This post is the second guest post by my friend Connor Leonard, in what I hope to be a somewhat regular “column” here at BHI (by regular, I mean as often as Connor decides to put the proverbial pen to paper and share his insights with us). Based on the quality of his work, he’s welcome back anytime.
What follows is what I’ll call “Part Two” to his excellent post on Reinvestment Moats vs. “Legacy Moats”.
Here is Connor’s post:
Reinvestment Moat Follow Up
A couple of months ago John invited me to contribute a guest post to Base Hit investing (link) where I discussed the difference between Legacy Moats and Reinvestment Moats. While I encourage you to read the post for the full explanation, below is a quick summary:
Low/No Moat: The typical business you encounter during the day likely falls into this bucket, such as your average convenience store or insurance agency. These are perfectly fine businesses and likely provide employment within the community and a solid product or service to customers. However without a sustainable competitive edge it will be difficult to earn exceptional returns as an investor owning a Low/No Moat business unless you time the entry and exit well. Specifically the game plan has to be to buy at a discount (say $.50 on the dollar) and exit at around fair value ($.95 – $1.00) in a relatively short amount of time[i].
Legacy Moat – Returning Capital: These businesses have an entrenched position within current markets that enable strong and consistent profitability relative to the prior invested capital. However there are few opportunities to deploy incremental capital at similarly high rates, so the management team decides to distribute the majority of the earnings back to owners at the end of each year. This is a prudent move by the management team, and essentially turns the company into a high yield bond. Many “wide moat” companies such as Procter & Gamble and Hershey’s successfully follow this strategy, distributing 80%+ of annual earnings out as dividends. While this investment profile is adequate for many, if you are aiming to compound capital at 15% – 20% rates it likely will not come from owning this kind of business over a long stretch.
Legacy Moat – “Outsider” Management: Here you have a business with all of the characteristics of a Legacy Moat, but the management team decides to retain all of the capital and deploy it into new businesses through a focused M&A program. The home office effectively serves as an internal private equity fund, using the permanent capital supplied by the operating companies to fund a disciplined acquisition effort. When the right businesses are paired with an exceptional capital allocator, the result can be remarkable compounding of shareholder capital such as Berkshire Hathaway (Buffett), Tele-Communications Inc. (Malone), and Constellation Software (Leonard).
Reinvestment Moat: This is the rare company that has all of the benefits of a Legacy Moat along with ample opportunities to deploy incremental capital at high rates within the current business. In my opinion this business is superior to the “Legacy Moat – Outsider Management” because it removes the variable of capital allocation: at the end of each year the profits are simply plowed right back into growing the existing business. This is the purest form of a “compounding machine” and when combined with a long reinvestment runway the result can be a career defining investment. Examples listed in my last post include GEICO, Walmart, and Amazon.
Following my initial write-up I noticed some questions and discussion around a fourth type of business: companies that can grow revenue and earnings without requiring additional capital. In this follow up post I thought it would be useful to discuss the characteristics of these “Capital-Light Compounders”, the playbook for how they should be run, and some current examples. Consider it an addendum to the original write up:
As an investor I’m constantly looking for businesses that I believe can increase intrinsic value per share at a high rate over a long period of time. As John outlined in a recent post (link), a simple formula for estimating the rate of increase in intrinsic value is:
This makes sense, if a company keeps 50% of earnings and reinvests that capital at a 20% rate, over time that should add about 10% to annual earnings power, thereby increasing intrinsic value by 10%. However there are a handful of companies that defy this logic. These “Capital-Light Compounders” are able to increase earnings power with zero or even negative capital employed. How do these companies accomplish this feat?
There are a couple of common characteristics in almost all Capital-Light Compounders, specifically negative working capital, low fixed assets, and real pricing power.
Negative Working Capital:
To determine the working capital structure of a company examine the balance sheet over the last few years and do some quick math to calculate the typical levels:
Note: For this calculation I advocate using round numbers and rough estimates for excess cash. Working capital is dynamic and it is not necessary to calculate a precise number down to the last dollar to arrive at a general conclusion[ii].
A typical business will have a positive number for this calculation, however certain companies will be consistently negative – these are the ones we are looking for. Negative working capital often means the customers are paying the company cash up front for goods or services that will be delivered at a later time. This is a powerful concept for a growing company, as the customers are essentially financing the growth through pre-payments. Best of all the interest rate on this financing is 0%, pretty tough to beat. It is common to see negative working capital in subscription-based business models where customers pay up for recurring service or access. Some examples include SiriusXM, Verisk Analytics, and Atlassian. Because revenue is recognized when the service is performed, which is after the cash comes in, these businesses typically have operating cash flow that exceeds net income.
