“Success breeds complacency. Complacency breeds failure. Only the paranoid survive.” – Intel co-founder, Andy Grove

There’s a lot to like about economic moats. By keeping competition at bay, moats allow businesses to sustainably produce returns on invested capital (ROIC) above their costs of capital. The result is economic value creation. As investors, firms that compound intrinsic value are attractive since they put time on our side.

But it’s essential that moat analysis continues beyond your initial investment. Indeed, wide moats, in particular, can make companies too comfortable and thus susceptible to upstart competition.

Consider the following passage from Jean-Denis G.G. Lepage’s book, Castles and Fortified Cities of Medieval Europe: An Illustrated History (my emphasis):

A wet moat, called a douve or wet ditch, formed a very efficient obstacle against the assaulting army. However, wet moats could be something of a mixed blessing; they were inconvenient in peacetime, which meant that unofficial bridges were often erected – with subsequent argument and indecision about the right moment to chop them down in an emergency. Besides, water might dangerously erode the base of the wall, and stagnant water might be a year ‘round health hazard for the inhabitants of the castle.

When things were going well, the moat-encircled defenders often let their guard down until it was too late. The simple existence of a water-filled moat could lead to pestilence or otherwise weaken the castle’s residents before the next attack.

Lulled to sleep

At the risk of over-extending the analogy, there are parallels with economic moats here. It can help explain how Dollar Shave Club snuck up on Procter & Gamble’s lucrative Gillette razor business, how Apple and Google unseated BlackBerry’s smartphone dominance, and how Netflix helped lead a cord-cutting movement much to the chagrin of cable companies.

Successful companies that aren’t vigilant or are afraid to disrupt themselves can quickly lose the next battle with competitors. As Andy Grove said in the above quote, “only the paranoid survive.”

And there’s never been a better time in the business world to be paranoid. Rapid innovation and cheap and abundant capital make moats more vulnerable.

• Billion-dollar brands that once won consumer mindshare by having the most robust advertising budget now face upstart brands with vibrant low-cost social media followings.
• Tech companies that built switching cost advantages using legacy systems now need to justify their typically-high prices against Software-as-a-Service (SaaS) alternatives.
• Industrial distributors that relied on scale-driven cost advantages and sticky relationships are finding their customers more willing to shop and price-compare.

Investors should seek opportunities in which they believe future ROIC will be ahead of market expectations. As the market revises its ROIC expectations higher, it should lead to a rising stock price. Conversely, if ROIC erosion happens faster than the market expects, it will likely lead to a price drop. As such, it pays to make moat evaluation part of your regular investment process.

Process

So, how might we be more vigilant about moat vulnerability?

First, determine the company’s moat source.

If the moat source is…	…beware of
Network effect	Emerging distribution technology; Declining user engagement
Switching costs	The arrival of cheaper alternatives with quality approaching that of the incumbent; Fading pricing power
Intangible assets	An inability to create new brands, develop new patents, etc.; Product gaps in the company’s offerings
Cost advantages	New technology that reduces costs industry-wide; Secular trends in underlying commodity prices
Efficient scale	The entry of irrational competitors; A change from a price-over-volume to a volume-over-price strategy

Second, consider management’s capital allocation decisions.

• Is the company reinvesting enough capital in its best operations or is it irrationally milking them for cash flow?
• Has recent M&A strengthened the moat or were there other motivations (e.g. growth-for-growth-sake, management’s ego, etc.) behind the deals?
• Is management returning too much capital when it should be reinvesting to face new competitive threats?
• Does management understand ROIC concepts and work to sustain/improve those metrics?
• Has management shown a willingness to shed underperforming businesses and reallocate the capital to better opportunities?

Finally, study the company’s corporate culture.

• How quickly can the organization adjust to change?
• Are decisions made in a bureaucracy or are operations decentralized?
• Does management have skin in the game or are they well-paid mercenaries?
• Does the corporate culture directly support the moat (g. Starbucks’ “happy employees make happy customers”) or might the culture work against it?

One of the more difficult things to grasp about eroding moats is how quickly the process can occur. Moats that took decades to build can disappear in the matter of a few years – or less. As we’ve seen, once the market agrees a once-powerful company no longer has a moat, its premium valuation vanishes and investors who were slow to react pay the price.

Bottom line

By periodically reviewing a company’s economic moat, we acknowledge a key principle: Moats are not static. They are getting wider or narrower every day. In the hands of the wrong management team, they can even be a mixed blessing.

If we can identify an eroding moat early, we stand a better chance of exiting the investment with more capital to reallocate. Better still, we might avoid making an initial investment and putting your money at risk in the first place.

Clients, employees, and/or principals of Ensemble Capital own shares of Apple (AAPL), Netflix (NFLX), and Alphabet (GOOGL).

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