How do you define a ‘good’ business? ‘Earnings Power’ defines the good from the bad.
The Plain of Six Glaciers is a beautiful hike. It starts at Lake Louise with busloads of sightseeing tourists, then winds up past lakes of otherworldly greens and blue, through pine-trees, waterfalls and wildlife. The terrain turns alpine once you reach 9,000 feet and the tourists thin substantially. Finally, you approach Victoria Glacier and more than enough demand for a very special teahouse serving cake and coffee.
The Plain of Six Glaciers Teahouse was built in 1927 by the Canadian Pacific Railway. In 1959, Joy Kimball picked up the local paper and read that the teahouse was closing. Joy wrote to the Chateau Lake Louise asking if it was for sale (nice dealflow generation). Joy and her family have owned the teahouse in the 60 years since.
The property has no electricity and staff sleep in the quarters downstairs. At the beginning of each season, a helicopter delivers 9,000 kilograms of supplies. Staff hike up with replenishments to start a 5-day shift. Fixed costs are the one helicopter trip per year and variable costs are wages, flour, tea and coffee. Hikers share cake and views with travelers and chipmunks. My guess is it does annual sales of around half a million (let’s say that during the 5 month season, 200 people per day visit the teahouse spending just under $15 each). Joy’s daughter confesses they could raise prices higher: “once they’re up here, they’re up here.”
The Moat
The teahouse has pricing power (or barriers to entry - choose a framework you like). There won’t be another Tea House popping up next door that provides better or cheaper coffee so margins are stable. This pricing power is the Tea Houses’s ‘moat’ or sustainable competitive advantage. A moat around a business will generate great returns over long periods of time. The moat for the Tea House is sustained by Parks Canada red tape (if anyone could open a business on those beautiful mountains, Banff will become Thailand’s Maya Bay). This moat has earned Joy and her family a solid return on the price she paid to a seller in 1959 (whose alternative was to close down). Other than maintenance on the log cabin, most of the earnings Joy and her family receive are ‘unrestricted’ and so are for the owners to allocate at their discretion. If the cabin has some special coffee machine that needed ongoing R&D, upgrades or other costs to keep pace with a competitor, then a lot of the earnings would need to be reinvested into the business, and hence would be ‘restricted.’ Warren Buffet defined this concept in 1984:
all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let’s call these earnings “restricted” - cannot be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength.
No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused. Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential.
So far so good. However, Joy’s allocation options are limited. There are no opportunities for her to invest these earnings for the same high returns the business generated in the past. She could look for other teahouses to acquire, but the market for teahouses built by old railway companies is very small. She could look to build another on an adjacent mountain, but Parks Canada won’t like that. The only obvious allocation option is to pay dividends to the family and occasionally donate to Parks Canada. There are no attractive opportunities to warrant retaining earnings and reinvesting them into the business.
Connor Leonard defines businesses like the teahouse as having a ‘legacy moat’:
Businesses with a legacy moat possess a solid competitive position that results in healthy profits and strong returns on invested capital. In exceptional cases, a company with a legacy moat employs no tangible capital and can modestly grow without requiring additional capital. However because there are no reinvestment opportunities offering those same high returns, whatever cash the business generates needs to be deployed elsewhere or shipped back to the owners.
Connor has influenced my thinking on what makes a ‘good business’ more than anyone (as you’ll see below). A good business is one with Earnings Power.
Earnings Power
Earnings Power separates the wheat from the chaff. It is the most important concept in investment analysis (early stage venture or Reddit sourced investments being exceptions).
Earnings Power is the availability of opportunities to deploy incremental capital and the expected return on those opportunities. In other words, it is the product of: 1) the reinvestment rate; and 2) the return on incremental invested capital (ROIIC):
Earnings Power = Reinvestment Rate ✕ ROIIC
For readers unfamiliar with ROIIC, Mauboussin and Callahan provide an excellent explanation (page 11).
