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The Diff is a newsletter exploring the technologies, companies, and trends that are making the future high-variance. Posts range from in-depth company profiles, applied financial theory, strategy breakdowns and macroeconomics.
Equity as an Option on Future Reinvestment
A good intuition pump for thinking about companies in general, and the stock market in particular, is to ask: why does the average company trade at a premium to book value? The S&P 500's total market cap is about $32 trillion, and it trades at 4.1x book value, so for a mere(!) $7.8 trillion you could replicate all the assets—buildings, factories, equipment, inventory, receivables, cash on hand, etc. And yet investors are overwhelmingly more likely to allocate their money to an existing public company at some premium to book value than they are to rebuilding the same business at a discount.
This is not an entirely silly question. Some of it comes down to accounting: the book value of $100 million of last year's branding, employee training, etc. cost is $0, but obviously that kind of work still has value. And there are other accounting elements: a nuclear power plant's book value will drop over time as it depreciates, but its replacement value has gone up as new plants have gotten more expensive. Tobin's Q Ratio is an effort to look at this as a signal, by measuring the market value of companies relative to the replacement cost of their assets. Right now it's at 1.24, down from a recent peak but well above the long-term trend. (This ratio was below 1 from the 1930s through the 90s, i.e. there was a multi-generation period where corporate America, by one measure, was simply not worth the effort.)
Of course, it's easy to think of companies that are worth more than more than the money that's gone into them, even if we correctly capitalize upfront costs that have long-term payoffs. In other words, the premium to book value does make sense even in a world where capital is mobile and competition is ubiquitous, in part because the best companies have assets that are worth more than their accounting value and in part because the biggest chunk of some companies’ economic value is the fact that they can keep reinvesting in good assets. There are many ways to model this out. One fruitful option is to take the nuclear power plant comparison from before, and apply it to other kinds of investments that are cheaper to make upfront.
For example, setting a high standard for product quality, customer service, unwillingness to offer discounts, etc. has some cost. The cost of maintaining such a standard is lower. So the right time to obsess over it is from day one; when the "customer support" team is every cofounder checking a shared inbox, the cost of responsiveness is low because there simply aren't that many customers. And maintaining this—both keeping latency down and treating customers well—is partly a matter of tracking metrics and partly one of setting a good example. Being tough to negotiate with on pricing is another sort of asset whose value compounds; being stubborn early on (especially when there's room to be flexible on what gets delivered in exchange for delivering it at a particular price) establishes a norm internally and externally that can scale as revenue grows. For reputational issues in general, the "reputational replacement cost" goes up as a function of the size of a business; when a big company messes up, or is perceived to, it's a long and daunting process to get back to even. It wasn’t easy for Google to make “Google” a verb, but whatever it cost, it would be much, much more expensive to convince people to stop “Googling” and start “Binging” or “DDG-ing” instead.
There are other practices in the broader world of "get things right the first time" that can produce compounding returns. The more equity someone has in an early-stage business, the more their de facto part-time job is recruiting; this applies to VCs and to early employees. And it means that hiring and raising capital are also decisions about which network to tap into (when a company has a founder from a name-brand tech company, it doesn't just mean that the founder has been vetted by that company—it means that the hires they make through their network will include a subset of people vetted by that company and by the founder.)
And there are some kinds of expenses that are closer to a bet on the future state of the world. For some categories of product, the world needs 1 +/- 1 of them, so building it means some chance of a total loss, some chance of a monopoly, and the possibility of a cozy-or-not duopoly. Distribution networks and AI models both fit this category; the right time to build one is before it's obvious that it will get a good return, because that's also the time when it's plausible to be the only company building it, and there are plausible future worlds in which it's lucrative to be the only company to have built it.
Working backwards, the big companies must have been good at at least one of two things:
Raising money.
Getting an above-average return on the money they raised.
And the bigger a company gets, the more difficult it is for point #1 to remain an advantage. A company that's better at raising than at investing can do fine in private markets (and can, with a bit of luck, evolve into being good at both—some of the skills required to negotiate with VCs translate nicely into the skills required to negotiate with key hires). But as such a company gets bigger, the due diligence process gets stricter, and once it's public there's a very strong incentive for short sellers to identify flaws in its economics.
Warren Buffett has a nice quote on the matter of ROE that's worth thinking about: "If you earn high enough returns on equity and you can keep employing more of that equity at the same rate—that’s also difficult to do—you know, the world compounds very fast." That's a deep point, because there are many businesses that can achieve a high return in retrospect, but not in prospect.
