What are franchise stocks? And why do we make a point of investing in the same?

Let us first review what franchise stocks are not, at least for our investment purposes. They are not businesses established or operated under an authorization to sell or an authorization to distribute a company’s goods or services in a particular area. Said differently, the are not franchisees such as most of your local McDonald’s stores, Century 21 Real Estate agents, or even Coke bottlers. If anything, the concept of franchise stocks would include the franchiser (owner of the brands, reservation systems, copyrights, etc.). Big board companies such as Cendant, Coca Cola, and McDonalds. Which brings us to another point: franchise stocks are often non-capital intensive.

So what are franchise stocks? They are stocks (businesses) endowed with the “earmarks of sustainable differentiation.” Factors such as the lowest unit cost structure, pricing power, leading market share, top-notch distribution assets, first-rate brand equity, large client lists, material patent portfolios, etc. Stocks with these earmarks bestow on shareholders above average “all-weather” earnings power and, generally speaking, higher returns, implying reduced risk and greater upside potential assuming price sensitive purchase.

It’s been said that finance/investment is not rocket science (we’re glad!). That investment is a lot like golf or tennis. Meaning: most anyone can figure out the rules of the game, but few can play it well. In short, it’s all about execution. And we’d argue discipline. Which brings forth a game plan, an investment strategy “must have.” Which dovetails well with our attempts to use the “vagaries of finance” (such as Pfizer’s pronounced recent correction) to make hopefully enlightened investment bets. Bets not on the next high-tech silver bullet wonder capitalized at 100 times next year’s prospective sales, but on established, mid-life cycle companies running on “multiple differentiation cylinders.”

In a related sense, it is a well-known fact (well, maybe not so well known after all based on investment patterns) that true growth industries -- and by association the prominently involved competitors -- tend to generate extra returns (above their own cost of capital) not primarily for shareholders, but for economy at large. Specifically, for consumers, in the form of bargain prices resulting from an overabundance of capital chasing top-line growth prospects.

We’d prefer not to risk our capital in what the famous Austrian economist Schumpeter called [capitalistic] waves of creative destruction. Call us “chicken little” investors. Make that “girlie men” who’d rather make a bet on a strong-as-an-ox “terminator company” that needs a valve repair job and a bit of down time before having at it again on multiple, perhaps less than sexy, Prussian-like fronts. A company that focuses like a laser beam on relentlessly majoring in countless operations minors and eschews headline-grabbing, adrenaline-pumping acquisitions that all too often call for a long-lasting supply of shareholder Bepto Bismol.

We’ve seen (and sometimes suffered, at least near term) what we consider to be terminator companies -- make that franchise stocks -- “fall out of bed.” On the heels of such implosions we redouble our analytical efforts to test the sustainable differentiation earmarks waters.

If we’re convinced that Mr. Market is being bipolar, i.e., that the on-our-radar-screen stock’s future free cash flow is not suddenly worth 16% less (sorry, to pick on you, Pfizer) by way of NPV modeling assumptions, we pound the table. This has given us entrance points to stocks that had been too pricey before while allowing us to further promote existing BUY recommendations. In short, we’ll trade the near-term black investment eye for a renewed opportunity to invest in a franchise stock at a lower price (versus attempting to ride Schumpeter’s creative waves of destruction, for example).

Go ahead; call us investor “girlie men” as you ponder our Austrian complex!

Or maybe you’d be interested in having a look at our work at www.dkequities.com? It tells a story about what we attempt to do as we major in lots of sustainable differentiation earmark minors.