I previously wrote about the 7 types of moats of quality companies. Another way to look at moats is from a capital allocation perspective. A few years ago, Connor Leonard from IMC made a wonderful presentation on 3 types of capital allocation moats:
- Legacy moat
- Reinvestment moat
- Capital-light compounder
Legacy moat is companies that earn an above-average return but without much opportunity to reinvest those earnings back into the business. Therefore, the management decides to pay those earnings in dividends.
Sydney Airport is a company that distributes all of its earnings as dividends because of limited reinvestment opportunities. Sydney Airport earns a good return because it has a toll-like business that operates with little to no competition. They make money whenever people or freight travel in and out of Sydney by air. However, there’s little opportunity for them to reinvest what they earn back into the business. Although Sydney Airport requires capital expenditure to maintain and upgrade its facilities such as terminals and retail stores, there’s not enough demand to build more runways, retail stores, or car parks every year. As a result, they distribute most of the earnings to their shareholders because that’s the best thing to do.
If a company earns 20% return on capital (ROC) but pays out all of its earnings in dividends, the only two ways to earn a long-term return of 20% is to reinvest those dividends:
- In another company that can earn an incremental return of 20% or higher, or;
- In the existing company at more or less the same multiples to own more shares over time.
This points to the dilemma of investing in high dividend-paying companies. Dividend is a good source of shareholder return but it also means you’ve to decide where to redeploy that capital. Market conditions also determine how fast you’re able to do so.
Some legacy moat companies have the opportunity to reinvest their earnings but at a lower return. A company that earns a high ROC today is the result of the capital investments it made years ago. But that is no guarantee that every dollar invested today will generate that same level of ROC in the future. Factors such as higher investment to produce differentiated products, lower selling price to maintain market share, or in some cases, companies pursuing an adjacent market that’s less profitable can all lower incremental ROC.
Reinvestment moat is companies that have the opportunities to reinvest earnings at the same rate. Reinvestment moat companies are worth more than legacy moat companies simply because you can compound your investment at a faster rate due to its growth opportunities.
Hartalega is a good example of a company that possesses a reinvestment moat. Hartalega is the 2nd largest glove manufacturer and was able to grow its revenue over the past 15 years from $110 mil to $2.9 billion (24.4 % annualized growth), while net income went from $13 million to $434 million (26.3% annualized growth). It can grow at such a pace despite paying out half of its earnings as dividends because of its high ROC and growing demand for nitrile gloves.
Another class above reinvestment moat is the capital-light compounders. Capital-light compounders are companies that can grow and compound their return at a very high rate without much incremental capital. The difference between capital-light compounders and reinvestment moat is that companies with reinvestment moat like Hartalega have to continuously reinvest to grow. It has to invest in plants, production lines and so forth. On the other hand, capital-light compounders can grow without a lot of investment in fixed assets. For example, business models like franchising (Domino’s Pizza), SaaS subscription, or two-sided networks (Airbnb) don’t require intensive capital to grow because of their high scalability.
Atlassian is an example of a capital-light compounder. Atlassian builds collaboration software that makes it easy for teams to work together. Most of their capital expenditure goes towards software development and cloud hosting infrastructure. Other than that, there’s a little marginal cost to add every new customer. The cost of adding the 10,000th customer would be similar to the 100th customer.
These moats are dynamic. Companies can move from one moat to the other depending on changes in the industry structure, strategy and capital allocation decisions. Amazon’s retail business was a capital-light compounder a decade or so ago because they sell everything online. But the business becomes more capital intensive as they move into brick & mortar stores by acquiring Whole Foods in 2017 and purchase aircraft as part of their last-mile delivery strategy. For the past 10 years, fixed assets as a percentage of total assets grew from 30% to 59%. So their retail business now resembles more of a reinvestment moat than a capital-light compounder.
Companies go in the opposite direction as well. Disney used to be somewhere between a legacy and a reinvestment moat. They have a decent ROC, return free cash flow through a mix of dividends and share repurchases, and grow revenue around 8% p.a over the past 10 years. But their foray into the streaming business with the rollout of Disney+ will likely increase their incremental return. Their streaming business has the characteristics of a capital-light compounder more than other businesses such as theme parks.
All else equal, it is more desirable to own a capital-light compounder than a reinvestment moat, and a reinvestment moat than a legacy moat. Or put it differently, you can pay more for a capital-light compounder than for a reinvestment moat; more for a reinvestment moat than for a legacy moat.