Franchise Blog

It is a quiet Saturday morning. If you are the average American, the downturn in the economy has started you to think about how it will impact your career and the opportunities for your children as they enter the workforce. Articles about Enron and Tyco and Global Crossing and other corporate scandals abound and some of the most respected brand names internationally are talking about layoffs and bankruptcy.

Surfing the web you read stories about entrepreneurship and wealth creation by individuals who grabbed a piece of the “Great American Dream” of individual business ownership. But you don’t know where to start to look for your opportunity. One-way may be to simply open up your own independent business – but even here you don’t know where to begin. The simplest way may be to join a growing franchise or business opportunity network. But you don’t know which one is right for you. You are not even sure of the differences between a biz-op and a franchise and you are not certain you really need to care. Read the rest of this entry »

One of the big no-no’s of franchising is allowing a franchise sales person to make verbal promises or give earnings claims of potential profitability that are not verifiable or in the franchisor’s disclosure documents. This is very serious and more than one franchisor has had their pants sued off for allowing this practice. Indeed, franchisees should be very leery of a franchise salesperson that makes such statements, if they cannot be found in the official disclosure documents.

In fact, the prospective franchise might even wish to consider skipping that franchise business opportunity all together and moving onto the next best franchise they might consider. Not long ago a franchise arbitrator awarded a franchisee 5 times the franchisor’s net worth and 3 times its earnings during its 5-year history. Needless to say this mistake by a franchisor’s sales man cost the company everything, and it will pay off part of the judgment and then file for bankruptcy.

Worst, there is no possible way in this present economy to make up the difference, so the franchisor is history along with the entire franchise chain, all because the sales guy made a verbal like promise, this one on the last line at the bottom of an email during the sales process.

The extremely business savvy franchise buyers that invested in the franchise business opportunity may or may not have known at the time that this two line sentence at the bottom of the email would later sink the franchisor and make them a good chunk of change for their original investment. So, this ought to be a lesson to all franchisors and franchisees, beware of verbal or email promises that cannot be substantiated during the sales process. Think on this.

At a glance, it seems that our community is working harder and longer than ever. As the national economy is slowing and unemployment is predicted to rise accordingly, it seems only natural that workers put their noses to the grindstone in an attempt to move up the ladder, or even just to make ends meet.

Whilst this is certainly the case for a majority of the population, for the remaining group there can be noticed a significant shift in their intention and chosen direction when it comes to making decisions about their working life. More and more people, females in particular, are choosing flexibility and family commitments over climbing the corporate ladder and earning the big bucks.

Currently, one of the most common options that people are turning to as a way to have more control over when, where and how much they work, is franchising. Once only associated with large multi-national businesses such as McDonald’s and Starbucks, the franchising sector in Australia continues to grow steadily and can be anything from a cleaning business, to mortgage brokers and supermarkets. This growth is attributed to two major factors, one being that a greater number of successful business owners are looking to expand their empire and do so by creating and selling franchises. The second reason compliments the first, as people chose to prioritise what is important to them and what best suits their desired lifestyle, they are consequently choosing to purchase these newly created franchises.

Owning a franchise allows business owners to have control over a range of aspects that would be unlikely to be up for negotiation in a regularly employed position. By owning a franchise, business owners are able to set their own work hours, perhaps molding it around picking up the kids from school, playing tennis with friends at 11am on a Wednesday or any other commitments that may exist. They are able to work from home or a selected convenient location, as well as having the satisfaction of reaping the direct benefits of their hard work.

Franchising contributes large amounts to Australia’s economic landscape through not only creating a wealth of new business owners and providing them with a platform in which to learn and grow as business people and as human beings, but also provides job opportunities and valuable products and services to the community.

By purchasing a franchise, the franchisee is provided with a support framework from the franchisor. This can be anywhere from regular training, to marketing support and networking opportunities, all of which directly benefit the franchisee’s business as well as contributing towards the good name and future success of the company as a whole.

