Saturday, July 1, 2017

Moats & Knights, Part Deux

In December, I wrote about the rare and powerful "moat and knight" combination - a company with a defensible competitive advantage led by top-notch capital allocators. 

Since coming across that concept a few years ago, I've wrestled with the relative importance of the two factors. What's more important: moat or knight?

In a recent post, my former office mate at Motley Fool UK, Maynard Paton (who you should follow), paralleled my current thoughts on the subject quite well:

Years ago I used to believe that traditional business ‘moats’ — such as brands, patents, regulations, economies of scale, network effects, and so on — were the most critical feature of any investment . 
But these days, such ‘barriers to entry’ appear increasingly at risk of being challenged by intrepid startups that can use the Internet to gain customers much more quickly than ever before. This investment paper cites a good example of Gillette and Dollar Shave Club. 
Over time then, I have become far more convinced about the importance of management to an investment. 
Put simply, I’d like to think a business is more likely to enjoy long-term success — and fend off intrepid startups — with a loyal and committed executive at the helm. 
(Indeed, a company’s positive and adaptive working culture — instigated by a loyal and committed boss — can in itself be a difficult-to-replicate ‘moat’.) 
On the other hand, I am no longer so sure about professional ‘salarymen’ executives, who may be quite happy to run things in a customary way and risk becoming complacent when it comes to fresh competition.
Spot on.

There was likely a time when the advice to "go for a business any idiot can run" made sense. Find a wide moat business and be patient. All management had to do was look the part and not screw things up too badly.

That time has passed.

Today's raiders have new siege weapons and it's critical to have a knight - or ideally, a number of knights - implementing nimble defenses.

Run away! Run away!
This isn't to diminish the importance of economic moats - a knight defending a grass hut doesn't do anyone much good - but it is worthwhile to spend more time considering who is manning the ramparts.

Here are five questions you can ask about management before making your next investment.

  1. Has management been forthcoming about competitive challenges or do they downplay the threat of new entrants?
  2. Does management have the right financial incentives in place or has the board set up low hurdles to make sure large bonuses are realized, regardless of performance?
  3. Does management know what the company's advantages are and have plans in place to extend and strengthen those advantages?
  4. Does management have meaningful personal ownership in the business (and thus have skin in the game) or are they akin to mercenaries? 
  5. Does management have a track record of sacrificing short-term results for long-term results or do they seem to play the quarterly earnings game?
Stay patient, stay focused.



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