Last week, there were two great posts on the world wide web. Legacy Moats vs. Reinvestment Moats by Connor Leonard as a guest post at Base Hit Investing and Young Money’s post about the Difficulty in Predicting Long-Term Winners.
You should read both. Now…….
Ok. For the slackers in the audience, I will reluctantly provide a summary wrapped in a children’s story.
A Legacy Moat is a business that generates significant free cash flow, but without significant reinvestment opportunities. WD-40 is a great example of a company in this category. A Reinvestment Moat company, on the other hand, is an even better business because the free cash flow that it generates can also be reinvested to create additional free cash flow.
In the children’s book version, a Legacy Moat is the goose that lays the golden egg, The “Original” Golden Goose. It’s great business, you get a golden egg everyday. A Reinvestment Moat business is The Golden Goose Squared. This Golden Goose Squared lays a golden egg every morning and in the afternoon gives birth to another Golden Goose that will subsequently lay golden eggs itself (please no biology questions). Both geese are amazing businesses, but obviously the Golden Goose Squared will be a better investment even if you pay substantially more than the Original Golden Goose or even more than you would ever pay for a goose in your life.
To add a slight wrinkle into the story and give you the perspective that Young Money brings to the table, we will alter the fairly tale slightly.
Instead of being offered two full grown Golden Geese, you are instead offered one fully grown Original Golden Goose or a baby Golden Goose Squared (or the technical fairly tale name: Golden Gosling Squared). Now the story becomes slightly more interesting. Should you pay up for the gosling that will supposedly produce not only a golden egg every day, but also another Golden Goose or go after the more certain Original Golden Goose who is already produce one golden egg per day.
Your patience with this children’s book parable may be starting to run thin. However, I want to take it one step further. Predicting which gosling will become a Golden Goose Squared is immensely difficult. It must be a stable business, with continued opportunities for reinvestment and a management team with the ability to correctly identify those areas.
My favorite approach to golden geese/goslings is as follows. After you identify one, wait. And then wait some more. At some point, both will get sick. The Original Golden Goose and the Golden Goose Squared will, at some point, be sick.
The best sickness is one that can be completely removed without affecting the ongoing health of the patient. Some examples from Buffett’s history are American Express where an unfortunate experience in its commodities lending business had no impact on its dominant Traveler’s cheque business. Or GEICO in 1976 where their underwriting became aggressive (and therefore unprofitable) but their low-cost advantages remained strong. I will write more separately about identifying which types of sicknesses can be “removed” and which ones may permanently affect the patient (amputation of the left arm for a southpaw pitcher would be catastrophic).
In summary, the Golden Goose Squared is a better investment than the original Golden Goose, however, it is much hard to tell when companies are goslings which one is going to grow into a Golden Goose Squared. My advice, wait until they are “more” full grown and are diagnosed with a non-life threatening illness.
Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients.
I can be reached at firstname.lastname@example.org