Welcome to Bookworm, my weekly column where I share insights from investing books and letters that I find interesting or useful. My goal is to update older insights with new examples and add an Aussie twist to ideas originating from elsewhere.

Today's insight

In a slight twist, today’s insight comes from what I view as a classic investing article. It was written by Connor Leonard as a guest post for John Huber's excellent investing website.

At its core, today’s insight is about why some companies are well placed to grow the value of their business exponentially from today's standing point and others aren't. More specifically, it is about the power of being able to reinvest lots of your profits at high rates of return.

If a company can continually do this, these reinvested earnings can eventually snowball into an earnings stream that is much bigger and much more valuable.

In theory, then, the company that can reinvest the biggest amount of its earnings in its business, at the highest rates of return, over the longest time period, should achieve the most compounding in the underlying value of its business.

Companies vary greatly in their ability to do these things, which brings us to today’s insight: the difference between what Leonard calls “legacy moats” and “reinvestment moats”.

Two leagues of moat?

First, a quick reminder of what a moat is: it is a sustainable advantage that allows a company to reap excess returns on investments made into its business over time.

Most businesses do not enjoy this privilege because there is nothing to stop other companies competing away their profits. At Morningstar, we assign each company one of three moat ratings:

  • No Moat, which is self explanatory
  • Narrow Moat, which means we think the moat will last at least ten years
  • Wide Moat, which means we think the advantage will last for at least twenty years

Leonard’s concept of legacy moats and reinvestment moats adds something else into the mix. First let’s look at legacy moats, which Leonard says are much more common.

Leonard labels a “legacy moat” as one where a company is competitively advantaged and enjoy strong returns on past capital invested into the business. But because their market and business are mature, they cannot deploy much new capital into the business at such attractive rates of return.

For Australian examples of this, look no further than Woolies, Coles, Endeavour, or the big banks. They are mature cash cows. Most of the white space in their markets is gone and their opportunities to reinvest their earnings cash are therefore limited. This will likely be reflected by:

  1. The company paying out the vast majority (often 75% and above) of their profits as dividends, and maybe even conducting share buybacks on top.

  2. Their main avenue for shareholder value creation coming from corporate actions, like Woolie's spin-off of Endeavour and its subsequent $2 billion share buyback.

Leonard says that legacy moat businesses bought at a good price can still deliver satisfactory returns to investors. In many cases, he says, owning shares in this kind of business will resemble owning a bond with payouts (dividends) that increase over time.

For those with a long time horizon and a hope for more capital growth, however, he says it may be best to seek out companies with reinvestment moats.

Looking for reinvestment moats

Reinvestment moats arise where a company not only enjoys high returns on capital, but still has the ability to reinvest a significant chunk of its earnings back into the business at these high rates of return. Not just last year or this year, but for many years in the future.

"The key to Reinvestment Moats” Leonard says, “is having conviction that there is a very long runway and the competitive advantages that produce those high returns will remain or strengthen over time."

As a filter, Leonard asks investors to ponder whether the company could be “five or ten times” its current size in a decade or two. And he makes it quite clear that “for 99% of businesses, you will find that it is almost impossible to have that kind of conviction”.

Like most other stock markets, Australia's bourse is dominated by companies with legacy moats. But that doesn't mean there aren't potential reinvestment moat candidates on our shores.

The main things you might look for here might include 1) a market with plenty of “white space” and growth opportunities ahead and 2) a moat meaning that an outsized portion of this growth potential will be captured by the company in question.

"I’m looking for a business that actually becomes stronger as it gets bigger” says Leonard. “In my opinion there are two models that lend itself to this kind of positive reinforcement cycle over time: companies with low-cost production or scale advantages and companies with a two-sided network effect."

How might you spot companies like this? I would probably start by looking for some combination of:

  • Rapid and sustained revenue growth in the recent past
  • High returns on investments made back into the business
  • A low (or non-existent) emphasis on returning capital to shareholders

WiseTech’s potential reinvestment moat

WiseTech's CargoWise suite of products has become the default software for freight forwarders. WiseTech has already captured most of this industry’s biggest companies as clients but appears to still have plenty of white space ahead of it.

For one, many WiseTech clients still only run a small portion of their overall shipments through CargoWise, partly because of how long it can take to map a client’s business processes to the software and train employees.

Then you have the potential for WiseTech to branch into digitising adjacent parts of the logistics chain like customs and compliance or container-based road and rail freight.

As for the “moat” part, CargoWise benefits from client switching costs due to its lengthy setup process and its deep integration into mission critical client workflows. These underpin WiseTech’s Narrow Moat rating from our analyst Roy Van Keulen, who notes sky-high customer retention rates despite material and repeated price increases.

Roy also sees traces of the network effect sought by Leonard.

As using CargoWise results in significant labor cost savings for freight-forwarders, they are incentivised to prefer operators that are integrated with the platform. Hence, asset operators integrate with CargoWise to win more business. This increases the pool of potential asset operators that freight-forwarders can work with in a more efficient manner, making the platform even more attractive to forwarders, and so on.

Let’s see if the potential symptoms of a reinvestment moat show up in WiseTech's financials.

  • WiseTech’s revenue grew by 25% in 2022, 29% in 2023 and 27% in 2024. Our analyst Roy Van Keulen expects that this can continue, and forecasts an increase in revenue from around $1 billion in fiscal 2024 to just under $3 billion in 2029.

  • WiseTech paid out just 20% of its net profit in fiscal 2024 as a dividend. Roy expects this payout ratio to remain at a similar level throughout his five year forecast, suggesting that WiseTech will continue to invest heavily in growing the business.

  • WiseTech has averaged returns on invested capital of over 20% over the past three years, according to Roy’s adjusted numbers. Not only is WiseTech finding plenty of ways to reinvest money into growth opportunities. It seems to be doing it at exceptionally high rates of return.

WiseTech looks like a strong ‘reinvestment moat’ candidate. But in terms of it being an investment candidate, there is an obvious caveat: valuation.

Companies that look this well-placed to grow their business over several years inspire a lot of excitement in markets. As a result, they will often trade at prices that reflect this excitement and pull a lot of growth forward. WiseTech is no exception.

It currently trades at a 15% premium to Roy’s Fair Value estimate, even though he could hardly be more bullish on the quality of WiseTech’s business and its growth potential.

In situations like this, it is worth remembering that a business can grow 'several times bigger' in terms of its revenue and profits, only to deliver a flat or negative return to investors that paid for all (or more) of that growth up front.

How can investors use this insight?

Weighing up the difference between a “legacy moat” and a “reinvestment moat” focuses us on the key drivers of a company’s underlying value over time: a company's ability to reinvest its earnings and what rates of return they can achieve on those investments.

It also underlines that companies at different stages of their life cycle can suit different investment needs.

While finding a ‘reinvestment moat’ company at a reasonable price might be attractive for those seeking long-term capital growth, a 'legacy moat' company that gushes dividends and is available at a fair price might suit other goals far better.

Previously on Bookworm:

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You can find the original article cited in this edition of Bookworm here.