It's not moat size that matters
Conventional wisdom and financial textbooks will stress the importance of valuing a company’s competitive advantage or economic moats. WCM Investment Management has moulded this strategy, instead placing their focus on the direction of company moats.
WCM believes that competitive advantages are not static. What is more important for investors is whether a business growing or losing this advantage over time rather than how big that advantage currently is. Sanjay Ayer cites incumbents of the past - Blackberry, Nokia and Dell - as examples where investors failed to see contracting competitive advantages.
Investors tend to underestimate the damage that can be caused when a company's competitive advantage is shrinking. It's not a slow bleed. Usually, it's a sharp decline.
Ayer explains this approach employed at WCM and one stock which his fund believes is losing their competitive advantage.
Can you explain how WCM uses competitive advantages to find opportunities?
I think most investors learn from reading textbooks, and most of the textbooks about quality investing are very comparable. They tell you to look at companies and analyse them through a lens of competitive advantage. They stress the importance of finding companies that have large competitive advantages, or in industry parlance, wide economic moats. So that could be lots of scale, strong brand, intellectual property, or big bargaining power with buyers and sellers. Our view is different. Our view is competitive advantages are not static, things change. There are forces working for a company, against a company, and it's really the direction of that competitive advantage, not the size of the advantage that drives stock returns. So, we'd much rather own a good business that's becoming great than a great business that's becoming good.
When you think about it, technology is the easiest way to kind of illustrate that point. If you go back 15, 20 years ago, you look at the ‘who's who’ of technology companies, many of them don't exist today, or they exist in much smaller forms like companies like Blackberry, Nokia, Dell. It's easy, in hindsight, to poke fun at these companies and where they've ended up, but back in their day, they were the paragons of quality and technology. What I think investors missed is that they were becoming less great companies over time. Their moat trajectory, as we call it, was negative.
I think investors tend to underestimate the damage that can be caused when a company's competitive advantage is shrinking. It's not a slow bleed. Usually, it's generally a sharp decline, especially in technology. So really keeping that bar high and owning a portfolio of companies whose competitive advantages are growing is the name of the game for WCM.
What is a perceived quality company that is losing its advantage?
One of the investments we exited recently, was a company called Activision. It's a video game company, and our original thesis was the large-scale players are in a good shape in that industry because the cost of game development is rising. There are things like connected gameplay, digital gaming, and all of these kinds of new themes are helping the existing large companies who have big budgets and existing large franchises.
I think things changed pretty abruptly in the last two years where you had the emergence of games like Fortnite, free-to-play gaming, social gaming, and really the relevance of some of the advantages of the big companies was steadily diminishing.
So it's not to say these businesses won't continue to be good businesses and can churn along, but for us, we're trying to keep that bar very high. We find it hard to think that those economic moats, those competitive advantages are still growing, and so that's enough for us to exit a position. We're not a manager who will wait for evidence that the moat is breached. I think if you're in the growth camp and you're waiting for that signal, it's far too late. There's irreparable damage done to the stock and the portfolio.
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