I was incredibly lucky to be a summer research analyst at WCM Investment Management this summer. At WCM, there is a belief that a company’s moat trajectory is more important than its existing moat. This post, inspired by WCM’s concept of moat trajectory, will reflect on how a moat may be thought of as an asset.
Before I apply the language of assets onto WCM’s framework, I want to outline first the origin story of moat trajectory.
A moat, in common parlance, is a deep, wide water-filled ditch surrounding a castle. In investor-speak, a moat refers to a business’ ability to protect its long-term profits by maintaining its competitive advantages. A business’ economic moat, a term popularized by Buffett, works just like a medieval moat, which protects those inside the castle from attack. Following in Munger and Buffett’s footsteps, fundamental investors have gravitated towards investing in fairly valued businesses with large economic moats.
However, in keeping with one of the foundational tenets of microeconomics, competition, drawn by the potential for supernormal profits, often erodes away the competitive advantages enjoyed by such superior companies. The result is that business’ moats may shrink over time. Once great businesses become simply good ones. Returns in such cases are less than spectacular. The WCM team’s key realization was that it is not just the existing but the future moat that really matters. Enter moat trajectory.
Having explained the importance of investigating the moat trajectory of a business, I will now make the case that the language of assets can be used in relation to moats.
An asset, broadly defined, is something of value which can be converted into cash. As a company generates cashflows, a part of this asset may be used up. Take for example a luxury brand which overexposes itself and so generates outsize profits today. Here, the extra cash generated is really from the sale of an asset: the brand equity or intangible moat. In other words, the company divested an asset.
Just as companies can divest part of the moat, they can also invest to create and grow it. For example, a luxury brand may forego some cashflows today by hiring the best designers, spending on brand advertising, and curbing sales to maintain scarcity. These moves may be thought of as investments in the intangible moat. Preserving brand equity will lead to sustainable, strong performance and vice versa.
It may be said, then, that the future moat drives future cashflows, which ultimately determine how much a business is worth. Thus I believe the moat is an asset. Thinking like this will help us (i) reduce the risk of buying optically cheap businesses which are selling assets to generate outsize profits today, but will have less future cashflow; and (ii) identify companies which, although they might appear expensive, are really great businesses that are under-earning because they are constantly investing in their moat-asset.
To end I will return to the image of a medieval castle, one that is constantly under attack. As enemies fill the moat with dirt in a bid to make it crossable, one must spend on digging to maintain and grow it. Similarly, companies too must invest to create and expand their economic moats.
