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Economic Moats: The Key Ingredient for Sustainable Dividends and Buybacks
Regardless if you prefer dividends or buybacks, the key to both in generating long-term value is the presence of an economic moat.
One of my early jobs was helping portfolio managers at a regional bank administer ultra-high-net-worth customer investment accounts. Some accounts were well more than eight figures, and at least one was nine.
I distinctly remember my hand shaking when submitting my first multi-million dollar Treasury order to the traders on behalf of one of these clients. Any error would have easily cost the bank more than my annual salary.
These were accounts of families in the Washington, DC-area who built great wealth over many decades. The families obtained most of their wealth through their businesses, but their investment portfolios were also impressive.
To a 24-year-old investor, it was illuminating to see these portfolios in detail. What impressed me the most were the microscopic cost bases of Blue Chip companies, acquired decades prior, from which they were generating gobs of dividend income.
Inspired by what I saw, I wrote a lot about dividend investing over the next decade and ran a Motley Fool dividend-focused investing newsletter in the UK before joining Morningstar.
With hindsight, my research into dividend investing and the moat-focused education I gained at Morningstar led to much of my investment philosophy.
Quality investing is finding companies capable of generating large and sustainable amounts of distributable cash flow for a decade or longer.
For that to occur, a company must have an economic moat that enables it to generate returns on invested capital above its cost of capital. Otherwise, any cash flow the company distributes is a sign of a melting ice cube rather than a robust business model. I'll illustrate this in just a moment.
In 2016, I self-published a book called Keeping Your Dividend Edge, which I consider to be a capstone of my years of writing about dividend investing.
In the book, I wrote:
“For dividend investors, we specifically want to know if the company can maintain and grow its cash flows over the long term. This requires a vision into the company’s prospects well beyond the average investor’s time horizon, which in turn requires a serious consideration of how the company will protect its profitability in a very uncertain future. When companies’ competitive positions erode, there will be increased pressure on cash flows and therefore the dividend itself, so we’re compelled to give a company’s competitive dynamics some thought – both before and after we make the investment.”
It's incumbent upon investors interested in dividends – or buybacks, for that matter – to identify and monitor a company’s economic moat to measure the size and scope of future return of capital.
Management has various choices with what to do with capital and cash flow. It can invest organically in the business or through M&A, repurchase shares, pay dividends, or prepay debt. How management allocates across these choices is a critical element to long-term value creation.
The proverbial “ham sandwich” might be able to run an excellent firm for a time. Eventually, things start to break down, and entropy sets in. At that point, you’ll want more than lunchmeat running the show.
Cash flow machine
Imagine you have a machine in which you can insert $100 and get a positive or negative payout on the other end. The net payout is based on your return on invested capital (ROIC) and weighted average cost of capital (WACC). In the below example, you can invest at 30% ROIC and have an 8% WACC.
The machine gives you your $100 back, plus $30 from the ROIC, minus an $8 cost for using the capital. Consequently, this produces a net $22 in distributable cash. At that point, management has some choices to make.
If a company can reinvest the whole $122 back into the machine at 30%, it would have a net $149 in the next iteration, and so on. This is what a "compounding machine" looks like. If a company has enough projects that generate high ROIC, management should be plowing all the capital back into the machine. Over enough iterations, the value created is massive.
Eventually, even great companies run out of enough high ROIC projects in which to reinvest all of their distributable cash. In the above example, the company might be able to reinvest the $100 at 30% ROIC, but the incremental projects available to it have much lower ROIC.
Management can take the $22 and repurchase stock, pay dividends, or prepay debt to reduce financial leverage. This scenario resembles a "legacy" moat where reinvestment opportunities are more limited, but high ROIC projects continue.
The above are all positive scenarios, made possible by ROIC being more than WACC.
If ROIC and WACC were both 8%, the machine would continually return a net $100 to the operator. It is a fruitless endeavor but not value-destructive. If ROIC was 4% and WACC was 8%, management should stop putting capital into the machine as it destroys value with each turn of the crank.
In both cases, if management returns capital to shareholders, it shrinks the business. This may be the proper thing to do, but few management teams are willing to accept that their business is dying. We're barking up the wrong tree if we're hoping these companies can grow their dividends or expand their buyback programs indefinitely.
Economic moats allow companies to generate ROIC above their cost of capital, providing management teams with more and better options for allocating capital.
Management may misallocate that capital, but the option has value. For example, consider two companies in the same industry, growing at 8% per year.
Company A has a 16% ROIC, and Company B has an 8% ROIC. All else equal, Company A must reinvest half of what Company B does to maintain the 8% growth rate.
Company A can use its surplus to distribute to shareholders in the form of dividends or buybacks. Consequently, Company A should carry a premium valuation relative to Company B.
The dividend versus buybacks debate is a subject for another time. Still, the key for either to be sustainable over a decade and beyond depends on the presence of an economic moat.
I'm sure the bank's ultra-high-net-worth families had their share of investment disasters over the previous 30-50 years. Still, the investments that went on to produce many times their value and provided copious amounts of dividend income were in companies that sustained their competitive advantages. Procter & Gamble and Coca-Cola are two companies I remember being common holdings across the portfolios.
With hindsight, I regret not asking these families what enabled them to hang onto some of those investments as long as they did. I doubt they or their advisors were thinking about economic moats, per se, but the companies' continued fundamental performance likely inspired confidence.
The continued fundamental performance, we know, was a function of sustained competitive advantages and at least adequate stewardship of capital over that period.
As active investors with the skills for doing economic moat and management analysis, we must regularly monitor both factors if we hope to own companies capable of delivering significant value in the coming decades.
Stay patient, stay focused.
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This material is published by W8 Group, LLC and is for informational, entertainment, and educational purposes only and is not financial advice or a solicitation to deal in any of the securities mentioned. All investments carry risks, including the risk of losing all your investment. Investors should carefully consider the risks involved before making any investment decision. Be sure to do your own due diligence before making an investment of any kind.
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