Moats as assets

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.

The Art of Worrying Productively

Worrying is an often unproductive activity. I certainly am guilty of worrying about tasks for longer than it eventually takes to complete them. In investing, too, worrying can breed doubt and become paralyzing (for no company is perfect).

But, worrying is not all bad. Worrying can induce a desirable level of stress which is, in fact, conducive to productivity. Similarly, in investing, too, worrying can be an incredibly productive activity — perhaps even more so than in any other field. Worrying is doubly useful. First, worrying about all the ways you might be wrong allows you to discover what you don’t know. Secondly, worrying in this way leads one to work harder, dig deeper, and become more vigilant, enabling a more thoughtful view on the range of potential futures a business might face. 

Long-term investment success probably relies on a mastery of the art of worrying productively.

Decline and Fall

So far in my journey as a student of investing, I have gravitated towards the strategy of buying stakes in good businesses at reasonable prices. Execution of this strategy often involves investing in these great businesses when they are going through a period short term turmoil. This sounds simple enough. 

Although it sounds simple, it is quite challenging in practice. Investor's typically study a business' history and forecast its future. Evaluating historical track records is undoubtably a crucial part of analyzing  a business and is helpful for developing conviction in investment ideas. However, historical greatness does not imply future success. So, when great businesses sell-off, you run the risk of buying optically cheap businesses where the silent creep of impending doom has set in and the sell-off is, in fact, appropriate.

To learn how to avoid making such mistakes, I have read Jim Collins' How The Mighty Fall, which presents institutional decline as a staged disease. Collins develops a framework for identifying great companies, which are on the path of decline and fall. Here are my notes on Collins' framework.

Stage 1: Hubris Born of Success

For Collins, this stage is characterized by a change in the internal orientation of the company from an emphasis on understanding why you adhere to certain practices, to simply insisting that they are best. This in turn might mean that management stops focussing on the core business, failing to renew obsessively. Thus, the primary flywheel is neglected. 

Stage 2: Undisciplined Pursuit of More

Contrary to popular belief, not a lack of innovation, but overreach is the more common cause of decline, particularly for great businesses. This is for two reasons. First, when hubris kicks in, bravado (not insight and understanding) starts to drive decisions. Second, when businesses start to pursue new projects outside their circle of competence without the right people, they are forced to institute bureaucratic processes. Collins would say a culture of bureaucratic mediocrity replaces a culture of disciplined excellence.

Stage 3: Denial of Risk and Peril

This follows from stages 1 & 2. Management starts to "discount negative data, amplify positive data, and put a positive spin on ambiguous data". The last of these three is perhaps most dangerous. In stage 2, businesses take undisciplined risks. In stage 3, leaders fail (i) to cut losses when the facts change and (ii) to maintain a sharp focus on customer loyalty and stakeholder engagement.

Stage 4: Grasping for Salvation

Companies may stumble towards the end in stops-and-starts. Along the way, there are always moments of exuberant hope. A charismatic visionary, bold and revolutionary bets, that much-mentioned hoped-for-blockbuster. People become so desperate to avoid the worst outcome that they cling to the few straws (frayed as they may be) of hope. However, as is the case with a critical patient, the next speed bump is only too often around right around the corner. As goes the discerning Buffetism, turnarounds seldom turn. 

Stage 5: Capitulation to Irrelevance or Death

In Stages 1-4 organizations burn through cash. By stage 5 they are mere shadows of their former selves.

I find this this framework super useful. But, as a rookie, small investor who is not privy to the internal workings of a business and cannot meet management, I am faced with a practical issue: how do I determine if the silent creep of impending doom has set in? Collins' book suggests the following markers which one can look out for in company presentations and transcripts.

• Good decisions are attributed primarily to skill, and bad ones to luck
• Management exudes a know-it-all attitude
• M&A inconsistent with core business and values
• Personal interests are placed above organizational interests
• Management bets the ranch on grand visions and complete overhauls as opposed to taking a build, test and grow approach. 
• Hype about the future and insufficient focus on risks
• Constant reorganization and chronic restructuring
• Leadership churn
• ALSO: Watch out after a legendary leader steps away

Simple things matter

No one wanted the pandemic. It is, nevertheless, an opportunity to learn. In this post, I will reflect on one of my most important learnings from this experience: simple things matter.

There is a lot of angst around covid. Some simply seem not to care; others have fully holed themselves in. My approach is simple. We must endeavor to lead near-normal lives whilst doing simple things (following good hygiene and some social distancing) to contain the spread. Indeed, having spent a quarter on the UChicago campus, I can say with some degree of conviction that small measures can go a long way. If people wear masks, use hand sanitizer, and form well-defined social bubbles, we can not only contain covid, but can also lead fairly, albeit not entirely, normal lives while we are at it!

I see parallels to this in investing, which too is all about responsible risk-taking. Doing seemingly simple things like focusing on the long term, limiting oneself to one's sphere of knowledge, and emphasizing management quality can help avoid blowups, the equivalent of a covid outbreak perhaps. This is a lot of the job done! Indeed, as Howard Marks says, "If we avoid the losers, the winners take care of themselves." The reverse of this logic also holds true: if we fail to do the small things right, we are more likely to have a covid outbreak, or make a terrible investment. And a single blowup can negate the effects of several good decisions.

It's all about the little big things!

Betting on humankind

As the 2020 saga is coming to a close, I want to take a quick look at the world's scorecard:

Deaths? MILLIONS extra

GDP? DOWN

Mental health? SCREWED 

World? SHUT the hell DOWN

2020 was a bummer year for the world. Full stop!—no ifs, no buts. 

As the 2020-saga comes to a close, however, it seems the covid-saga is, at long last, near the beginning of its end too. I think the world is ready (almost!) to let out a muted "Phew": the economy has not been decimated, mortality has fallen, vaccines are being rolled out...there is light at the end of this dark tunnel. 

In March, fear engulfed the world. Now, our lips are poised, tongues are ready for that collective sigh of relief and sense of having made it out of the woods. We have shown great resilience and displayed a capacity to cope with and adapt to unforeseen and highly undesirable situations. Perhaps the age-old adage "this too shall pass" is indeed accurate. Humankind has survived two pandemics, two world wars, and a great deal more. The full weight of human history points in one direction: Betting on humankind is wise.