How Moats Make a Difference

In our writing here we’ve made clear the the single most important element of our investment approach is focusing on companies that have a wide competitive moat. Usually when people talk about different kinds of moats, they are referring to the elements of the business model that give rise to the company’s competitive advantages. These concepts, like being the low cost producer, having proprietary intellectual property or exhibiting network effects, have been well documented by many writers. Morningstar’s book Why Moats Matter offers an excellent overview. But just as important is the different types of opportunities that different types of moats can afford companies.

Our friend Connor Leonard who runs the public market portfolio at Investors Management Corporation has developed an excellent framework for thinking about moat outcomes.

Connor explained his thinking in two posts on Base Hit Investing last year, which you can read here and here. Here’s a quick overview:

  • Low/No Moat: Companies that may be perfectly well run and sell good products/services, but which do not exhibit characteristics that prevent other companies from competing away there profits if they start earning attractive returns. Most companies fall into this category.
  • Legacy Moat-Dividend: A company that is insulated from competition, but does not have much opportunity to grow through reinvesting cash flow. So they pay most of their cash earnings out as dividends.
  • Legacy Moat-Outsider: A company that is insulated from competition, but does not have much opportunity to grow through reinvesting cash flow. So they deploy their cash flow in service of acquiring other companies as well as paying dividends and opportunistically buying back stock, as described in the book The Outsiders.
  • Reinvestment Moat: A company that is insulated from competition and has the opportunity to reinvest their cash flow into growing the business.
  • 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.

Our approach to investing is very similar to Connor’s and we thought it would be worth looking at our approach and portfolio holdings through his framework.

Low/No Moat

We strive to avoid investments in this category. Morningstar, which rates companies based on an assessment of the quality of their moat, only assigns a Wide Moat rating (their top rating) to 10% of the companies they cover. But they assign the Wide rating to about 67% of the stocks in our portfolio and give a Narrow moat rating to another 28% (these percentages exclude the few companies in our portfolio that they do not cover).

We believe that Low/No Moat companies are so subject to the competitive nature of the markets in which they operate that their future is far more governed by luck than by conditions within their control. There’s no doubt that the stocks of these companies can experience periods of fantastic performance. And those that are in the right place at the right time can generate massive returns for shareholders. But we systematically avoid investing in these companies because we don’t believe we have any particular edge in understanding when is the best time to own them.

Note that Morningstar does rate our holding in National Oilwell Varco (NOV) as having No Moat. However, until 2015 they rated the company as having a Wide Moat. As oil prices fell, they downgraded the rating first to Narrow and then final to No Moat as a new analyst picked up coverage. We believe that this analysis is flawed.

Legacy Moat-Dividend

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 throw more capital against the wall hoping they can extend 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 this sort of business as like a toll bridge connecting two busy cities. Building more toll bridges is futile, but so long as the number of people wanting to cross the bridge is steady, the business can throw off lots of cash in the form of dividends and is clearly valuable.

We don’t invest in many of these businesses as the “yield sign” in Connor’s framework suggests. But these sorts of businesses can make sense if the stock price is cheap enough. The closest to this type of holding in our portfolio is Pepsi (PEP), which over the last three years has returned more than 90% of its net income to shareholders in the form of dividends and share buybacks. But we think that Pepsi also has more growth potential than investors give it credit for and is thus a hybrid between a Capital-Light Compounder (see below) and a Legacy Moat-Dividend company.

Legacy Moat-Outsider

The book The Outsiders by William Thorndike is probably one of the most influential investing books of recent years, in no small part because it was recommended by Warren Buffett in one of his annual letters. The book is a series of case studies that describes how a small number of CEOs have used cash generative businesses as platforms to drive massive returns for shareholders by directing excess cash opportunistically between large stock buybacks, special dividends and acquisitions of other businesses. While studies show that mergers and acquisitions as a group are value neutral or negative for shareholders (on average the selling company gets all the excess returns), The Outsiders explored how some management teams focused on driving shareholder value with their M&A rather than simply using it as a mechanism to get bigger, have shown extraordinary success.

This category includes companies that have strong moats around their current business, but rather than simply paying out excess cash to shareholders they deploy cash opportunistically across various strategies, including mergers and acquisitions. In our portfolio, TransDigm (TDG) is the clearest example of this strategy and in fact the company was briefly mentioned by Thorndike in his book.

At Ensemble we do not focus on this type of business and believe that the bar for a management team to demonstrate the ability to execute this approach is so high that it is a relatively special situation and there are not a large number of these sorts of investment opportunities.

Reinvestment Moat

This sort of moat characterizes many large, high quality growth companies. A Reinvestment Moat company has the strong competitive advantages around their core business as seen in the Legacy Moats, but their market is not yet saturated and the company has the ability to reinvest the cash they generate into growing. One classic case of this sort of business is Home Depot in the 1990s. The company was pioneering the home improvement big box business model and from 1990 to 2000 was able to growth revenue from $2.8 bil to $38.4 bil (30% annualized growth), while net income went from $112 mil to $2.3 bil (35% annualized growth). It was able to do this because its business had solid returns on capital and the market was large enough that the company was able to reinvest all of the cash it was able to generate while borrowing even more money to fuel its growth.

Most businesses don’t have this opportunity. Returns on their existing business may be strong, but most companies don’t have the opportunity to reinvest their earnings at similarly attractive rates. Historically, public US companies have generated an average return on invested capital of 10%, yet have only been able to reinvest about half of their earnings at similar rates. So companies that can earn higher rates of returns on both their base business and new business are uncommon.

Our portfolio holds companies such as First Republic (FRC), Alphabet (GOOGL) and Tiffany & Co (TIF) that exhibit these characteristics. In each case, the company generates strong returns, needs to reinvest their earnings to fuel growth and has the opportunity to do so. However, compared to Home Depot which was reinvesting more than 100% of earnings to fuel growth, the capital requirements of growing First Republic, Google and Tiffany still leave room for the companies to pay a dividend or buy back stock. This feature is something we find highly attractive in the businesses we own and leads us to the moat type that is most prevalent in our portfolio…

Capital Light Compounders

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. We view these as dream businesses. They earn good returns today and they 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.

This wonderful situation means the businesses are resilient during difficult environments where they have plenty of cash on hand to go after opportunities just at the time when their competitors are forced to play defense. 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.

In our portfolio, companies such as Paycheck (PAYX), Advisory Board Company (ABCO), Broadridge Financial (BR), Landstar Systems (LSTR) and MasterCard (MA) are all good examples. These businesses generate returns on invested capital in the range of 30% to over 100% while simultaneously having the potential to grow earnings at annual rates from 8% to 14%. This ability to generate returns on each new dollar of capital they invest at rates of up to 10x better than the average company while growing at rates approaching 3x the average public company makes these businesses very valuable.

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 expense, 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.

We think that Connor’s framework for thinking about the benefits of moats is an important complement to frameworks that explore the various strategies that give rise to moats. A moat that allows a company to protect its profits and pay them out to shareholders is quite valuable. One that presents an opportunity to reinvest earnings at solid rates is even better. A moat that allows a company to do both at the same time creates a cash generating machine that we search far and wide to find.

Ensemble Capital’s clients own shares of Advisory Board Company (ABCO), Alphabet (GOOGL), Broadridge Financial (BR), First Republic (FRC), Landstar Systems (LSTR), MasterCard (MA), Paychex (PAYX), Pepsi (PEP), Tiffany & Co (TIF), and TransDigm (TDG).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

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