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Supersize returns VI

Todd Wenning looks at the US markets to see how defensive moats can lead to bumper gains
March 23, 2018

In the Middle Ages, moats were often used to protect castles from sieges. Moats could be dry or wet, and both types had distinct advantages and disadvantages. Wet moats offered better protection during an attack, but in peacetime the stagnant water could be a health hazard. The circumstances dictated the value of one type of moat over the other.

The same is true for economic moats. Although the phrase ‘economic moat’ has gained popularity in the past few years, it’s worth a brief review. Coined by Warren Buffett, an economic moat is a durable competitive advantage that enables a company to earn high returns on capital over a decade or longer. Without an economic moat, a company’s strong performance can be short-lived as competitors can quickly replicate its model.

Classic economic moat examples include Coca-Cola (US:KO) (brand advantage), Sage (SGE) (switching cost advantage), eBay (US:EBAY) (network effect) and Wal-Mart (US:WMT) (low-cost production).

It’s not enough to identify a company with a moat. What matters is how your evaluation of the company’s moat might differ from the market’s expectations. It’s only when you have a differentiated opinion from the market – and are subsequently proved right – that outperformance can occur. Further, moat analysis is naturally qualitative, which makes it potentially valuable to active investors competing against ever-improving algorithm-based strategies and indexes.

A different angle

A helpful framework for determining how your analysis might differ from the market is to separate economic moats into two types: reinvestment moats and legacy moats.

Companies with reinvestment moats typically have long growth runways and plenty of opportunities to reinvest cash flows back into the business at attractive rates of return. Consider Wal-Mart in the 1980s and 1990s.

Between 1980 and 2000, Wal-Mart went from 276 stores, all of which were in only 11 US states, to 3,989 worldwide stores – marking a furious 14 per cent annualised growth rate. By 1980, Wal-Mart had already established itself as a dominant low-cost retailer in small American towns with populations between 5,000 and 25,000. It had a proven, very-profitable store model and strategy that could be replicated again and again – at home and abroad.

With each new store, Wal-Mart’s bargaining power over suppliers strengthened. In fact, its returns on equity never dropped below 19 per cent during this 20-year run. Incredibly, a $1,000 investment made in January 1980 with dividends reinvested would have turned into over $440,000 by December 2000. Few investments will produce such a return, but it illustrates how catching a reinvestment moat early in its cycle – well before most investors realise what’s happening – can be lucrative.

Slowing down

Naturally, all reinvestment moats come to an end. For Wal-Mart, the number of attractive locations for new stores got smaller. Today, 90 per cent of the US population lives within 10 miles of a Wal-Mart store. This evolution left Wal-Mart with a lot of cash flow from existing stores and fewer reinvestment opportunities. To illustrate this transition of priorities, in 1990, as Wal-Mart continued to plough cash back into rapid store expansion, its dividend payout ratio (dividends/earnings) was just 12 per cent; today, it’s 54 per cent.

Sometime in the early 2000s, Wal-Mart entered its ‘legacy’ moat stage. At that point, its advantages depended more on established stores than future stores. Indeed, the transition from reinvestment to legacy moat was messy for shareholders. Supported by the moat, Wal-Mart’s underlying business performed well, but the stock traded sideways from 2000 to 2012 as the market dialled back growth expectations (Wal-Mart’s price/earnings ratio fell from over 40 in 2000 to 14 in 2012).

There’s nothing wrong with a legacy moat. Again, what matters is your assessment relative to market expectations. In fact, a legacy moat steered by skilled capital allocators can still post attractive long-term returns, as evidenced by the likes of Unilever (ULVR) and McDonald's (US:MCD) over the past decade. The opportunity exists here because the market usually expects some reversion to the mean for legacy moat companies. Good capital allocators can extend the company’s competitive advantage period, requiring analysts and investors to revise estimates upward. As you assess your companies, here are some questions to keep in mind regarding reinvestment and legacy moats.

Reinvestment moats

  • How long is the company’s growth runway? Pay attention to market penetration rates and organic growth as these can tell you whether or not the company has the wind at its back. It’s a red flag when management starts doing acquisitions in non-related businesses, as it’s usually a sign that the growth runway of their core business is shorter than your previous assumption.
  • Is the company’s culture or business model well suited for optionality? Consider how Amazon (US:AMZN) started as an online bookseller and morphed into the retail behemoth it is today by adding new product categories and entering new geographic markets. Most companies are laser-focused on their niche and, whether it’s due to a bureaucratic culture or the nature of their work, cannot successfully branch out into complementary business lines. The result is a quicker approach to legacy moat status.
  • What’s the company’s reinvestment rate? Does the company plough back the bulk of its cash flows into growing the business, or is it increasingly paying out cash flows as dividends and buybacks? Without altering their capital structure, companies can only sustainably grow earnings at the rate of reinvestment (one minus dividend payout ratio) multiplied by return on equity. Holding return on equity steady, a lower reinvestment rate (or higher payout ratio) reduces the sustainable growth rate.