A recent Potential Franchisee Survey, conducted by Mortgage Choice, shows that for those considering purchasing a franchise, the most appealing factors were all related to the fact that what they are buying into is already established. In most cases, there is an established recognition of the business brand within the community. Purchasing a franchise also ensures that there is an established business model along with other necessary tools such as suppliers and access to support networks via the franchisor and other franchisees. Potential franchisees like the fact that there is a better likelihood of success when compared to starting a small business from scratch. It also opens the door for increased exposure through advertising and media as the combined resources of a franchise can access much more that a single small business owner.

Obviously, purchasing a franchise is not necessarily the right fit for everyone, however many of those that have made the choice would swear that it has made a drastic change in their lives and they will never look back. As with every important business decision it is strongly recommended that you seek professional independent advice before taking any action, as failure to do so could be damaging down the track.

If you are going to buy a franchise business opportunity, then you need to do a little extra work while looking over the franchise disclosure documents and I’d like to specifically discuss the section that addresses restrictions of ownership in ancillary companies, suppliers of the franchisor and ownership of the competitors of the franchising company. You’d be surprised how competitors of a franchisor will try to get a spouse or family member or even a close associate to buy a franchise just to learn the secrets and inner workings of the franchisor’s system.

It happens all the time, such is one of the realities of business. Corporate Espionage is alive and well in the franchising sector, and when a franchisor is growing fast and winning market share, well, let’s just say it scares the bejesus out of the competition, as well it should. I seriously doubt there is a single franchisor in existence worth their salt that has not had a competitor attempt to shop them or pretend to be a franchise buyer in order to receive information or get a copy of the Franchisor’s FDD or UFOC.

This is one reason that franchising companies make it known to franchise buyers of their franchise opportunities that they will not allow anyone to buy into their franchise that has a stake in a competitive business. And they also are careful not to allow vendors to buy-in, as often they also sell to the competition, besides other franchisees will complain if one franchisee is involved as vendor and money is funneled towards that vendor.

When you see this clause in your franchisor’s disclosure documents, remember that these notations are there for a reason. Anyone who violates these stipulations can find themselves terminated for cause and a lawsuit pending with damages to be assessed. Courts will generally find in favor of a franchisor in this case, when someone has misrepresented themselves to steal proprietary information. Please make a note of this.

Perhaps the biggest question that folks ask after any major election is will the new President be good for their industry, their business, or our economy in general. And there is good reason for this, as many folks’ livelihood is at stake.

No one that has a good paying job, a family, a house and a couple of cars want to get a pink slip or be laid-off from work and with the US economy in recession, perhaps President Obama’s victory has some people wondering.

In the franchising industry, it’s no different, President Obama will definitely matter for both franchisors and franchisees. For franchisors there will be higher costs perhaps more taxes and more regulations. For franchisees some of these regulations may help them as investors in franchise business opportunities, making sure there are adequate transparency rules, accountability and consumer investment protections.

Senator Barrack Obama while running for President promised to look out for the little guy, and to take care of small businesses, in fact, he said on his website that he believed small businesses were the backbone of our economy, something that most politicians say. He also claimed that the economy was his top priority and a strong economy is very good for franchising and the many franchisees that have bought into the franchise opportunities.

But, did you know that franchising companies enjoy their biggest spurt and growth periods during down times? It’s true, and it is because unemployment is high, lay-off numbers increase and there is a steady pool of new franchise buyers to choose from, allowing franchising companies to pick the cream of the crop. So, think on all this and then make your own decision.

Many entrepreneurs do not make such great franchisees, no it’s not that they don’t know how to run a business, it’s because their mentality is based on complete trust in self and self-reliance almost to the point others might think too risky or even dangerous.

Often, when franchisors get a superstar entrepreneur as a franchisee, they either use them to help with innovations in their business model or they completely clash with them and consider them a rogue franchisee, and even try to figure out ways to terminate them from the franchise contract prior to the end of the franchise term.

