Moat Erosion Starts Behind the Castle Walls

17 June 2019 | by Todd Wenning, CFA

A great civilization is not conquered from without until it has destroyed itself from within. – Ariel Durant

Traditional competitive analysis focuses on external threats.

The most famous framework, Porter’s Five Forces, for example, looks at:

  • Competitive rivalry
  • Supplier power
  • Buyer power
  • Threat of substitution
  • Threat of new entry

All of these factors analyze what’s going on outside the company and how the company fits in its competitive ecosystem.

Even the concept of an “economic moat” suggests that companies should be fortifying themselves against threats from without.

 

Expectations

Of course evaluating external threats is critical, but we believe that moat erosion typically begins behind castle walls.

Only after the company loses customer focus, gets lazy, or gets weighed down by bureaucracy, do competitors have a chance to destroy the incumbent’s moat.

In The Founder’s Mentality, Bain & Co.’s Chris Zook and James Allen write that corporate stagnation is “An internal problem caused by growth. Ninety-four percent of large-company executives cite internal dysfunction as their key barrier to continued profitable growth…As companies grow in size and complexity, they lose the dexterity and the flexibility they need to sustain growth.”

To illustrate, the common perception of Kodak’s downfall is that the company was slow to react as competitors launched the digital photography revolution. This is partially true. In fact, Kodak patented the first digital camera in 1978. Kodak just refused to market it, lest digital sales ate away at their high-margin film sales. Kodak’s moat erosion started from within.

To be sure, understanding internal dynamics is challenging for outside investors. (Perhaps that’s the reason researchers focus on more observable and measurable external dynamics.) Even boards can fail to recognize internal problems, which is why activist investors have a place in the market.

Yet we think it’s essential to get a big picture view of a company’s values, mission, and work environment. This matters for both “defensive” and “offensive” reasons.

On the defensive side, we want to own companies we believe will maintain (and ideally widen) their economic moat for the next decade and beyond. If we believe the company is culturally agile, run by exemplary stewards of capital, and cares for all its stakeholders, then we’ll be more confident it can keep competition at bay. However, if one of our companies is rotting from the inside, we want to get out as soon as possible.

As for offense, we like passionate companies that are sieging a castle that’s crumbling from the inside.

Reality

In 2016, for example, we concluded that Time Warner favored protecting its dividend over competing with Netflix on streaming. As such, we exited our position in Time Warner. We had been following Netflix closely, but had not built enough conviction in the strength of their moat to invest in the company. With Time Warner having trouble behind its castle walls, our conviction in Netflix’s ability to attack the profit stream of linear TV increased and we established our initial investment in the company.

Shortly afterwards, Time Warner threw in the towel and sold themselves to AT&T. Here’s what Sean wrote in an October 2016 post after Time Warner agreed to be acquired by AT&T.

While Time Warner has put resources behind HBO NOW and it has had some success in building a direct distribution business, the management team has seemed to believe that it is more important to protect their legacy business and their $1.3 billion annual dividend rather than invest aggressively in preparing their business for the transition to streaming.

By selling to AT&T, Time Warner is waving the white flag and admitting that Netflix has become HBO before the company could become Netflix. Therefore, their best option is to sell to a distributor like AT&T, which itself needs content to compete effectively against Netflix and other streaming platforms.

It’s behaviorally difficult for incumbents to innovate when it puts their cash cow at risk. While these companies are protecting their own interests, they are often doing so at the expense of their customers who want or need innovation.

As Professor Thales Teixeira writes in a recent Harvard Business Review article:

Disruption is a customer-driven phenomenon. New technologies come and go. The ones that stick around are those the consumers choose to adopt. Many of the fast-growing startups such as Uber, Airbnb, Slack, Pinterest, and Lyft don’t have access to more or better innovative technologies than the incumbents in their respective industries. What they do have is an ability to build and deliver faster and more accurately exactly what customers want. This is causing the change-of-hands of sizable amounts of market share is relatively short periods of time. 

And while Warren Buffett coined the phrase economic moat and painted the picture of companies fortifying themselves in the midst of unbridled competition, he made clear in his 2005 shareholder letter that what goes on behind the castle walls is what makes or breaks a moat.

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now.

It’s when companies take their focus off the customer, mission, and operational execution that challengers get an opportunity. And in today’s hyper-competitive world, it’s more important than ever that companies are internally strong and ready for a fight.

The better we can identify internal strengths and weaknesses in the companies we research – and their competitors – the better we believe we can play smarter defense and offense in the portfolio.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Netflix. This company represents 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.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.