Types of Economic Moats
Low/No Moat, Legacy Moat, Reinvestment Moat, Capital-Light Compounder
Economic moats are the unique collection of competitive advantages that allow for a durable business. No one moat is the same.
Connor Leonard, a renowned investor currently working at Investors Management Corporation, a Berkshire-Hathaway-like company, developed a useful framework for thinking about moat outcomes. He identified four types of moats, as shown below.
The following sections piece together excerpts, alongside my edits and commentary, from the various sources that are cited at the end of the article.
Low/No Moat
Low/No Moat companies may be perfectly well run and sell good products/services, but which do not exhibit characteristics that prevent other companies from competing away their profits if they start earning attractive returns. Most companies fall into this category.
Low/No Moat companies lack durable competitive advantages. They are subject to the environment and governed by luck more so than control.
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.
Legacy Moat
Businesses with a Legacy Moat possess a solid competitive position that results in healthy profits and strong returns on invested capital. Because there are no reinvestment opportunities offering those same high returns, whatever cash the business generates needs to be deployed elsewhere or shipped back to the owners.
Even if a business does have a moat, they might not have much of an opportunity to reinvest more capital that is protected from competition.
Plenty of companies make the mistake of using their cash flow to get into entirely new businesses or spend superfluously, in hopes of extending the life of their moat. But smart management teams recognize this sort of moat as an opportunity to milk cash flow out of the business in the form of dividends while simply maintaining, rather than expanding the business.
Think of a self-storage facility in a rural town with a high occupancy rate and little competition. This location may be generating $200,000 of annual free cash flow, a solid yield on the $1,000,000 of capital used to build the facility. As long as they run a tight operation, and a competing storage facility doesn’t open across the street, the owner can be reasonably assured that the earnings power will persist or modestly grow over time.
But what does the owner do with the $200,000 that the operation generates each year? The town can’t really support another location, and nearby towns are already serving the storage demand adequately. So maybe the owner invests it in another private business, or puts it towards savings, or maybe buys a lake house. But wherever that capital goes, it likely won’t be at the same 20% return earned on the initial facility.
This same dilemma applies to many larger businesses such as Hershey’s, Coca-Cola, McDonald’s or Proctor & Gamble. These four companies on average distributed 82.4% of their 2015 net income out to shareholders as dividends. For these companies that decision makes sense, they do not have enough attractive reinvestment opportunities to justify retaining the capital.
Even though these Legacy Moat businesses demonstrate high returns on invested capital (ROIC), their high ROIC reflects returns on prior invested capital rather than incremental invested capital. In other words, a 20% reported ROIC today is not worth as much to an investor if there are no more 20% ROIC 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 absolutely nothing wrong with this, businesses like Proctor & Gamble and Hershey’s provide a steady yield and are excellent at preserving capital but not necessarily for creating wealth. If you are looking to compound your capital at unusually high rates, the focus needs to shift to identifying businesses that also possess a Reinvestment Moat or Capital-Light Compounders.
Beyond the Returning Capital Legacy Moat, discussed above, Leonard carves out an opportunity for Outsider Management Legacy Moats. The idea of outsider management is most aptly described in the book The Outsiders, which describes a series of CEOs whose focus was on the effective deployment of capital. These CEOs brought new ideas and leveraged the existing cash flow to find new opportunities, whether opportunistically buying back stock or acquiring new businesses, effectively expanding the business into new areas. Great management teams have created an abundance of wealth for their shareholders. However, this caliber of management team is hard to find. Many legacy moat companies have attempted these types of expansions and few have been successful. AT&T is a prominent example.
Reinvestment Moat
A company that is insulated from competition and has the opportunity to reinvest their cash flow into growing the business.
Reinvestment Moat characterizes many large, high-quality growth companies. These are companies with strong competitive advantages around their core business, similar to Legacy Moats.
Instead of shipping the earnings back to the owner, however, the vast majority of the capital is retained. Because their markets are not yet saturated, they have the ability to reinvest into growing their business. They deploy earnings into unique investment opportunities that have a high likelihood of producing high returns.
Businesses with long runways of high-return investment opportunities can compound capital for long stretches, and a portfolio of these exceptional businesses is likely to produce years of strong returns.
Think of Wal-Mart in 1972. There were 51 locations open at the time and the overall business generated a 52% pre-tax return on net tangible assets. Clearly their early stores were working, they dominated small towns with a differentiated format and a fanatical devotion to low prices. Within the 51 towns, each store had a moat and Sam Walton could be reasonably assured the earnings power would hold steady or grow over time.
Mr. Walton also had a pretty simple job when it came to deploying the cash those stores generated each year. The clear path was to reinvest the earnings right back into opening more Wal-Marts for as long as possible. Today there are over 11,000 Wal-Mart locations throughout the world and both sales and net income are up over 5,000x from 1972 levels.
The key to Reinvestment Moats is not the specific growth rate forecasted for next year, but instead having conviction that there is a very long runway and the competitive advantages that produce those high returns will remain or strengthen over time.
Capital-Light Compounder
A company that is insulated from competition and has the opportunity to grow, but which doesn’t need to reinvest much cash to do so and is therefore able to return cash to shareholders even while growing.
A Capital Light Compounder is a business which exhibits strong competitive advantages and has significant growth opportunities, but which does not need much capital to pursue growth. These businesses earn good returns today and have the opportunity to grow materially in the years ahead. But they earn such strong returns on capital that they tend to always have cash pouring out of their business, even when growing rapidly or during recessions.
These Capital-Light Compounders are able to increase earnings power with zero or even negative capital employed. They do so by typically exhibiting negative working capital, low fixed assets, and real pricing power.
Capital-Light Compounders stand out in an inflationary environment. Due to the lack of physical assets, revenues increase without the corresponding need for heavy capital expenditures at inflated rates.
During good times, these businesses can pursue their core growth opportunity, while also paying dividends, buying back stock opportunistically or executing an acquisition when an attractive situation presents itself.
Because they produce an abundance of cash, these businesses are resilient during difficult environments, wherein they pursue opportunities just at the time when their competitors are forced to play defense.
The fact that these businesses are so valuable (in short, because they can grow quickly while returning lots of cash to shareholders at the same time) means that these stocks often do not look statistically cheap on simplistic measures like PE ratios. This leads to value investors often ignoring them believing they are too expensive, while growth investors will often only be excited during the early stages of rapid growth but lose interest when the growth rate slows to solid, but not exciting, levels.
Closing
Leonard’s framework helps in thinking about the benefits and characteristics of different types of moats. The nuanced differences between competitive advantages, operations, and opportunities can make outsized differences to investment results.
Legacy Moats, producing consistent and protected earnings with strong returns on prior invested capital, are the most common type of moat and are perfectly well-suited for investors looking for nice, comfortable returns.
Investors looking to compound capital at high rates may want to look into businesses with a Reinvestment Moat or Capital-Light Compounders with a very long runway. These businesses exhibit strong economics today, but more importantly possess a long runway of opportunities to deploy capital at high incremental rates.
Sources
Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
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