This is why I always ask franchise buyers to consider their personality type and make sure they will feel comfortable working within a structured franchise system. It’s certainly not for everyone. Those who have run successful small businesses in the past or even grew up with parents that owned their own small business may be the wrong folks to go and invest in a franchise business opportunity.

Now please realize, I am in no way trashing the franchise business model, in fact, I believe it is probably the best business model ever created and it has so many advantages that I surely could not list them all here. So, if you were to ask me if franchised businesses are too structured and controlled, I would have to truthfully answer that it depends on the franchisee or potential franchise investor that is considering on investing in a franchise business opportunity of their own. So, please think on this, make sure it’s right for you before you buy.

One thing that is important when considering a franchise business opportunity regardless of category is to look carefully and read over the exclusive territory rights. I always recommend that prospective franchise buyers re-read this section 5-times, until they can explain it back to me without looking at it.

Why you ask? Well, it’s simple really, you see, some franchise disclosure documents have the exclusive territory ending at the front door, while others give you a wide area like a 10 mile radius, an entire zip code or use the city limits. Still, some exclusive territories can change based on your sales volume, franchise attorneys call this an Exclusive Territory Tied to Sales Quota.

Now then, you might not think anything of this when shopping for a franchise business opportunity for sale, but let me tell you, this would be a mistake. For instance, consider it you owned one of the many retail franchise opportunities and during this year, the economy was very poor and you could not even come close to last year’s sales volume or your required sales quota and because of this your franchisor was allowed to sell an additional outlet very near your store?

You can see the problem, as this might take away a good chunk of your sales volume, maybe even enough to nix your profits even after the economy returned to full-steam.

Now then, before you completely consider this a no-win situation, you must also remember that if the sales quotas are fair, and a fellow franchisee in your franchise system is not pulling his or her weight, you’d want your franchisor to put in another unit nearby to prevent your competition from gaining strength and getting a foothold, which diminishes the entire brand name and thus, hurts you too. So please think on this.

It is often said by those who advocate for the franchising model over buying an existing business opportunity that in franchising you have a system, one that is over the learning curve. Perhaps, this is one of the biggest benefits to buying a franchise business opportunity over starting your own small business or buying someone’s used business on the cheap because it is failing or failing to meet its current owner’s expectations.

When we ask franchise buyers why they invested in a franchise opportunity rather than starting their own business, they have several typical answers, all of which are relevant such as; The franchising opportunity had financing, the franchised business model came with training, the franchise rate of failure is much less than start-up businesses or that the brand name is so well known by customers that it seemed like a no-brainer.

Yes, all these are great reasons for investing in a franchise business opportunity, but let’s talk about learning curves for a second. If you were to start a small business it might take you quite a while to learn the ropes to become efficient and actually turn a profit, in the mean time you would be operating at a loss trying to make ends meet. If you have been recently laid-off you may not have endless dollars to spend until one day you are magically profitable.

Franchise opportunities indeed take some of this fear away, in that the franchisor has already made all the mistakes you could possibly make in advance of you entering the franchise system. Thus, you are really buying expertise and know-how that someone else had to learn the hard way, someone other than you, and that my friend is a good thing, so think on it.

Every franchise buyer wants to know how much money they will make if they buy into a particular franchise business opportunity. Unfortunately, every company that competes with a franchising business also wants to know exactly how much each of its franchised outlets are earning each year.

In fact, since many franchising companies are not public companies and therefore the information on same-store outlet earnings are not available, their competitors will often find a way to get a look at their franchising disclosure documents in hopes that all the financial information of this type will be there. Sometimes it is, but because of this, many private franchising companies have chosen not to give earnings claims.

Should a franchise buyer that desperately wishes to know the profitability of a franchise investment opportunity shy away from those franchising companies that do not share earnings claims in their franchise disclosure documents? Well, it depends, if the franchise buyer thinks that the company offering the franchise opportunities for sale is hiding something then, yes!

