Bookworm: Is this a capital allocation red flag?
Some threats to a company's ability to generate high returns on capital are outside of management's control. Other things, not so much.
Welcome to the next edition of Bookworm, my weekly column that explores useful investing insights from books and investor letters.
Today’s insight comes from the Little Book That Creates Wealth by Pat Dorsey, who you could say is becoming a regular in these parts. The book is a short guide to investing in companies with moats, something we define as a sustainable competitive advantage that enables attractive returns on capital over time.
Dorsey includes a whole section on monitoring situations where a company’s returns on capital may be eroding. This erosion might be due to external factors like the emergence of a new technology or a drastic change in industry structure. But it might also be a result of management’s own actions.
When it comes to latter, Dorsey highlights the following situation as being especially dangerous: “I’d say the single most common self-inflicted wound to competitive advantage occurs when a company pursues growth in areas where it has no moat”.
This has the potential to harm a company in a couple of ways. Not only could it lead to lower returns on capital (or the complete destruction of that capital) in a business where the company has no edge. It can also distract from protecting and widening the moat enjoyed in the core business.
Let’s look at two examples from Australia where management’s allocation of capital ‘outside of the moat’ have impacted our analysts’ view on the company.
Gassed up
Most of APA Group’s revenue and profits come from its gas infrastructure business. It is by far Australia’s biggest owner of gas pipelines and is unlikely to face much in the way of new competition here because the up-front costs of entering this business are so high.
In recent years, APA has also invested heavily in growing a completely different business in renewable power generation. Most notably, it purchased wind and solar power assets in Pilbara from Alinta Energy (as well as some traditional gas power stations) in 2023 for around $1.8 billion.
The plan for the renewable assets is to provide greener power to remote locations in WA such as mines. Atkins sees a long runway for growth as miners seek to cut emissions, but he struggles to see returns on investment here matching those in the existing pipeline business.
The reason for this is pretty simple: customers requiring the transport of gas on certain routes need to use APA – it’s not like a competitor could quickly build another option. And for its part, APA can hike its throughput relatively easily by investing in compressors that increase pressure.
By contrast, the barriers to establishing a solar or a wind farm are far lower. A miner in WA could feasibly solicit bids from multiple parties interested in providing them with renewable power and choose the cheapest one. Or they could just develop one themselves. The business model just seems less moaty.
Atkins also points to the price and structure of the Pilbara deal, which included the issue of equity and some rather expensive looking debt, as being dilutive to returns. This reminds us that it’s not only what is being invested in that matters. But also how much.
While we are on the topic of APA, it’s worth remembering that renewable power still makes up a relatively small slice of the overall pie. And for what it’s worth, Atkins thinks markets have been too harsh on APA recently. You can see why in this edition of Ask the analyst from January.
Now for a more extreme example, where a company has a clear competitive edge in one business segment but a ‘No Moat’ rating overall due to where it is investing.
Reece’s pieces
Reece is Australia’s dominant plumbing supplies business. It enjoys a formidable domestic advantage because of the size and density of its store network. Its strong brand gravitas at home also opens the door for higher margin own-brand sales.
If that was end of it, Reece would likely boast at least a Narrow Moat rating. But the concept we are exploring today – the risk of investing in growth outside your company’s moat – may explain why Esther Holloway actually has Reece down as a No Moat company.
A No Moat rating means that Esther Holloway is unsure that Reece will be able to generate excess returns on its invested capital for a decade or more. Her uncertainty here stems mostly from Reece’s ongoing expansion efforts in the US.
Esther expects this to reap lower returns because Reece does not yet have anything like the scale or brand that it enjoys in Australia. The amounts being invested are no chump change, either. The A$1.9 billion purchase of Morsco in 2018 represented roughly a quarter of Reece’s overall value at the time.
Reece may eventually be able to replicate its strong domestic position in the US. But Esther questions how long this will take and how much it will cost. She notes that several competitors, many of which had a stronger foothold in the US to start with, are pursuing a similar strategy and could push up prices.
As a predominately family-owned company, Reece appears well placed to stay in it for the long-term. But for now at least, it looks like a prime example of investing outside of the moat to the detriment of returns on capital.
How investors can use this insight
Dorsey’s chapter on monitoring moats and returns on capital reminds us that neither of these things are static. They can get better over time, or they can get worse.
While some things influencing this are out of a company’s control, some things are very much within it. As investors, it is therefore crucial that we keep tabs in how our investments are allocating capital.
Are management allocating capital in a way that should protect or widen the moat, and therefore returns on capital within the business? Or are they throwing cash at growth projects that have less attractive dynamics and dilute the returns achieved elsewhere?
This brings us to a sticky point: sure, it makes sense to invest inside the moat. But didn’t most businesses start off without a moat? What if the growth opportunities management are investing in will turn out to have moats in the future and need these investments to get there?
As Esther and Adrian aluded to in the examples I used, it’s also a question of how much is being paid to chase opportunities in the new space. And while some growth opportunities are clearly worth going after, I’d say that moderation is key. Why bet the company on something that isn’t as sure a thing?
For a walkthrough of how to work out where a company is allocating its capital, try this article that I wrote about the ASX-listed sleep device manufacturer ResMed.
