Guest post by

Blaine Hodder

Before you get into the article, this article is from a forum post where we were discussing competitive advantages and FCF. The conversation moved to how companies that do not generate much FCF can be great opportunities which prompted this post.

To get a better understanding of the discussion prior to this post, view the thread here.

#### The Problem with FCF

Let me share a lesson with you that I learned the hard way, even though Munger has written about it extensively, “invert, *always invert”.*

One way of interpreting this advice is to ask how, and in what circumstances you could be wrong. You will notice that both my qualitative and quantitative points in my prior post get back to this. So, why don’t we walk through a situation where analyzing **free cash flow** and FCF growth would be misleading?

I will use a simple example of two friends starting a lemonade stand.

**Lemonade Stand #1 – FCF Focused**

Jonesy loves **free cash flow**.

He gets to take his cash and buy Coca Cola (and who doesn’t love Coca Cola).

So when his dad gave him and his friend Vince, 10 dollars each to start a lemonade stand, he knew he could turn that into some cash to buy Coke. He took his 10 bucks and bought the usual supplies: a crappy table, some cheap lemonade mix (the returns on real lemons are lame!), some plastic cups, a few signs, and a jug.

There goes his 10 bucks.

The day goes great for him as he sold $30 of lemonade throughout the day.

That gives him a return on tangible equity (ROTE) of $30/$10= 300%. Definitely nothing to scoff at, especially as he won’t be paying any taxes. This likely beats even the most aggressive of investors’ hurdle rates for returns.

Now Jonesy knows he can pull out $10 of free cash flow and buy a massive supply of Coca Cola.

With the remainder he wants to reinvest in 2 more tables, more lemonade mix, cups and jugs.

Jonesy and his friend had both read Tom Sawyer, and figured they could trick their other friends into helping out with the lemonade stands, so they knew they would never have any labor costs. Jonesy also lives in a thirsty desert city, so he knows he will never run out of customers, and thus face diminishing marginal returns.

**Day 2**: Jonesy makes $90. Since he now has 3 table sets, for a total cost of 10 bucks a set, he is still achieving returns on tangible equity of 300%.

But he just loves Coca Cola, and is giddy with delight at how much he can buy now. So he repeats the 1/3 extraction rate of free cash flow and redeploys the rest of the cash into more stands.

2/3 of his days returns (60$) are going into tables, with the rest in cash for Coca Cola ($30). He continues this process for 5 days, leaving him with a swimming pool of Coca Cola and a massive pile of cash.

He then liquidates the supplies at the same price he bought them for since the lemonade business is really booming in other cities as well.

#### Results of FCF Cow Lemonade Stand

I suppose he could continue this process if he wanted, but for the example he will wind up after the 5 days.

Look at the table of his results:

** **

**Lemonade Stand #2 – Owner Earnings Focused
**

Vince (Jonesy’s friend) does not care about Coca Cola as much. He cares about snowballing his wealth. He has read his fair share of Berkshire’s annual letters, so he knows to not be fooled by FCF, but rather,to look at **owner earnings** and **returns on tangible equity**. He knows that a scalable lemonade stand would be a ridiculously great addition to his mini holdings firm.

So Vince takes his 10 dollars to start the lemonade stand and buys the same supplies as Jonesy: a crappy table, some cheap lemonade mix, some plastic cups, a few signs, and a jug. There goes his 10 bucks.

The day goes great for him as well as he handily matches Jonesy’s earnings by selling $30 of lemonade throughout the day. That gives him a return on tangible equity (ROTE) of $30/$10= 300%.

He knows this beats his hurdle rate, so like a smart manager in a snowballing company he decides to plow it back into more tables. His 30 bucks buys him 3 more table sets.

Vince faces the same economics of his friend Jonesy so he knows he can scale, he knows his ROTE = 300%, he knows his labor is free, and he knows he isn’t paying taxes.

Since Vince now has 4 table sets, he can really start to pull in big revenue.

#### Results of Owner Earnings Focused Lemonade Stand

His second day he makes:

4 table sets x $10 x 300% ROTE= $120

He continues snowballing all of his earnings back into table sets all week at the same returns. At the end of the week he could also sell his tables for the same price as Jonesy, so we will account for that as well.

Let’s look at his results:

#### Why the Difference Between FCF and Owner Earnings?

Wow! Vince has absolutely destroyed the economic returns of his friend Jonesy, as Jonesy was so busy concentrating on **FCF**, FCF growth, and Coca Cola, he was blind to his **Owner Earnings** and his returns on tangible equity.

- Jonesy had great cash flow, and a great FCF growth rate
- Vince had no free cash flow, and no growth of that free cash flow, but he was growing his owner earnings rapidly

Vince is the big winner.

He recognized his high returns and knew the moat protecting those 300% returns was strong:

- He lived in an outrageously hot desert city, with massive demand for lemonade
- The local kids were foolish enough to to fall for the old Tom Sawyer trick, so he knew they were unlikely to start a competing business which would destroy his returns.
- He was operating in an oligopoly business against weaker competition who foolishly allocated capital.
- The competition in neighboring cities can’t expand nationally, as the kids all live at home

Therefore, he was wise to reinvest.

If his growth prospects at high returns begin to dry up, he would then extract his free cash flow and put it into one of the other more profitable businesses he has going.

Similarly, if the neighborhood kids start to enter the lemonade business and he predicts his moat and returns will narrow, he will start to extract as much cash as he can.

Chasing growth for growth’s sake is not his style. Chasing Owner Earnings is what matters to him. He would even consider closing down the lemonade business altogether, as unlike Buffett, he doesn’t need to worry about his workers” pay (they weren’t receiving any). He is building a mini Berkshire.

Vince is a young Buffett in training. Vince understands the value of a snowball.

#### About the Author

Blaine Hodder graduated from the University of Lethbridge with a bachelor’s degree in accounting, and is currently working as a risk analyst in commodities trading for a large integrated oil company. He is a passionate self taught value investor in the style of Ben Graham and his disciples.

Blaine currently lives in Calgary, AB with his partner Bernadette and their dog Sonata, and he couldn’t be happier.

Follow him on twitter @blainehodder to stay tuned for more postings, and the debut of his blog, **The Hodder Blotter**