But, the franchise buyer should also realize that there are indeed other ways to obtain such information, such as talking to current franchisees, and it is required that franchisors provide a list attached to the franchise disclosure documents of each current franchised outlet or franchise unit.

There is one other reason that franchisors do not post their franchised outlet’s earnings. If they do they have to audit each franchisee, something that franchisees do not appreciate as it is adversarial and kind of like Big Brother. So, as a franchisee once you do buy, you might be very glad that the franchisor does not audit your books, thus, no earnings claims to new franchise buyers is a good thing.

Plus, as a franchise you do not have to worry about your franchise outlets financial information getting into the hands of competitors. Something you definitely don’t want. So, please think on this when considering purchasing a franchise business opportunity for sale.

When making a due diligence check-list to determine the best franchise opportunities for you, please add to this list a complete accounting of all the Franchising Company’s trademarks, patents, and proprietary methods; even its secrets. For instance, most of the top fast food franchises have secret sauce that they use, which gives their hamburgers, salsa, or sandwiches a special flavor that cannot be found anywhere else.

Often, it is such things as this that help the franchisor’s consistency and add to its brand name. But fast food franchise opportunities are not the only categories of franchisors where you will find such things. Most service franchises have slogans, and logos that alert customers of the franchised outlet that they are indeed part of a much larger and stronger team, one the client can trust. How much is this worth you ask?

Well, since it will bring in significant business it is worth a lot and something you must consider when purchasing a franchise business opportunity. A no name franchise company, even if it is labeled by Entrepreneur Magazine’s top 500 franchises, is not nearly as smart an investment as a franchise opportunity with a strong brand name a recognized logo.

Remember once you start your business you will need customers lined up to buy your products and services, so you need more than just a good marketing plan, you’ll need name brand recognition. Luckily, this is one major advantage to buying a franchise over just any old regular business for sale. So, please make a note of this.

There sure is a lot of talk about the need for franchise buyers to do due diligence when studying which franchise business opportunity to invest in. It’s amazing all the advice from franchise lawyers, franchising consultants, franchisee associations and even franchisors themselves. Still, in all of this many prospective franchisees never even fully read the franchising disclosure documents.

Indeed, I know it sounds absurd, as this is one of the largest investments that anyone may make in their entire lives. Even when considering a top franchise opportunity, you still need to read all the franchisor’s documents carefully, yes, every single page. If there is anything about the franchise business opportunity that you do not understand you need to have it explained to you by the franchising company and a franchising consultant or lawyer who specializes in franchise business opportunities.

There is a huge difference between franchise business opportunities for sale, and the franchise agreements can vary wildly even from within the same category. For instance, a Fast Food Franchise company that sells sandwiches will be different from another franchise agreement of one which sells submarine sandwiches. The terms, conditions, financing, equipment, exclusive territories and price will surely be different, sometimes by extremely wide margins.

Regardless of the type of franchise you are considering on buying all franchise opportunities are different, just like all used businesses for sale will have a different deal. So, do yourself a favor and listen to the advice of all the top experts in franchising, due your due diligence and pick out the best franchise for you and your family. Think on this.

When considering a franchise business opportunity for sale, a prospective franchisee must consider the financial wherewithal of the franchising company. It really doesn’t matter if the someone is looking to buy one of the best franchises in the Fast Food Franchise venue or one of the top franchises in the service sector. The financial strength of the franchising company and their capitalization is important.

Those companies with strong balance sheets deserve a second look. For instance, remember Krispie Kreme, Boston Market, and Scholtsky’s Deli? You would assume that a Fast Food Franchisor would be well capitalized if it is selling fast food franchises, but like anything else buyer beware. And, really this is just good common business sense, as it would not matter if you were buying a regular business for sale or a franchise, as you still need to look at the balance sheet right?

Franchise business opportunities should be no different from any other large business buying decision. You wouldn’t catch Warren Buffet buying General Motors for 50 Billion when it’s market cap it only a few billion would you, especially when it is in deep debt. Well, think like Warren Buffet when buying a franchise business opportunity and it will save you from severe hardship later in your franchised business.