Legacy moats

  • What is the company doing to protect its legacy moat? The big concern with a legacy moat is that it erodes faster than the market expects. It’s tempting for management teams in legacy moat stage to maximise cash flow rather than invest in keeping technology, products, or services ahead of the competition. Abandoned value-enhancing projects are golden opportunities for competitors.
  • Are industry dynamics rapidly changing? Businesses in legacy moat phase are often resistant to deviating from the model that got them there. It’s understandable to want to stick with what’s worked, but with the pace of innovation being what it is today, complacency will only lead to quicker moat destruction. If new entrants or large amounts of capital are flooding the industry, it’s time to reassess the company’s moat.
  • Does the company have the right dividend policy? Higher-yielding blue-chip shares almost exclusively have legacy moats, if they have a moat at all. It can be tempting for legacy moat leadership teams to drive dividend growth even when earnings growth has slowed. Wise capital allocation practices will balance cash payouts with necessary investments.

Just like wet and dry castle moats, reinvestment and legacy moats each have their benefits and drawbacks and much depends on the company’s current circumstances. Our job as investors is to assess those circumstances and weigh them against market expectations.

Here are three US-based companies with either reinvestment or legacy moats that are worth further research.

Alexandria Real Estate (US:ARE)

  • Share price: $128.24
  • Market cap: $13bn
  • Dividend yield: 2.8 per cent

Economic moats are rare in the real estate industry. If one property type (eg, apartments, offices, etc) sees surging demand in an area, new supply typically enters the market and keeps rent growth in check. An exception is when competitors are unable to add new properties in the face of rising demand. Alexandria is in one such position.

Founded in 1994, Alexandria focused on leasing office space to life science companies. The real estate investment trust’s (Reit) timing couldn’t have been better. Within a few years, scientists cracked the human genome, and the biotechnology industry took off. Concurrently, the dot-com boom was getting under way.

Alexandria’s strategy was to acquire properties in “innovation clusters” around the US, such as in Greater Boston, San Francisco and New York City, and provide high-tech office spaces to attract and retain quality tenants. These clusters are home to elite research universities, dense and limited office space, and a healthy mix of early-stage and blue-chip companies.

Take Cambridge, Massachusetts, as an example. A company map of the area shows Alexandria with 10 properties within a short walk of the Massachusetts Institute of Technology (MIT) and Harvard University campuses. Pharmaceutical and biotechnology companies want to be near these schools to be close to the latest academic research, recruit promising graduates and interact directly with highly-skilled scientists. According to Alexandria, occupancy in the Cambridge market is 98.8 per cent. Indeed, Alexandria’s overall occupancy rates are consistently higher than the office Reit industry average, reflecting the quality and desirability of its properties.

Another unique feature of Alexandria’s business model is that it has a staff of medical doctors and PhDs who evaluate applications for its limited office space. The team assesses the efficacy of the potential tenant’s new technology or drug. Unless Alexandria thinks the prospective tenant’s product will gain traction, they’ll reject the application. As of September, Alexandria also had 259 non-real-estate investments in various life science and technology companies.

Alexandria has a legacy moat, but has some reinvestment opportunities. For one, Alexandria has the capital and access to deal flows that enable it to pounce on rare property sales in its clusters. In addition to acquisitions, Alexandria redevelops existing properties to command higher rents. Alexandria’s balance sheet is solid with a BBB S&P credit rating, and 84 per cent of its annual rental revenue comes from investment-grade or large-cap tenants. Its top five tenants by annual rental revenue as of December 2017 were Illumina, Takeda, Eli Lilly, Bristol-Myers, and Novartis. Included in the top 20 tenants are universities such as New York University and MIT and technology companies such as Uber, Facebook and Pinterest.

Alexandria rarely looks ‘cheap’ versus Reit peers, but with investors nervous about the impact of rising interest rates on Reits in general, Alexandria may be unfairly sold off with the group and would be worth a look.

Valvoline (US:VVV)

  • Share price: $23.02
  • Market cap: $4.6bn
  • Dividend yield: 1.3 per cent

For most Americans, a car oil change has traditionally featured sitting in the dealership’s service waiting room for over an hour. The friendly mechanic would then come out to inform you that you needed some obscure repair, which always seemed to cost over $500. In short, it was not a pleasant experience.

