Shares of the world’s largest specialty retailer were recently added to the Steadyhand Equity Fund. Why? Because Starbucks is now a “franchise” company – that is to say, a great business, run by great people, trading at a good price. These are the three factors that the manager of the fund, Cranston, Gaskin, O’Reilly & Vernon (CGOV), closely scrutinizes when deciding whether a business qualifies as one of their top 25 ideas (they hold a maximum of 25 stocks in the fund).

The addition of a new name to the fund provides a good opportunity to walk through CGOV’s stock evaluation process and their definition of a “franchise” company. I’ll make this as plain English as possible, so no need to grab a venti double shot latte to stay awake.

Let’s start with the business. Starbucks has transformed the way people think about and drink coffee (as a non-coffee drinker, they’ve even converted me into a semi-regular customer thanks to their blended cremes and frappuccinos). The company is innovative, highly profitable, a leader in its industry, and has become one of America’s most recognizable brands – like it or not. And although it may seem like there’s a green awning on every corner (in Vancouver, at least), the business still has plenty of opportunity for expansion, especially in the promising Asian markets.

Now for the people. CGOV thinks highly of Starbucks’ management team. They are effective allocators of capital (they know where and how to reinvest profits in their business), have plenty of experience, a clear vision, and a clear alignment of interests with their shareholders (they want to see their stock price rise).

And finally, price. By early July, Starbucks’ stock price had fallen nearly 25% since the beginning of the year, due in part to sluggish U.S. sales and higher dairy prices. The valuation of the stock dropped to roughly 24X next year’s earnings, which CGOV believed marked an attractive entry point (the stock had been on their radar screen for a while), given the company’s potential for 18-20% earnings growth over the next five years.

This last factor, price, is often the most difficult determinant in any investment decision. A good business is pretty easy to find, a management team can be evaluated on their past accomplishments and experience, but what represents a good price? There are certainly other specialty retailers trading at lower valuations than Starbucks. In this case, however, the manager felt that the company’s growth prospects, in combination with its brand power and ability to generate lots of cash, justified a slightly higher price. Not to mention the stock has historically traded at much higher valuations.

Starbucks has always been a great business run by great people, but it hasn’t always traded at a good price. It was this latest drop in valuation that moved the stock into “franchise” status according to CGOV’s criteria.

While this is a rather simplified overview (CGOV’s research process involves much more number crunching, forecasting, and discussion with management), it’s a good example of what CGOV looks for in a “franchise” company.

Recognizing that "franchise" companies are hard to come by, the manager also invests a portion of the fund’s assets in "non-franchise" companies (of the fund’s current 25 holdings, 5 are non-franchise companies). These are good businesses, run by great people, trading at great prices. But this is the subject of another blog and I’m craving a raspberry mocha frappuccino.