Revisiting 'Gross Revenue Royalties'

A short article on the original 'quality' framework

John Huber of Sabre Capital Manager and Base Hit Investing brought up an interesting idea during his latest blog post:

Warren Buffett has famously said “the best business is one that is a royalty on the growth of others”.

…. A royalty on the growth others.

The more granular detail behind this idea was (by my reckoning anyway) first expressed in a 1979 article by John Train entitled Warren Buffett: The investor’s investor:

(Image sourced from Conor MacNeil of Investment Talk - article in the link)

Quote:

The few businesses that Buffett thinks are worth owning often fall into the category he calls “gross profits royalty” companies, perhaps better called “gross revenues royalty” companies: TV stations, institutional advertising agencies, iron-ore landholding companies, [and] newspapers. Benefiting directly from the large capital investments of the companies they serve, they require little working capital to operate, and, in fact, pour off cash to their owners. The unfortunate capital-intensive producer - Chrysler, Monsanto or International Harvester - can’t bring its wares to its customers’ notice without paying tribute to the “royalty” holder: The Wall Street Journal, J. Walter Thompson, the local TV station, or all three.

The three critical elements of this idea:

• Benefiting directly from the large capital investments of the companies they serve,

• They require little working capital to operate, and, in fact, pour of cash to their owners,

• The unfortunate capital intensive producer can’t bring its wares to its customers’ notice without paying tribute to the “royalty” holder.

Updating the Model

It’s an interesting exercise applying this approach to today’s available investment opportunities. While the concept neatly fits media (which has since converged with technology and the internet), in my mind, its application has transmuted much better into standards (SPGI, MCO, FICO), networks (V, MA), and software (ADBE, AZPN, MSFT). Although there is no denying that each of the “MAG 7” resemble royalties in varying degrees (Amazon’s purported retail take rate of 55% couldn’t be described any other way).

Another way to frame the first critical element is to think in terms of a ‘small, critical part of a much larger value chain’. These situations are generally more pervasive. A plane simply can’t fly without industry standard AMSAFE buckles. You can’t get a 30 year mortgage without a FICO score. If you want to list your shares publicly in Australia you can only do it on one exchange. You get the point. The control linchpin between a product or a service and the ability to deliver it to customers can be extremely valuable.

I take no particular issue with the need minimal working capital and returning plenty of cash to shareholders - that element is evergreen.

My own approach has gravitated more and more towards this kind of investing. It would be appropriate to say that as a general rule I have been trying to find the ones that are more nascent in monetising their market positions. It isn’t often that the names I have already mentioned get to attractive prices.

Larry.