When comparing franchise businesses to one another you need to add more weight and consideration to those business models and franchisors that are well capitalized and have the ability to borrow money in the future and have as significant and long track record of financial success. Please make a note of this.

When purchasing a franchise business opportunity or a fast food franchise, you must be concerned with many important things, all of which matter very much. But let me discuss with the issues that I advise franchise buyers to look into even more careful; let’s talk about exclusive rights and exclusive territories for a moment. In the franchise agreement there is a section on the rights that go along with the franchise and among them is the exclusive territory.

This is the area around your franchise outlet if you do go ahead and buy the franchise where you will have absolute exclusivity, meaning the franchise company that sells you the franchise will not put another outlet. This is extremely important because if the franchiser sells another store too close to yours then it will cannibalize sales and cut into your profitability.

Why would a franchisor do that? Well, because they will make more franchise fees, more royalties and attain an incrementally higher percentage of market share. In other words it could be very good for them, and well, not so good for you. Of course, if a franchisor sells you too big of a territory, one you cannot service, then your brand name strength in the region will be solely up to you and that means more marketing expenditure for a larger area, and you might be so far away from customers that they will not make the long trip to buy from you.

Thus, your competitors will get a foothold and cut into your territory anyway. You can see the catch-22 and this is why you need to have a good sized territory, but if you get too greedy, you may end up hurting yourself. It is for that reason that you must think carefully about the exclusive territory of your franchise investments and negotiate the best deal for you and your franchisor, after all you are in this together, so please think on it.

Often, we see franchise business opportunities available and we find from the franchisor’s disclosure documents that the company has only been in business a year or two, worse not only has the corporate franchising business only been in business a short time, they only have one corporate store that has been in business not even a year or more. Some of these new franchisors are rather interesting in that they are trying to cash in on a fad type business.

But should you really be buying a fad business, especially if the franchise term is 10-years or more, as who is to say that people will still be lining up for the product or service ten years from now? I always like to advise serious franchise buyers that are looking for the latest hot franchise opportunities to slow down and think about it for a bit. If the franchisor has only been in business or the concept itself for only a few years, then who is to say that it is even viable long-term.

After all, when you buy a franchise opportunity you are looking for know-how, brand name and a solid system to back you up, one which understands how to run a totally efficient business model. Without this track record and history, how on Earth can you be sure as to what you are getting into?

If a franchisor has fewer than 20 franchisees then you need to talk with each one of them and listen carefully; how are they doing? If they are too new to know and are still caught up in the “buzz” of newness, then you must slow down your emotions and think logically. Remember a franchise investment is a serious thing. Do not take it lightly.

Recession has historically, and lately, had a number of profound effects on the way Americans live life. It changes the way Americans invest and save their finances, it changes how much people are willing to risk employment security for pay increases or lifestyle changes, and perhaps more than anything, it changes American’s spending habits. Because recession makes money tight, or at least threatens that it will soon be in short supply, people begin to cut back on the non-essentials and seek every possible means of expense reduction on the necessities. Whatever the particular reason for someone to reduce expenditures, the fact is that they are, and any business, franchise or otherwise, that can help them save their hard-earned, economy-threatened cash is likely to do well in this turbulent time.

Private Tax Preparation

Every year, individual Americans spend roughly $9bil on tax preparation services. That dollar figure comes out of the pockets of an estimated 62% of the American population, or 187,000,000 people. Few markets see such a large number of people within their reach, and there are probably only a few simple reasons that there are so many seeking tax preparation services each year. First, taxes are something that aren’t a choice; by the decree of Uncle Sam, every American must pay them or face the penalties for tax evasion. Second, although a person could file his own tax return, and some do, many Americans either haven’t the time or the skill to do it. Finally, one of the foremost reasons that people hire someone else to prepare their return is that they trust a professional to be better equipped to take advantage of all possible tax breaks, saving them money.

