This article is authored by MOI Global instructor Todd Wenning, a senior investment analyst at Ensemble Capital Management, based in Burlingame, California. Visit Ensemble’s Intrinsic Investing website for additional insights.
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 [Stannard-Stockton] 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:
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About The Author: Todd Wenning, CFA
Todd is a senior investment analyst at Ensemble Capital. Before joining Ensemble, Todd was an analyst at Johnson Investment Counsel, where he worked on the firm’s SMID cap strategy. Prior to that, Todd was a sell-side analyst at Morningstar, where he led Morningstar’s equity stewardship methodology and covered companies in the basic materials, industrials, and consumer sectors. Earlier in his career, Todd worked for The Motley Fool, SunTrust Asset Management, and Vanguard. He holds a BA in History from Saint Joseph’s University in Philadelphia and the Chartered Financial Analyst designation.
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