Reinvestment Moat Follow Up: Capital Light Compounders by John Huber, Base Hit Investing

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:

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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:

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:

Reinvestment Moat, Capital Light Compounders

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:

Reinvestment Moat, Capital Light Compounders

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

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