Aside from the current recession, tax preparation is a high-demand business, but particularly in light of our current economic malady, starting a tax-service franchise business is a great idea. Here are two franchises that afford just such a money-saving and money-making opportunity.

Expecting no previous tax experience from its franchisees, Roni Deutch Tax Center is a flexible yet lucrative franchise opportunity for entrepreneurs versed in management and customer service. The franchisor is both able and willing to teach new franchisees how to prepare tax returns and how to market their businesses, as long as they come with a willingness to learn. Once the franchisee is up to speed with everything he has to know to operate the franchise, he has some options, the largest of which being whether to operate a seasonal or year-round business. Unlike so many other tax preparation establishments, Roni Deutch Tax Center allows franchisees to decide whether they only want to be open during tax season, providing only that one service, or remain open throughout the year and offer other services to their clients as well. Options are good, and Roni Deutch Tax Center provides plenty of them.

Roni Deutch Tax Center isn’t the only name in the tax business, however; Liberty Tax Services and Liberty Tax Services Canada are two recognizable names in the industry. Liberty Tax Services is acclaimed as the fastest growing international tax-service franchise in the world, touting over 2,700 offices in the US and Canada. Led by tax icon John Hewitt, who has been recognized as one of Accounting Today’s 100 most influential accounting professionals, the leadership of this company has a combined total of 400 years of tax-industry experience, making them one of the most trustworthy lead staffs in the world. Mixing cutting-edge tax technology and simple customer service, Hewitt and his worldwide franchisees are changing the face of tax preparation.

Consumer Savings

As strange as it may sound, there are business opportunities in helping the “Joe the plumber’s” of the world spend less on their daily needs. People see many of these opportunities every day, often without even recognizing that someone is profiting from discounts offered at someone else’s retail or food business.

If you’ve ever received in the mail a small packet of coupons to local businesses, you already have a good idea of how a home based business like SuperCoups works. The SuperCoups franchisee takes on the task of selling coupon space to local business owners in his protected area. That means making calls to local businesses, getting out and “pounding the pavement,” targeting the best places in the mailing for each advertisement, and ensuring that your clients are getting their money back in sales that the coupons stir up. The best part is that when it comes to actually printing the mailer, the franchisee only has to send the order away to central HQ for printing and mailing.

Business Financial Services

Private citizens, though, are not the only ones trying to save a dollar wherever possible; businesses are hoping to do the same, because in some regards, the recession is hitting them the hardest. What it really boils to is that our current recession began with the banking industry, which has begun to eat away at the business sector, and that, in turn, is what is now really affecting individuals.

Therefore, a small business that helps fish other businesses out of financial trouble is a great aid to everyone, and Global Broker System is one of those helpful financial small businesses. One of the biggest problems facing small business today is the inability to get decent financing for growth, or even just for upkeep, but that is precisely what Global Broker System franchisees offer: relationships with good lenders who can help get smaller operations up and running again with lease financing, working capital loans, business acquisition financing, and more.

Using Trends to Your Advantage

It’s never easy to start a new business, especially with recession looming overhead, but knowing market conditions can help show you what industries are available and may actually be doing well in spite of, or because of, the market. For the time being, finding a business for sale in finance is a good move because finances have become such a hot-button issue.

Whether your loyal customers are beginning to admire your little café and can see it turning into a bigger place, or you are looking to expand your business with some saved up cash, opening a small business franchise can open a lot of doors for your growth and success.

But opening your own business franchise can be an intricate procedure. First thing you need is to find out which franchise will be suitable for you, and make sure that you understand and meet the franchisee requirements. There are a lot of options available in the market for a business franchise opportunity and every franchise has their own set of rules and regulations to follow, must sometimes they may cater to your specific area needs as well.

This is why you will need to review the contracts and business plans beforehand to be sure you comprehend them. An important thing is the capital you have at hand – You will need to make sure you can meet the expense of opening your own small business franchise.

There are a lot of benefits of opening a small business franchise.

