Some things I read this week: 26/8/18

Return on Incremental Invested Capital

  • ROIC is a great historical indicator of how successfully a business allocates its capital to new initiatives. However, in evaluating the future outlook of a business, investors usually want to know how much money a business will generate in the future, relative to the incremental growth of its earnings.
  • Key questions to ask about a business: how much of its earnings are retained (net of buybacks and dividends), and at what rate of return is the business earning on those retained earnings?

Market Value Fluctuations of the 10 Largest U.S. Companies

  • “Time arbitrage”: taking a multi-year outlook in contrast to the market’s quarterly focus. This enables you to take advantage when even the large cap stocks get significantly mispriced from time to time.
  • John Huber’s chart:

52 week fluctuations June 2016

Reinvestment Moats vs Legacy Moats

  • “Legacy moats” apply to companies that earn strong returns on capital but do not have compelling opportunities to deploy incremental capital at similar rates. Most businesses with durable competitive advantages belong in this category.
  • “Reinvestment moats” are earned by companies that continue to deploy incremental capital at high rates of return (see ROIIC)
    • These companies usually share at least one of the following characteristics: low-cost production/scale advantage (Walmart) and/or two-sided network effects (Airbnb)
      • Companies with high “flow-through” margins (a.k.a. operating cash flow margins) will be more likely to expand margins as network size increases
      • If the company has low-cost production, explore whether a larger incumbent can duplicate its strategy. Hopefully the company will be using proprietary technology or a differentiated business model.
      • In retail: seek companies with consistent, repeatable and profitable unit economics.
    • Once you’ve identified these companies, consider the reinvestment runway (market size). How far can this compounding go?

Warren Buffett’s Letter to See’s Candies (1972)

  • When it comes to great brands, you must do at least one of two things: offer a materially better product or service, or tell a better story. Buffett notes, “maybe grapes from one little eighty-acre vineyard in France really are the best in the whole world, but I have always had a suspicion that about 99% of it is in the telling and about 1% is in the drinking.”
    • A company’s brand is highly dependent upon associative factors, like the retailing environment. Buffett says, “just as the New Yorker creates a different “editorial environment” for a Lord & Taylor ad than does the Village Voice, so does the surroundings in which our candy is offered affect our customer’s mental — and even gastronomical — impression of our quality.” Think quality of the store, method of packaging, surrounding merchandise, etc.

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