Valvoline, which was fully spun out from chemicals company Ashland in 2017, is offering drivers something different. It’s rapidly expanding its Valvoline Instant Oil Change (VOIC) locations across the US via both company-owned and franchised stores. VOIC stores provide 15-minute oil changes, along with routine care such as windshield wiper and air filter replacement. Currently with 1,459 locations, Valvoline wants to add more than 500 VOICs in the next five years. In fiscal year 2017, the ‘Quick Lubes’ segment turned in impressive 24 per cent operating margins.

Valvoline is also growing its international presence, particularly in Asia, as it works with original equipment manufacturers including General Motors, Mahindra, and Tata and has a joint venture with engine maker Cummins. The strategy is to get Valvoline premium motor oil into more heavy-duty vehicle owners’ manuals as the manufacturer’s preferred oil for routine maintenance.

About half of Valvoline’s sales come from its core North America segment, which is more of a legacy moat. Major customers in this group include DIY auto shops such as O’Reilly and AutoZone and ‘do it for me’ repair shops. In recent years, divisional operating margins have hovered around 20 per cent, but sales have been down slightly. This is due to fewer drivers changing the oil themselves, but those that do are increasingly choosing premium oil blends.

Notably, Valvoline is the only premium motor oil brand not owned by an integrated oil company, as Shell owns Pennzoil and Quaker State, BP owns Castrol, and Exxon produces Mobil 1. Its independence and focus have helped it recognise and capitalise on the instant oil change opportunity in the US.

The longer-term risks to Valvoline are twofold: newer combustion-engine cars can go longer between oil changes and, eventually, electric vehicles will take a more significant share of the US car parc. If you think electric vehicle penetration will occur faster than expected, Valvoline’s growth initiatives may stall (pun intended). That said, Americans are also driving their cars longer, and low gasoline prices in the US (the national average in early March was $2.52 per gallon) may slow the electric vehicle adoption rate.

First Republic Bank (US:FRC)

  • Share price: $96.64
  • Market cap: $15.6bn
  • Dividend yield: 0.7 per cent

There’s usually little differentiation between US regional banks. They all borrow and lend at similar interest rates and offer comparable services to their customers. Relative to this peer group, First Republic Bank stands apart in some important ways.

Most prominently, First Republic is customer service obsessed, and it shows in its results. Take, for example, First Republic’s ‘net promoter score’ (NPS), which measures client loyalty and willingness to refer business to others. First Republic’s score of 72 puts it in line with Ritz Carlton hotels and above Amazon and Apple; its NPS is more than double the US banking industry score of 34. Annual client attrition of 2 per cent also compares favourably with the US banking average attrition rate of 8 per cent.

While First Republic must abide by banking regulations, its customer-service-driven business model is more akin to that of a high-end retail or hotel chain. As such, it’s myopic to compare its valuation multiples against other banks alone.

The traditional banking model aims to minimise customer service expenses, but First Republic turns that on its head by offering each customer a dedicated banker. There are no tellers at First Republic branches. New clients are sent freshly-baked cookies as a welcome gift. For traditional banking competitors to try to replicate First Republic’s model, it would require massive cultural shifts, something for which banks are not well known.

The bank caters to high-net-worth individuals in a few major US cities including San Francisco/Silicon Valley (40 per cent of loan portfolio), New York (22 per cent), Los Angeles (17 per cent) and Boston (8 per cent). Single-family residential and home equity line of credit loans have consistently accounted for about 60 per cent of total loans. On the wealth management side, it had $107bn in assets in December 2017, up 26 per cent from the year prior.

In 2017, deposit and loan growth has also been impressive at 17.6 per cent and 20.8 per cent, respectively. Granted, rapid growth and banking are rarely a durable combination. Banks that expand too quickly often relax underwriting standards to grow their loan book. However, First Republic’s underwriting has been sharp, with average annual net charge-offs of eight basis points since 2002 versus 45 basis points for the top 50 US banks.

The bank’s exposure to the pricey San Francisco area real estate market is indeed a concern, particularly if the technology boom were to go bust. Some consolation can be found in the fact that First Republic experienced no losses in the San Francisco area from 2000-02 when the late 1990s tech bubble burst. Further, the Bay Area’s business climate has shown resilience through previous recessions and has the second-largest concentration of Fortune 500 companies in the country, after New York City. There’s only one Silicon Valley.

Todd Wenning, CFA is a senior investment analyst at Ensemble Capital Management in the US. As of the date of publication, clients, employees, and/or principals of Ensemble Capital owned shares of First Republic Bank and Apple. Mr Wenning contributes to Investors Chronicle in his personal capacity only. The views expressed are his own and do not necessarily represent the views of his employer