You do not have to worry about brand recognition. When you open an established franchise, you will be launching a business with a name that is already widely known and respected. You will be able to focus on other aspects of your business than constantly having to market your name and brand to the people. An established brand will give you the energy you need to begin a business of your own.

An established franchise has a track record of success. This is one of the main comforts to entrepreneurs who choose to open franchise operations. The fact that the business framework they are executing has had the benefit of a history of success in other places can be a driving force for growth potential.

Any new business has enormous risk factor. With a new small business you always have a 50-50 risk-success ratio. But this success rate tends to be much higher for franchises. This is because when you open a franchise, you are opening a business that has a history of success elsewhere. Someone else has worked out the problems in the business model and has created an effective framework upon which new franchises can be built.

A franchise opportunity gives you corporate support. When you own a franchise, part of your franchise cost for is to make sure you have access to training and support from your company’s corporate headquarters. The company from which you purchase your franchise has a vested interest in seeing you succeed, and they know your business inside and out.

Another main advantage that franchise owners have is the ability to participate in company’s marketing promotions. Many franchise operations have extensive marketing support and advertising campaigns going on, which of course benefit the franchise owners. Most small business owners cannot afford this level of advertising support on their own.

This is why opening a small business franchise can be more productive than starting your own business. If you think being a franchise owner is right for you, you should investigate all of the options available so you can finalize your entrepreneurial plans.

Understanding the quality of a business is critical to being a successful investor, as it is a major determinant of what one should be willing to pay for a stock. Commodity cyclical businesses with poor economic characteristics might be worth at most 10 times normalized after-tax earnings — meaning a savvy investor would never pay more than five times earnings — while insanely great businesses such as eBay might actually be worth a very high multiple of today’s earnings (though at 92 times this year’s consensus estimate, eBay is significantly overvalued today in my opinion).

To determine how good a company is, it helps to think about what the perfect business looks like. Since the value of anything — companies, bonds, real estate, etc. — is the future free cash flows discounted back to the present, obviously the perfect business has huge free cash flows that will grow for a very long time. With this in mind, let’s examine the characteristics of the perfect business:

1. High profitability. If customers want or need a product or service very much, and only one company can provide it, then that company can charge prices far above its costs. Good examples are Microsoft– try using a computer without Windows or Word — and pharmaceutical companies , because many of its drugs save or vastly improve lives (so people really need them) and also are unique and patent-protected (so there are few, if any, substitutes). (Incidentally, I think margins across the pharma sector are likely to shrink for reasons I discussed in a column last month.)
2. High returns on capital. A company can have high margins but not be particularly attractive if it requires massive amounts of capital to launch or maintain its business. For example, Union Pacific ,has above-average net margins of 7.2% but only 7.0% returns on equity because railroads are so capital-intensive. The greatest businesses require little or no money to start, can grow without major additions of capital, and do not require much maintenance cap ex. Think eBay.
3. An enormous moat. Far more important than high margins and return on capital today is whether such characteristics can be maintained long into the future. Thus, it’s critical for a company to have major competitive advantages that are unlikely to be dissipated over time. The key here is lack of change — it’s amazing how few investors understand that rapid change (think most of the tech sector), while fun to watch and benefit from as consumers, is very bad for investors. Warren Buffett has said, “We see change as the enemy of investments… so we look for absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs…. I guarantee that Coke (NYSE: KO ), Wrigley, and Gillette (NYSE: G ) will dominate. The Internet won’t change what brands people like.”
4. Profitable reinvestment opportunities. The greatest businesses — a good example is Coca-Cola during its first 100 years — can reinvest their robust free cash flows back into the business at equally high rates of return on capital. For example, Warren Buffett has often lamented the fact that See’s Candies has never been able to expand much beyond its historical West Coast markets. It’s a fabulous company and was one of his best acquisitions ever, but the inability to reinvest its free cash flows back into growing its operations makes it an inferior business to, say, Wrigley, which has been able to grow globally over the years.
5. Future growth. I deliberately did not put this at the top of the list because, despite investors’ fixation with growth, I don’t believe it’s of paramount importance. Of course, all other things being equal, it’s better to have a company that can sell to vast worldwide markets (see the many examples above), but how many companies have crashed and burned mindlessly pursuing growth? It’s especially common among multiunit retailers that saturate their markets, yet keep building more units — look at what happened a few years back to the Gap and McDonald’s . Growth benefits shareholders only if a company can continue to earn good returns on incremental invested capital.
6. Good cash flow dynamics. Some companies tie up huge amounts of money in working capital, while the best companies actually receive cash from customers before they have to pay their vendors. This is measured by the cash conversion cycle (CCC), which is simply days of inventory plus days of accounts receivable, minus days of accounts payable. Dell (Nasdaq: DELL ), for example, has a CCC of negative 34 days, far better than its competitors — a major differentiating factor in a commodity business (especially one in which inventory is declining in value by the day). Or consider Wal-Mart, which over the past four years has reduced its CCC from 22 days to 15 days, thereby freeing up $4 billion of extra cash.

