradical management.

Fifty years ago, milking the cash cow could go on for many decades. Whats different today is that globalization and the shift in power in the marketplace from buyer to seller isdramatically shortening the life expectancy of firms that are merely milking their cash cows.Half a century ago, the life expectancy of a firm in the Fortune 500 was around 75 years. Now its less than 15 years and declining even further.

The above articles are yellow flashing lights on the longevity of competitive advantage for established companies.Do you agree with the articles premise?

This entry was posted inCompetitive Analysisand taggedBBYCompetitive AdvantageCorporate extinctionRTMSteve JobsValue Traps. Bookmark thepermalink.

Warren Buffett Lesson on Franchise InvestingThe Qualitative Difference

John, as usual, you post very thought-provoking questions. I dont think Im quite up to the task of providing a good answer.

As regards group A, thats easy: none of the companies had barrier to entries.

Group B is a toughie. Youve stumped me. I dont know why, for example, Whirlpool would be in group B, but Maytag is in group A. Whirlpool does have some brand recognition, but I dont think it means too much. Perhaps I could say that group B has a moat. Boeing has significant development costs, which are very costly to replicate. Beoing seems to be in a oligopoly, where its very difficult to get scale to compete. I just had a look at Wikipedias entry for Airbus. It was formed as a consortium of European aviation firms to compete with American encumbants. Campbell soup has the moat of mindshare. I heard someone say that Campbells moat might be contracting, as people are losing interest in soup. Deeres moat is its distribution of dealerships. As it turns out, I live in a farming community in Scotland, and there is indeed a Deeres. The community is small. theres a limited demand for farm machinery, so any competitor would have a very difficult task ahead of them getting scale.

IBM. Well, I dont know about them. They clearly used to have a monopolistic position, but now they just seem to be a consultancy firm. Mary Buffett rant time. She recently gave an interview ( where, predictably, she plugged her latest book, and lauded Warrens purchase in IBM. All the talismanic phrases were used: consumer monopoly, branded, buying back its own stock. Everyone can be a pundit! I think IT consultancy is a very cut-throat business, though. Theyll be plenty of competitors at whatever scale youre looking at (say, EDS, Accenture, there must be others), and contracts are run by competitive tender. So I think that the case for IBM is weaker than Mary is stating. The fact that Warren bought into it almost certainly means that my analysis is wrong somewhere, though.

Group C, their common thread seems to be that they caught a wave. McDonalds caught the franchising wave. Microsoft caught the PC wave, and the others caught the internet wave. Microsoft and Yahoo are both cloners. Its worth remembering that Yahoo stands for Yet Another Hierarchical Officious Oracle. It looks pretty vulnerable, actually. eBay has the network effect. Microsoft has stickiness. In order to compete, you have to do the same thing that Microsoft does, only why would anyone buy it, when theres already Microsoft. Microsoft is not invulnerable though. With programs like Firefox, and an increasing use of the web, the OS is becoming less relevant. Theres also things like smartphones, where traditional Windows doesnt fit. So there are chinks in Microsofts armour, and its moat, whilst still large, is getting narrower.

But Im sure youve got the real answer.

I think he provided the answer right below the question, but maybe the question was much more profound than I realized in which case your further attempts to answer it are well-done.

Something I noticed about all of these companies is they make their own things, they arent in the business of reselling/distributing other peoples things (retail). I am wondering how many Fortune 500 companies produce their own things (goods, services) and how many are connected to retail? My mind is blanking right now on specifics but I am thinking that of most of Buffetts/BRKs holdings, theyre all selling their own things rather than retailing those of others, which would seem obvious given Buffetts penchant for strong brands.

I was going to say Maybe retailing is not a business model that is likely to produce long-term value creation for the investor but then I realized you just mentioned WMT in your latest posts and the chart on that company would seem to argue otherwise. But perhaps WMT is the exception to the retail rule?

I think Im grasping at straws here and either way its a bit more complicated than retail has a weak moat but it was just something that came to mind so I thought Id ask about it.

I think in general retail has no Moat, but Buffett has invested in several retailers both successfully (Mrs. Bees Furniture Store in Omaha, Jewelry store) and not so successfully (Diversified Retailing in Baltimore).

Yes. Wal-Mart is an exception, but why do you think Starbucks is so successfuldo you notice something odd? Starbucks within 4 blocks of each other.

Whats interesting about the Omaha furniture store is it has a kind of moat its the dominant furniture retailer in its market and so far it looks like the Internet has not fully revolutionized the furniture market. Its a different kind of retail foray, than, say, BBY. Which, by the way, I think is always an interesting question to ask when considering any particular investment thesis, that being, Besides it not being cheap enough, why wouldnt Warren Buffett buy this company?

As for SBUX, I see them as different from BBY in a fundamental sense because even though they maybe dont grow their own coffee, people see it as Starbucks coffee its not some other companys coffee, sold by Starbucks. It is Starbucks coffee, implying unique quality, taste and value. BBY is selling Maytag washers, MSFT video games, SNE televisions, etc.

Why is SBUX so successful? Well, I am sure this question has been studied and researched quite a bit, so I could search around the web for what others have suggested before taking a stab, but I think the point of the exercise is to get my own creative juices flowing so Ill attempt a go without that aid first time around: part of it has to do with the fact that they sell an addictive product, but so did tobacco companies and there were many contenders in that space.

I dont know anything about their supply efficiencies and other operational advantages and I assume youre question wouldnt require knowledge of that to answer, that youre looking more at something unique to their relationship with customers.

Best I can come up with right now is they created something institutional and prestigious for their consumers. They made them feel like carrying around their product in their hand added some sophistication and class to their life, and they did it all while providing something that people generally enjoyed and found to be high quality. I dont know how important their ability to turn Starbucks into hangout/study halls is to their success but I am guessing that plays a role as well.

I dont know if I have the answer for SBUXs success. But I am observing the density of their stores. We would need to dig into their financials and do an industry map.

I think he provided the answer right below the question

I had assumed that he was making an observation, but real the question is what is it that puts them in each group apart from the obvious like Microsoft didnt exist in 1955.

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