Three things to point out about this definition of Earnings Power versus the tradtional ‘Earnings Power Value’ formula (earnings divided by the cost of capital):
It is defined by both the expected return and reinvestment rate. The traditional equation ignores the set of attractive growth opportunities (or lack thereof) to warrant (or not) reinvesting into the business. Using the traditional formula, the Lake Louise teahouse commands a valuation of: $500k / very low cost of capital = very very high valuation. In reality, the Lake Louise teahouse would be valued closer to a lifestyle business, not one that can keep growing through continued high returns on incremental invested capital.
It is expressed as a percentage and not the absolute valuation in $ provided for in the traditional formula. We are interested in how much wealth a business can generate, not a rule-of-thumb valuation. Also, the term “power” expressed as an absolute number rather than a rate does my engineers brain in.
It is forward-looking. We use incremental invested capital in opportunities available to the business, and the expected return on that capital.
“earning power” must imply a fairly confident expectation of certain future results. It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline - Graham & Dodd, Security
For example, a business that needs to spend 80% of its earnings to maintain equipment has 20% left to invest for growth. With a 15% return, it would have an Earnings Power of 20% ✕ 15% = 3%. On the other hand, a business that needs to spend only 20% of its earnings to maintain equipment with the same 15% return would have an Earnings Power of 80% ✕ 15% = 12%. We can expect the first business to grow inline with GDP and the second business to grow much faster.
Reinvestment Moats
Businesses with high Earnings Power have high returns on incremental capital reinvested into the business. Connor Leonard’s brilliant framework calls businesses with inherently high Earning Power “reinvestment moats.” These companies would do better retaining earnings to reinvest in the business, rather than returning capital to owners (unless the owners have another business or investment with even higher Earnings Power).
Reinvestment moats are compounding machines.
A reinvestment moat allowed the business to earn high past returns, with plenty of runway to deploy incremental capital for high future returns. This moat can be cost leadership or pricing power (or to use another framework – product or consumer advantage). They can also be aggregators or platforms (or elements of both) with network effects.
Businesses with reinvestment moats generally have low capital requirements. If two businesses make an extra $2M in earnings from one year to the next, is that good or bad? Say the first business used $4M to invest in software or marketing, and the second business invested $10M on new equipment. The ROIIC of the first is $2M/$4M = 50%. The ROIIC of the second is $2M/$5M is 20%. Capital intensity means the denominator (capital) in ROIIC is large, so the numerator (earnings) needs to be as proportionately large (capital intensity is not always bad in the context of competition - a post for another time).
This is why a capital-light business, with a reinvestment moat, is so brilliant and so rare. Capital is sourced internally, through the retained earnings of the business, and used to invest in new opportunities, which themselves have low capital requirements, and that compounds earnings over time. Nice.
A business we owned in my days working for a GP was a very rare and special case. This company looked like a boring business but it was far from it: it was a ‘Capital Light Compounder’. From the time we bought into this business, no further capital was needed to grow – incremental capital is zero. The denominator is negligible, the numerator high. The business grew substantially through organic geographic expansion. This business achieved extremely high returns on the initial invested capital (and no incremental capital) because it had three things:
negative or zero net working capital;
very low fixed assets; and
pricing power.
This meant we didn’t need to grow working capital in proportion to sales, nor did we need to spend much on CapEx, and finally, we could maintain our margins. Our earnings were ‘unrestricted’: they didn’t need to be reinvested. We could even take out a small loan to buy-back the remaining 30% of the equity in the company to take our ownership to 100%.
Our singular focus was extending the runway (in this case, global sales) as far as possible.
Building Wealth
Businesses with Earnings Power are businesses that have ample opportunities to deploy incremental capital at high rates of return. To earn superior returns, a business needs a reinvestment moat that compounds returns on its own internal capital (there are other ways, like exceptional capital allocation, which is a post for another time).
If you want to build wealth, focus on your Earnings Power and continually increase your opportunity cost.
It’s no wonder Berkshire Hathaway focuses on “constantly improving the basic earning power of our many subsidiaries.”
Tell your mates. Or not.