Case study of the money management business

As I wrote in one of my all-time favorite columns, Traits of Successful Money Manager , the best investors love what they do. Buffett has said at various times, “I’m the luckiest guy in the world in terms of what I do for a living”; “I wouldn’t trade my job for any job”; and “I feel like tap dancing all the time.” This is certainly true for me as well: I truly enjoy evaluating companies and industries and trying to outfox the market — no easy task , but a fun and challenging one.

While I chose this profession because I enjoy it and think I’m good at it, I’m certainly not complaining that it’s as close to the perfect business as any I can think of. Let’s go through the criteria above:

1. High profitability. Costs are low — in fact, I operated my business out of my home and had no employees for the first few years — and fees are (let’s be honest) high, especially if one is running a hedge fund (as I do).
2. High returns on capital. It costs almost nothing to get into the hedge fund business (it costs somewhat — but not much — more to open a mutual fund), growth requires little capital, and there’s virtually no cap ex.
3. An enormous moat. In this area, money management businesses don’t look so attractive, as there are almost no barriers to entry. On the other hand, a talented money manager is rare.
4. Profitable reinvestment opportunities. While money management businesses don’t require much capital to grow, the lack of reinvestment opportunities is hardly a disadvantage. The owners can simply take their profits and reinvest them in other attractive opportunities — that’s their business after all.
5. Future growth. The money management business is almost infinitely large worldwide and is growing at a healthy rate, so the sky’s the limit for a successful firm. In fact, the most successful ones tend to stop growing not because of lack of opportunities but because they choose to stop taking in new money.
6. Good cash flow dynamics. Investment firms have no inventories, and management fees are generally paid in cash, in advance. And for hedge funds, the promote is paid the instant that it’s earned, with zero risk of not getting paid. (The promote is the percentage of the profits — typically 20% — that is earned at the end of each year.)

It’s little wonder that Buffett has said, “Investing is the world’s best game. I was in the department store business where you have to match your competitors — it’s a business that throws defensive decisions at you all the time. We want a business where we don’t have to make defensive decisions. Investing is a perfect example. You can just watch ball after ball come through and sit and wait for just the right pitch.”

Hedge fund bubble?As money continues to pour into hedge funds — they attracted $46.6 billion during the first nine months of this year and now have $890 billion under management — there’s been a lot of talk about a hedge fund bubble. I don’t buy it. Given the economic characteristics detailed above, the only thing that surprises me is that it’s taken so long for so many smart people to get into the business. The fact that a large amount of capital is following such people is simply logical, not the sign of a bubble.

That being said, there’s a lot of leverage building up in every layer of the system, and many inexperienced people are starting funds. But this is a recipe not for a bubble bursting, in my opinion, but rather reduced returns industry wide (especially net of such high fees), as the happy hunting grounds in which hedge funds have typically made their profits become more and more competitive and picked over.