What To Buy: Great Franchises
After understanding the importance of accounting quality, the next major element in the Consistent Compounding Formula is identifying businesses that possess strong and sustainable competitive advantages. In this chapter, Saurabh Mukherjea explains why great franchises become the foundation of long-term wealth creation and why only a small number of companies in India have the ability to consistently generate superior returns on capital.
A great business is not simply one that earns profits today. A truly exceptional company has the ability to protect its profitability from competitors over many years. This ability allows the company to maintain high returns on capital, generate strong cash flows, and continuously reinvest those earnings into further growth.
The author begins by explaining the relationship between Return on Capital Employed (RoCE) and competitive advantage. Every business requires capital to operate. Companies invest money into factories, technology, employees, inventory, distribution networks, and other resources to create products and services. The objective of any business is to generate returns from this capital.
When a company earns a return higher than its cost of capital, it creates value for shareholders. However, in a competitive market, such attractive returns naturally attract new competitors. As more companies enter an industry, competition increases, pricing power reduces, and profitability gradually declines.
This natural process explains why consistently high returns are rare. If a company is earning exceptional profits, competitors will usually attempt to copy its success. Over time, competitive pressure pushes returns closer to average levels. Therefore, companies that can maintain high RoCE for decades must possess some form of protection that prevents competitors from easily challenging them.
This protection is known as a competitive advantage or economic moat.
A strong competitive advantage allows a company to maintain pricing power, retain customers, defend market share, and continue earning superior returns despite competition. These businesses create a cycle where high profitability generates more cash, which can then be reinvested into strengthening the company's position even further.
The author explains this as a virtuous cycle. A company with a strong franchise generates high returns because of its competitive advantage. These excess returns create additional cash flows. Management can then reinvest these cash flows into expanding capacity, improving technology, strengthening distribution, or building customer relationships. These investments further increase the company's competitive advantage, making it even harder for competitors to challenge.
However, high RoCE alone is not enough to create long-term wealth. A company may generate excellent returns but fail to grow if it cannot reinvest capital effectively. Therefore, investors must evaluate both the quality of returns and the ability of the company to redeploy capital into profitable opportunities.
The author provides examples of companies that demonstrate this combination of high returns and effective reinvestment. Businesses with strong franchises are able to continuously expand while maintaining profitability because their competitive advantages create opportunities for further growth.
One such example discussed is Page Industries, the company behind the Jockey brand in India. The company has consistently generated exceptionally high RoCE compared with its industry peers. Its ability to maintain premium pricing, strong customer loyalty, and brand positioning has allowed it to create significant value for shareholders.
The difference between Page Industries and its competitors highlights an important investment lesson. Operating in the same industry does not mean all companies possess equal quality. While many businesses may sell similar products, only a few develop the advantages required to consistently outperform their competitors.
The same principle applies across industries. In the automobile sector, for example, companies with stronger brands, better distribution networks, and efficient operations can generate better returns than competitors even when they operate in the same market environment.
The author explains that great franchises are usually built around strong barriers to entry. These barriers prevent competitors from easily copying the business model. They may come from several sources, including superior technology, customer relationships, brand strength, efficient supply chains, exclusive partnerships, or economies of scale.
A business without such protection may enjoy temporary success but eventually faces pressure as competitors enter the market. On the other hand, companies with strong barriers can continue creating shareholder value for decades.
Another important concept discussed is the difference between high RoCE and sustainable growth. A company may have excellent profitability but limited growth opportunities if it cannot effectively reinvest its earnings. Therefore, the best businesses combine two characteristics: strong competitive advantages and the ability to deploy additional capital at attractive returns.
This combination is what makes consistent compounders unique. They are not only profitable businesses but also efficient machines capable of converting today's profits into tomorrow's larger profits.
The author also highlights that competitive advantage is not always permanent. Even the strongest franchises can lose their dominance if management becomes careless or fails to adapt to changing market conditions. Consumer preferences evolve, technology changes, and new forms of competition emerge. Therefore, maintaining a franchise requires continuous innovation and disciplined management.
Great companies do not simply defend their existing position; they constantly strengthen it. They invest in improving products, enhancing customer experience, upgrading technology, and finding better ways to serve their markets.
The chapter emphasizes that investors should not focus only on current market leadership. They must understand why a company is successful and whether those reasons are likely to remain valid in the future. A strong brand without innovation, a large market share without customer loyalty, or high profits without competitive protection may not represent a true franchise.
The author concludes that identifying great franchises is one of the most important tasks for long-term investors. These businesses form the second pillar of the Consistent Compounding approach because they reduce revenue and profit risks while creating opportunities for sustainable growth.
A great franchise is not defined merely by its size or popularity. It is defined by its ability to consistently generate superior returns, defend its position against competitors, and reinvest profits intelligently. These rare businesses become powerful wealth creators because they allow investors to participate in decades of compounding.
The search for such companies requires patience, deep analysis, and an understanding of business fundamentals. However, investors who successfully identify these exceptional franchises gain ownership in businesses that can continue creating value long after short-term market trends have disappeared.