Reinvestment Moat Follow Up: Capital Light Compounders | Base Hit Investing 8/8/17, 5(04 PM

Reinvestment Moat Follow Up:

Capital Light Compounders
Posted on August 1, 2016 John HuberPosted in Education, Investment
Philosophy

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. Connor and I live in Raleigh, NC, and get together regularly to share
investment ideas. I encourage you to reach out to us if you’d like to meet up
sometime for coffee. My contact info is on this site, and his contact info can
be found at the bottom of this post.

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

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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

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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:

Capital-Light Compounders

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

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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:

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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

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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

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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.
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[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. For more information
visit www.investorsmanagement.com or reach Connor at
cleonard@investorsmanagement.com, or on Twitter at @Connor_Leonard.

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