The Many Ways to Mortgage a Moat

11 February 2019 | by Todd Wenning, CFA

When investors worry about a company’s eroding moat, they’re usually focused on external threats. A new competitor with a revolutionary technology or offering.

But the external threats often come after a company has mortgaged its moat.

Over the edge

Companies mortgage their moat when they press their advantage too hard and alienate stakeholders in the process. This practice can be particularly tempting for executives aiming to maximize short-term performance at the expense of long-term durability.

To illustrate, a recent Wall Street Journal article talked about how many of the big consumer packaged good brands are aggressively raising prices despite falling volumes. We think this is a dangerous strategy in product categories where there are reasonable substitutes, as it could make loyal customers shop around and try other branded and private-label offerings.

Companies with strong family ownership often take a different approach. According to Credit Suisse, public companies with meaningful family ownership, as a group, tend to outperform the market. They also tend to have more conservative balance sheets and post better fundamentals than their peers. One reason for this could be that family-owned companies care more about the firm’s legacy over generations than meeting quarterly targets.

To illustrate, we heard notes of this in Ferrari’s capital markets day in September, which we attended in person. Here’s CEO Louis Camilleri:

“Beyond the numbers, you can rest assure that the entire management team and all the men and women of the Ferrari family will work continually and incessantly with the relentless dedication and, yes, with passion to excel and delight our customers, shareholders, and racing fans.”

Cutting into muscle

Well-meaning executives can also mortgage their moat by “over-optimizing” their operations, depriving the company of oxygen needed to deliver on its long-term strategy.

Analysts herald companies that announce cost-cutting initiatives, yet we see little discussion of the non-obvious yet important impacts of those costs. A company slashing SG&A costs, for example, may be harming employee morale by reducing benefits. A company cutting back on R&D may impair its ability to compete during the next product cycle.

Conversely, companies that ramp investments and expenses to the detriment on quarterly margins often get criticized by investors. (And to be fair, sometimes for good reason.) When we believe a company has high returns on incremental invested capital, however, we want them to invest more and widen the moat.

Bottom line

Here are some ways that companies can mortgage their moat in relation to basic moat categories.

If the moat source is… …beware of
Network effect Poor user curation, alienating one side of the network
Switching costs Taking customers for granted with a lack of innovation and service, Raising prices too aggressively
Intangible assets Cutting back on investments to support brands (marketing) and new products (R&D), Raising prices too aggressively on search-cost brands.
Cost advantages Dismissive of new methods and technology, Sticking with what always worked so as to not frustrate legacy employees and systems
Efficient scale Pursuing a volume-over-price strategy

By focusing on the sources of the company’s economic moat, we hope to more quickly recognize situations in which management may be mortgaging their moat. If we do this correctly, we stand a better chance of getting out of the castle before the siege.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Ferrari (RACE). This company represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

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