Low Fixed Assets:
The second characteristic of a Capital-Light Compounder is low fixed asset intensity, which can be analyzed by comparing net PP&E and/or capital expenditures to annual sales. If a typical manufacturing business wants to grow it will require significant capital investments in new factories, machinery, and trucks. Instead we are looking for companies that make money based off intangible assets such as brand name, intellectual property, or developed technology. A classic example is a franchisor, such as Dairy Queen, Burger King, or Winmark. In this business model the franchisor collects a royalty from franchisees in exchange for the use of the brand name, business plan, recipes, and other proprietary assets. The overall system grows as franchisees supply the capital to build new locations, enabling the franchisor to increase revenue and earnings without deploying additional capital. The key factor to focus on when analyzing a franchisor is the cash-on-cash returns the franchisees earn from building new locations. If this metric remains strong, the brand should have a long runway of unit growth ahead.
Real Pricing Power:
Finally if the business provides a product or service that is differentiated, has high switching costs, and is critical to customers it may be able to consistently raise prices at levels exceeding inflation. This is the simplest way to grow earnings without additional capital because the flow-through margins on price increases should be extraordinarily high. Companies such as CapitalIQ and See’s Candy have long histories of raising prices at or above inflationary rates, and Buffett considers this one of the most important variables when analyzing a business:
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
So if you run a Capital Light Compounder that is fortunate to have all of these characteristics, what is the playbook for maximizing intrinsic value per share? One option would be to allocate the excess capital into mergers and acquisitions in an effort to grow earnings power. The issue here is that if you start with an exceptional business like Visa or Moody’s, it’s almost certain that the acquired business is inferior and will dilute the overall quality. Additionally, acquisitions can end up becoming a distraction that take management’s time and focus away from the core “crown jewel” business. The classic example of this pitfall is Coca-Cola in the 1980’s, which allocated proceeds from the core business into acquiring Columbia Studios before refocusing a few years later.
Instead my preference would be for management to undertake a systematic share buyback program, what Charlie Munger would affectionately label as “cannibalizing” their own share count over time. Instead of acquiring a new business and the risks associated with that strategy, the management should instead direct M&A funds towards acquiring more of the exceptional business that the shareholders already own. Aggressive share shrinkers such as NVR, Inc., AutoZone, and DirecTV successfully reduced share count by over 50% within ten year stretches.
This strategy creates a “double dip” for shareholders that can greatly enhance the compounding of intrinsic value per share. Imagine you own shares in a Capital-Light Compounder that is about to begin a decade long run of share cannibalization. Over that stretch, the business may increase earnings power at 10% per year, which would typically result in a ~10% return to an owner if the valuation multiples were held constant. However in this case additional capital was not required to grow, so instead 100% of earnings power was available for ongoing share repurchases, raising the IRR on the investment to 17.9% (refer to calculations below). This formula is how certain companies can turn solid growth into exceptional shareholder returns over long stretches.
Note: even the best Capital-Light Compounders require some annual capital expenditures, so the amount of earnings allocated to share repurchases will probably be less than 100%. This example is more for illustrative purposes.
Are “Capital-Light Compounders” superior businesses to “Reinvestment Moats”? My current thought is that in an inflationary environment the Capital-Light Compounder is the preference because the lack of physical assets enables revenues to increase without the corresponding need for heavy capital expenditures at inflated rates. It is an interesting topic to debate, one which certain investors have weighed in on overtime:
“The best business is a royalty on the growth of others, requiring little capital itself.” – Warren Buffett[iii]
[i] Many great investment careers have been built on this method, I am not knocking it at all, it’s just a different approach from the one I focus on. I think the key to identify what approach works best for your personality and then be disciplined within that framework.
[ii] Calculating excess cash is more art than science. Some investors would advise you to remove all cash from this calculation, personally I believe you need a reasonable amount of “cash in the drawer” for a business to run.
[iii] From John Train’s The Money Masters – which has an excellent chapter on Buffett
Connor Leonard is the Public Securities Manager at Investors Management Corporation (IMC) where he runs a concentrated portfolio utilizing a value investing philosophy. IMC is a privately-held holding company based in Raleigh, NC and modeled after Berkshire Hathaway. IMC looks to partner with exceptional management teams and is focused on being a long-term owner of a family of companies.