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Moats of the market: Legacy, Reinvestment, and Outsider Management

Updated: 3 days ago

Have you ever heard of a "moat"? In investing, Warren Buffett coined the term to describe a company's unique advantage, allowing it to generate high profits over the long term. These companies are like rare gems.

 

I chanced upon an article authored by John Huber and Connor Leonard, which categorizes them even further. They split them into "Legacy Moats" and "Reinvestment Moats."

 

The Cozy Comfort of a Legacy Moat

 

Businesses with a legacy moat hold a secure position in their markets, generating strong and consistent profits. They can grow modestly without needing much additional capital, but they often face limited opportunities to reinvest their earnings at high rates of return. As a result, management typically distributes most of the profits back to shareholders.

 

Take Coca-Cola, for example. Their iconic recipe and massive marketing muscle have built a fortress around their market share. They are synonymous with cola, and customers keep returning for more. This translates to billions in revenue annually, with a substantial portion of profit remaining after expenses.

 

But what does Coca-Cola do with all that extra cash? They can't exactly open a new "super cola" company in a saturated market, so they return a significant portion of those profits to shareholders as dividends. It's a smart move for Coca-Cola, but it might not be ideal for investors seeking explosive growth.

 

While legacy moat companies boast impressive returns on their initial investments, that doesn’t guarantee the same windfall for investors today. A reported 20% return reflects the money invested years ago, not new investments. In simpler terms, a 20% return isn't as exciting if there aren't more opportunities to reinvest those profits.

 

Owning stock in these companies is like buying a high-interest bond. It provides a steady income stream, and companies like Coca-Cola are great at protecting your investment. But if your goal is to see exponential growth, you might want to look for businesses with a Reinvestment Moat.

 

The Growth Engine: The Reinvestment Moat

 

Companies with a reinvestment moat benefit from their legacy moat while also having opportunities to reinvest profits at high rates. They have a knack for finding new ways to use their profits, generating impressive returns year after year.

 

They hold onto their core business that keeps the money flowing, but instead of sending it all back to you, they reinvest it in high-return opportunities. These companies outperform those with only a legacy moat because they excel in capital allocation.

 

Think of Walmart in 1972. Their stores dominated small towns with rock-bottom prices. Each store generated healthy profits, which they reinvested into opening more stores. Today, with over 10,000 locations, Walmart's moat is massive, showcasing the power of the reinvestment moat.

 

The number of Walmart stores from 2017 to 2024

Spotting the Reinvestment Moat Masters

 

Finding these companies requires looking beyond typical investment strategies. Here's what to keep an eye out for:


  • Defying Capitalism: Normally, high profits attract competition, squeezing returns. But reinvestment moat companies defy this logic. They actually get stronger as they grow.

  • Two Key Models: There are two main ways companies achieve this magic trick:

    • Low-Cost/Scale Advantages: Think back to Walmart. Their massive stores allowed them to undercut competitors on price. As they grew, this advantage snowballed, attracting even more shoppers and widening the moat. Companies like Costco and Amazon follow a similar playbook.

    • Two-Sided Network Effect: A two-sided network, like an auction or marketplace, requires both buyers and sellers. Once established, the network strengthens as more participants join, attracting even more participants. This cycle makes it difficult for either side to leave the platform. Companies like eBay and Airbnb have built robust two-sided networks over time.

 

Airbnb, a reinvestment moat company, establishes a strong network effect.

How Long Will the Party Last?

 

Many investors get caught up in short-term growth. But for a reinvestment moat, the key is the runway. Can the company keep reinvesting profitably for years to come?

 

Here's how to assess the runway:

 

Positive Indicators:


  • Two-sided networks: If a platform like Uber is still small but user numbers are exploding, that's a good sign.

  • High "flow-through" margins: This means the company makes more money with each new user, making expansion even more profitable.

  • Structural cost advantages: Maybe a company has a unique business model or superior technology that keeps costs low compared to rivals.

 

Red Flags:


  • Shifting focus: If a company with a supposedly long runway starts venturing into new markets, it might be a sign their core business is slowing down.

  • Inflated market size: Beware of management teams boasting about a massive "total addressable market" (TAM). They might be exaggerating to attract investors.

  • Declining returns: If recent growth hasn't been as impressive as before, it could be a crack in the runway. This is especially true for multi-unit businesses where new locations might not be as profitable as the originals.

 

The Bonus Moat: The Outsider Manager

 

Between the legacy moat and the reinvestment moat lies the legacy moat with “Outsider” management. These businesses have all the characteristics of a legacy moat, but their management team reinvests all the capital into new businesses through strategic acquisitions. They become masters of capital allocation, driving long-term growth.

 

Sure, there's a lot of research out there warning against bad acquisitions. But here's the secret: some management teams are simply better at deploying capital than individual investors.

 

They know their industry inside and out, have access to exclusive deals, and can combine acquired businesses for even greater efficiency. Think of them as private equity firms with permanent capital (and without the hefty fees!). Companies like TransDigm Group, Danaher Corporation, and Berkshire Hathaway exemplify this approach.

 

Berkshire Hathaway is a legacy moat with an “Outsider” management company and its top holdings.

These management teams typically include an Operator and an Allocator. The Operator manages existing businesses to maintain their competitive positions, while the Allocator seeks high-return opportunities and optimizes the capital structure. This strategy includes special dividends, strategic use of leverage, and share buybacks when the stock is undervalued.

 

So, how do you spot these hidden gems?

 

The best way to identify these companies is to read annual shareholder letters and note certain qualitative patterns. A well-written, informative letter shows that management views shareholders as partners, not just a quarterly hurdle.

 

They'll talk about "intrinsic value," "return on capital employed," and "free cash flow per share" instead of just sales growth. These companies are proud of their frugality, understanding every dollar belongs to the shareholder.

 

If you want to read the full article from John Huber and Connor Leonard, check it out here.

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