Sometimes Warren Buffett divides companies into franchise companies and commodity companies. A franchise company is another name for a company with a strong economic moat. In the 1991 Annual report of Berkshire Hathaway, Buffett explains that an economic franchise "arises from 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."
He continues,
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. Moreover, franchises can tolerate mismanagement. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.
In contrast, a commodity company has products or services that that are indistinguishable in the minds of consumers from those of its competitors. Sometimes Buffett simply refers to such companies as “businesses” rather than commodity businesses. He writes:
In contrast, a “business” earns exceptional profits only if it is the low-cost operator or if supply of its products or services is tight. Tightness in supply usually does not last long. 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.
In practice, most enterprises fall somewhere between being an economic franchise and a business. Also, just because an enterprise was once an economic franchise, does not man that it will always be one. It is important that the enterprise understands what makes it special and actively works to maintain this while at the same time fighting costs.
