Principles: Identifying Great Businesses
Two Types of Moats
The term “economic moat” popularized by Buffett is often defined as a durable competitive advantage that allows a business to earn high returns on capital for a long time.
Such businesses are rare but we can further divide them into two types of moats:
Legacy Moats
Reinvestment Moats
Most businesses with a durable competitive advantage belong to the Legacy Moat group, meaning the companies earn strong returns on invested capital (ROIC) but do not have compelling opportunities to deploy incremental capital at similar rates.
The Reinvestment Moat group contains the set of truly elite businesses. They have all of the advantages of a Legacy Moat, but also have opportunities to deploy incremental capital at high rates. Businesses with long runways of high-return opportunities can compound capital for long stretches, which inevitably result in unusually high stock portfolio returns.
Legacy Moat Characteristics
In this group, businesses have strong competitive position in their respective industries, they generate consistent earnings, and have returns on invested capital that are much higher than the cost of capital.
Even better, there are some companies that can grow modestly without additional tangible capital. However, because there are no reinvestment opportunities offering those same high returns, whatever cash the business generates must be deployed elsewhere or given back to the owners.
This is the problem with many large businesses such as Hershey’s, Coca-Cola and MCD. These companies payout at least 60% of earnings as dividends. It makes sense for them since they do not have enough attractive reinvestment opportunities to justify retaining capital.
Even though these Legacy Moat businesses produce high ROIC, leaving aside the purchase price, an investor will only realize returns much lower than their ROIC. This is because this ROIC is on prior invested capital rather than incremental invested capital, coupled with a low reinvestment rate.
In other words, a 20% reported ROIC today is not worth as much to an investor if there are no more 20% return opportunities available to direct the profits.
Equity ownership in these businesses ends up resembling a high-yield bond with a coupon that should increase over time. There is nothing wrong with this, Legacy Moat group is good for preserving capital, but not necessarily significant out-performance. If we are looking to compound at unusually high rates, the focus needs to shift to identifying businesses that fall in the Reinvestment Moat group.
Reinvestment Moat Characteristics
Companies in Reinvestment Moat group have current profits protected by a Legacy Moat, so their core earnings power are maintained. But instead of sending earnings back shareholders, a large portion of capital will be retained and deployed into opportunities that have high expected returns.
For example, Walmart in 1972 had 51 stores opened and the overall business generated a 52% pre-tax return on net tangible assets. Clearly, their early stores were great, dominating small towns with a devotion to low prices. Each store had a moat that Sam Walton could reasonably be assured that the earnings power would grow over time. So the clear path forward is to redeploy the cash existing stores produced into building new stores. America is big, the runway is long. Today, there are more than 10,750 stores globally. The ability to reinvestment at good rates resulted in earnings growing by 5,300x since 1972.
Treasure Hunt
All of the above is not rocket science, you can even say it’s common sense. Then how can we find these Reinvestment Moat types of companies?
We are essentially looking for a business that defies capitalism. Isolated profits in a small market is one thing, but continuing to achieve high returns on incremental capital for decades should, in theory, not be attainable.
We are led to believe that as a business gets bigger, the profits also become larger, competition will come and returns should eventually compress. However, we are looking for a business that actually becomes stronger as it gets bigger.
We think that there are 2 factors that lend itself to this kind of positive reinforcement:
1. Low cost production & economies of scale.
2. Two-sided network effect.
Low cost & Economies of Scale
Using the Walmart example again, due to their low cost of production Walmart was able to offer lower prices than competitors. So the more stores Walmart built; the more customers it attracted. It’s a volume game.
Businesses like Costco and GEICO follow the same playbook. The bigger they get, the more entrenched they are.
Two-sided Networks
Creating a two-sided network such as an auction or marketplace business requires both buyers and sellers. Both groups only show up if they believe the other side will also be present. Once the network is established, it actually becomes stronger as more participants from either side engage.
As more buyers join, it attracts more sellers and in turn attracts even more buyers. Once this flywheel is in place, it becomes nearly impossible to convince either group to leave. Examples include Copart, META, Amazon.
Time Factor
Most of the work involves identifying the features of the Reinvestment Moat. But there’s also another factor that contributes to compounding; how long is the business able to sustain the high reinvestment rate and continue to get high returns on those incremental capital?
The key to identifying long runways is not extrapolating quarterly or yearly growth rates. We need a rationale to believe that strong growth can be sustained over decades.
Admittedly, this is the most difficult factor because there are many variables and uncertainties unique to every business case. But there are some signs that can help us along the way…
Flow through Margins
Look out for businesses that own two-sided networks and are able to onboard the marginal customer at no additional cost. This feature protects margins as the business grows.
Operational Advantages
These are structural or cultural features that enable the business to operate efficiently with low cost. For example, GEICO has a business model for selling 100% through direct channels, resulting in the lowest cost producer at scale for auto insurance.
Or NVR, the homebuilder doesn’t participate in land development and offers limited customisation options, resulting in much higher inventory turn and return on capital.
These are operational features that cannot be copied by incumbents because that will usually mean a complete redesigning of their business models.
Replicable Unit Economics
Business models that can copy and paste themselves without losing unit economics can also contribute to a long runway.
Costco is a good example. They operate warehouses with low SKUs and buy in bulk, developing close relationships with suppliers, which result in better bargaining power. Then Costco transfers these cost savings to customers by artifically capping gross margins. On the other hand, their membership fees scale without incremental cost. With this model in place, all Costco has to do is copy and paste the warehouse blueprint.
Pay up for Quality
If you made it this far, there is still the final question of valuation. What is a fair price to pay for the treasure you found?
Many people turn to PE ratios (or some other multiples-based metric) and often make the error of omission.
As an exercise, imagine 2 companies: Reinvest Corp. (RC) versus Undervalued Corp. (UC)
Both start with current earnings of $100.
RC is able to reinvest 70% of profits at 40% returns. It retains 100% of capital.
UC reinvests only 20% of profits at 30% returns. It pays out 80% of profits as dividends.
Thus, RC compounds at 28% (= 70%*40%). While UC gets 6% (= 20%*30%).
The market acknowledges this and gives RC a higher PE 30x, and UC trades at low PE 10x.
For comparison, suppose that at Year 10 both companies trade at PE 15x.
At Year 10,
RC earnings = $922
UC earnings = $169 + cumulative dividends $1054
At PE 15x,
RC market value = $13,830 (4.6x returns)
UC market value = $2,535 + $1,054 dividends = $3,589 (3.6x returns)
As expected, the optically cheap UC did not achieve better results even though the exit multiple was a +50% boost for UC and a -50% penalty for RC.
This exemplifies Charlie Munger’s quote:
If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.
Time is the friend of businesses in the Reinvestment Moat group!
Role of Management Teams
Given all the benefits of finding Reinvestment Moat, it does not mean that it’s a one way street. Legacy Moat businesses can outperform when they are run by good capital allocators.
In other words, the Reinvestment Moat becomes management’s ability to allocate capital wisely.
Although there are more bad examples of value destructive M&A in corporate history, we know of some good capital allocators like Berkshire and HEICO. These management teams take cashflows from Legacy Moat subsidiaries and redirect them to other areas, combined with a partnership attitude, clever incentives structure, and long-term mindset, such business models can achieve outsized returns.
After all that writing, we hope this sheds some light on why we put emphasis on business economics and capital allocation. Focusing our efforts within our competencies allows us to maximize the chance of correctly identifying gems.