Cash Generation Has Always Been King

“In the short run, the market is a voting machine but in the long run it is a weighing machine.” - Ben Graham

Buffett demystifies investing into something that’s simple, yet not easy: find understandable businesses with superb economics, run by competent and trustworthy management, selling at reasonable prices. His 1991 letter gives more color on what he means by businesses with superb economics selling at reasonable prices. The result of a superb business is substantial cash generation. The result of buying said business at a reasonable price is substantial stock returns because “in the short run, the market is a voting machine but in the long run it is a weighing machine.”

Economic franchise versus a business

Buffett makes a distinction between a “business” and an “economic franchise.” He characterizes a franchise as an entity that provides 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...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. 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. And a business, unlike a franchise, can be killed by poor management.

Products or services that are needed are utilities, whereas products/services that are desired are discretionary. I think it’s helpful to consider when a product/service can transition from discretionary to utility, which should lead to durable revenue growth.

For example, at a certain point smartphones transitioned from a ‘nice to have product’ to a modern day utility for communication, finding information, and doing work on the go.¹ Amazon Prime probably went through a similar transition, becoming a modern day commerce utility for nearly every household in America. For many families Costco is a similar thing. I think many people view Spotify as a utility. What are other examples??

For (2), it’s interesting that Buffett says “is thought by its customers to have no close substitute,” rather than “there is no substitute.” This gets at consumer perception, which is powerful. Android smartphones are feature comparable to iPhone, yet many people feel iPhone is superior. Apple or Amazon or YouTube Music is essentially the same service as Spotify, but listeners perceive Spotify to have a superior algorithm and curation. I think the same applies to Zillow versus Realtor.com or Redfin. There’s also an element of switching costs that can be real, even if a close substitute exists. Blue bubble for iPhone users, saved songs and playlists on Spotify, a familiar UI for Zillow. An example to the contrary is Uber v. Lyft, which I would argue are perfect substitutes.²

Deterioration of a franchise and its effect on intrinsic value

Intrinsic value (IV) is the expected amount of future cash a business will generate. To estimate the amount of cash a business will generate requires an opinion about the future growth prospects of the company, along with an understanding of a business’ earnings power. Earnings power is driven by factors such as a durable moat, pricing power, operating leverage, and return on incremental invested capital. Buffett gives an example with See’s Candy:

For an increase in profits to be evaluated properly, it must be compared with the incremental capital investment required to produce it. On this score, See's has been astounding: The company now operates comfortably with only $25 million of net worth [assets less liabilities], which means that our beginning base of $7 million has had to be supplemented by only $18 million of reinvested earnings. Meanwhile, See's remaining pre-tax profits of $410 million were distributed to Blue Chip/Berkshire during the 20 years for these companies to deploy...In our See's purchase, Charlie and I had one important insight: We saw that the business had untapped pricing power.

As a business such as See’s exhibits the ability to consistently grow and protect earnings from competitors, the market rewards those earnings more favorably because the business can earn an attractive return on invested capital; this creates a “double-dip” effect: increasing earnings and a higher multiple on those earnings. Increased earnings power = higher intrinsic value.

When the opposite happens and a company’s earnings power deteriorates (weakening franchise), it has a negative compounding effect on intrinsic value. A company grows earnings more slowly and the market looks less favorably on said earnings because the business will likely earn lower returns on invested capital (fending of competition). Buffett identified this effect on the media companies Berkshire owned as the landscape began to shift in the late 80s:

Until recently, media properties possessed the three characteristics of a franchise and consequently could both price aggressively and be managed loosely. Now, however, consumers looking for information and entertainment (their primary interest being the latter) enjoy greatly broadened choices as to where to find them. Unfortunately, demand can't expand in response to this new supply: 500 million American eyeballs and a 24-hour day are all that's available. The result is that competition has intensified, markets have fragmented, and the media industry has lost some - though far from all - of its franchise strength.

Dollars are dollars whether they are derived from the operation of media properties or of steel mills. What in the past caused buyers to value a dollar of earnings from media far higher than a dollar from steel was that the earnings of a media property were expected to constantly grow (without the business requiring much additional capital), whereas steel earnings clearly fell in the bob-around category. Now, however, expectations for media have moved toward the bob-around model. And, as our simplified example illustrates, valuations must change dramatically when expectations are revised.

A similar dynamic and investor calculation has played out in the market over the past few months with Netflix, Facebook, and PayPal, for example.

Cash generation is king

If stock market returns are ultimately driven by a business’ cash generation, the goal of investors should be to construct a portfolio of companies that deliver the most future owner earnings.³ I thought Buffett’s advice on how to think about a portfolio was helpful:

We also believe that investors can benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the highest possible look-through earnings a decade or so from now.

An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.

1. I wonder if Buffett thought about this when he made his Apple investment.

2. Drivers work for both marketplaces, and riders are usually agnostic, selecting primarily based on price.

3. Equivalent to free cash flow.