Buffett divides stocks into a small number of franchises floating in a sea of commodity businesses, most of which are not worth buying. His definition of a franchise is a company that provides a product or service that is needed or desired, has no close substitute and is not regulated. These traits give a franchise the power to raise prices regularly and without fear of losing market share or unit volume. Franchises have the potential to increase prices even during times of flat demand and underutilised capacity.  Franchise businesses may also possess greater amounts of economic goodwill, enabling them to better withstand the effects of inflation.

A commodity business offers a product that is virtually indistinguishable from those of competitors. Despite mammoth advertising budgets consumers know well enough that there is very little difference between brands. The only way that most commodity type businesses can compete is on price, which of course does put a dampener on profits. The most dependable way to make a good profit in a commodity business is to be the low-cost provider.

The only other time that a commodity business can make a good profit is during times of tight supply, though in many industries this period can be unpredictable but brief. Buffett quips that the last time Berkshire's textile division enjoyed a supply-tight period, it was over in the "better part of a morning".

Franchises can be financially bullet-proof. Their strength lies in the potential to freely raise prices and earn high rates on invested capital. Franchises are more tolerant to financial mismanagement, they are businesses where mistakes can be made and above-average returns can still be achieved. Inept managers can reduce profitability, but seldom inflict mortal damage. The perfect example being Coca-Cola, which was run in the 1970s by an autocratic CEO who insisted on diversifying into unproductive ventures like Shrimp farming, bought a winery (which irritated people no end as it now meant that Coke was now associated with alcohol) and to deflect all the criticism they directed an unprecedented amount of money into advertising. Despite this ineptitude the company survived until the 80s when a new CEO was able to undo all his predecessors wrongs which prompted a boom in Coke's share price.

The major complication with franchises is that nothing can last for ever unchallenged, and sooner or later the high returns on investment in that industry may prompt other players to enter the fray in direct competition. Substitutes may be introduced and the gap may narrow. At this stage a strong franchise may deteriorate into a "weak franchise" and then a "strong business" before finally declining into a commodity business.

When the franchise's position is challenged, management suddenly becomes extremely important. A franchise can survive management blunders that will kill a commodity business.