Take the biotech industry: The biotech ETF, XBI, has produced an overall growth rate of 10.8% since its 2006 inception, about a point ahead of the S&P but with sharper drawdowns. Within that industry, though, we might treat each company as a business that has a 10% shot at a ~110%+ return on the fixed investment in a single drug, or a 90% chance of liquidating without achieving anything. Looking backwards, publicly-traded biotechs will have good returns on investment, but that's because they're the most successful subset of the entire industry.
Much rarer and more precious is the kind of company that can both produce a high return on its existing capital and continuously reinvest at above its cost of capital. Take Buffet’s Berkshire Hathaway as an example: the company is really a collection of two types of companies: those that will get minimal reinvestment and produce steady returns (think Buffalo News, which was acquired when it was the strongest paper in a two-paper town, and which had many years of profitable monopoly status before cable TV, AM radio, and finally Craigslist devoured its economics) and those that can take some of that harvested cash flow and reinvest it in something that will get a decent return. Berkshire's utility holdings (Berkshire Hathaway Energy) and its quasi-utilities (like the BNSF railroad) send lots of their cash flow back to the home office, but collectively they'll absorb around $12 billion in incremental capital expenditures this year (Energy's capex plans are here, BNSF's here).
When companies are valued based on a discounted cash flow analysis (explainer here for readers who want a deeper dive), the valuation number hinges in part on just how long the company can reinvest and grow before its growth rate converges on something below the discount rate applied to those profits. A continuous-reinvestor has a much longer growth period, and a correspondingly higher valuation once things settle down.
Of course, part of the trick is trying to find such a company. Peter Lynch seemed to use this pattern; from Beating the Street:
I was attracted to fast-food restaurants because they were so easy to understand. A restaurant chain that succeeded in one region had an excellent chance of duplicating its success in another. I'd seen how Taco Bell had opened many outlets in California and, after proving itself there, had moved eastward, growing its earnings at 20 to 30 percent a year in the process.
Once a chain has gone from regional to working well in two regions, the way to bet is that it'll work just about everywhere. Some things have changed since Lynch's day. Unfortunately for buy-what-you-love stockpickers with a penchant for fast food, the market has gotten pretty good at slapping a high multiple on chains that can show good unit economics and can plausibly talk about reaching "the other 90% of the country."
Still, it's a strong model, and it applies to many kinds of businesses. When you're underwriting some long-term growth trajectory for a business, a good question to ask is "what is it that makes their dollars the kind that produce a return on equity of 15%? (or 20%, or 25%) when the rest of corporate America mostly earns its cost of capital?" There isn't necessarily a good answer; some businesses started with a lucky break and converged on the median performance for their overall industry; last week, paying subscribers read about Capital One's trajectory from a proto-fintech to a big bank ($), and the commensurate reduction in shareholder returns from enviably-techy to about what you'd expect from buying equity in one of America's twenty biggest banks by assets.
But these companies do still exist. And they're usually priced accordingly:
TSM is buying equipment that other semiconductor manufacturers can buy (at least if they're not under sanctions), but their process knowledge and long-term customer relationships create persistently higher returns on equity.
Every successful creative effort at Disney turns into an opportunity for more capital expenditures: a popular character from a movie franchise can get their own Disney+ show, or can become an attraction at a park.
Cintas (written up for subscribers here ($)) already delivers company uniforms to over a million businesses, so adding other products to that delivery has a low marginal cost.
Microsoft (disclosure: long) has a more abstract distribution network, but when a new business tool gets identified, like video chat or, well, chat, Microsoft can throw it into the bundle.
Salesforce, of course, can do this too, often through acquisitions like their purchase of Slack. Nobody said this was easy.
A good company is a carefully-constructed bubble of negentropy; it's an environment in which high returns, on capital and people, are sustained over long periods, creating a company that’s worth more than the sum of its parts. But fighting entropy is hard, and only gets harder with scale; the bigger a company becomes, the more of its surface area is exposed to uniqueness-sapping, ROI-depleting problems. Some of these are internal; it's hard to maintain a distinctive company culture while adding massive headcount. Some are external: if the company does something special and profitable, competitors will try to figure out how they can do it, too, and other companies in the supply chain will try to weaken this advantage so the high profits accrue to them, instead. So the end conclusion of searching for the ability to continuously reinvest at high returns is a search for companies that have beloved brands, favorable regulations, or a relentlessly paranoid management team that's obsessed with delaying the onset of mediocrity.