In old times, the wider and deeper the moat was - with animals and alligators in and around - the safer the Fort or castle and its inhabitants were - from intruders and attackers. While the context has changed, we don’t have moats around our homes, moats are equally important today, just as they were 500 or 1000 years ago. Whether in sports, business, or investment - it is simplistically a combination of people, processes, and culture that keeps an entity always a step or two ahead of its competitors. In other words, it is a durable, competitive advantage. At Latticework, investing in wide moat companies is our core philosophy.
Now if one is building a business or investing in one, identifying and creating a moat is critical because profit cycles are mean reverting. When a business or an end market earns above average profits and cash flows, its attracts capital and me-too competitors. The result as one can imagine is lower profitability for the entire ecosystem.
To illustrate this capital cycle, lets focus on the frozen yogurt business. A few innovative companies created a new frozen yogurt category - one that was highly profitable. The return on capital was attractive and customers flocked to the product like they would to ice cream on a hot summer day. But as others noticed the high profit potential in the frozen yogurt business, capital rushed in, and yogurt stores opened at lightning speed. The barriers to entry were low, and without sufficient product and brand differentiation the results were predictable – return on capital declined until stores closed and demand and supply reached equilibrium. As an entrepreneur, these boom-bust cycles are devastating. But as investor, they are avoidable.
Let’s spend a minute on the strongest moat in sports today – The New England Patriots. Since the Brady – Belichick era began in 2001, the Patriots have won 5 super bowls, played in seven super bowls (eighth appearance this Sunday), won an incredible 12 regular season games or more every season this decade, and boast the only modern era undefeated season. Patriots are also the only team with two sports scandals – Spygate and Deflategate. But all joking aside, how does one team consistently find a way to win in the era of parity?
Generally, when a new coach gets hired, he brings in new players, new staff, creates new schemes, and shows exciting short-term results. But after a year or two, he leaves enough evidence, which after enough film study is neutralized by opposing coaches. Loses pile, the coach is fired, and then the cycle is repeated.
But not the Patriots. Since day 1, the philosophy has been different but consistent. Belichick, has stock piled draft picks, traded away expensive star players without fear, game planned differently each week to exploit opponent weakness as well as leverage team strength, given away very little information, etc. (This is no different from a shrewd CEO who makes large buybacks when his stock is cheap, makes a large acquisition when the target is cheap, uses stock to acquire when his own stock is expensive, but outside of that does very little and plays long ball.) But decade and a half later, the competition still hasn’t figured out how to close the gap. The Patriots haven’t mean reverted. Could it be as simple as the combination of people, process, and culture have created an enduring moat?
As a side bar, if you were a disgruntled, but eagle-eyed Cleveland Browns, fan studying the Patriots even as after three super bowl victories, you could have jumped on the band wagon and enjoyed football Nirvana while at the same time side-stepped the worst franchise performance for an entire decade.
Similarly, investing in a handful of wide moat companies can be equally joyful for a portfolio over the long run, regardless of perfect timing. But it gets better. The best moats grow over time. In case of the Patriots, as a team success endures, great players are willing to join the team for less to be part of a winning culture. Assistant coaches wait longer for the right head coaching job instead of bolting for the first offer. Owner stays hands off instead of meddling. Opponents press to make the “hero play” instead of sticking to the game plan. And the moat grows.
For example, a business that passes on its scale advantages to its customers in the form of lower prices and better service, one that forgoes short term profits for long term sustainability, can build a tremendous competitive advantage that is very difficult to disrupt. A product with high switching costs can stay a market leader and gain market share for a very long time, if it doesn’t indulge in self-harm. A network business can grow for a very long time and create a great ecosystem as long as it doesn’t try to maximize near term profits.
But the most important benefit of owning a durable business is when business conditions turn south. In tough times, average businesses shed jobs under the guise of “right sizing”, reduce investments in the business, and focus incrementally more on short term profitability or lack thereof. But rational managements take the long view, invest in new products, hire talented employees (sometimes those that were let go by competitors) and emerge stronger than ever. The intrinsic value of these businesses – while never captured in the short-term stock prices – grows at a very high rate exiting a recession.
Today, seas are calm, and most expect smooth sailing for quite some time, but it is virtually assured that at some point in the future we will experience choppy waters. At that point, when business is losing steam and markets are jittery, I hope you have already identified, or built your moat. I already have. Because in tough times, a moat is the only thing you can take to the bank.
This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund"). Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law. An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal. There is no secondary market for interests in the Fund and none is expected to develop. No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.
This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund. These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described. These forward-looking statements will not be updated in future.
I am an investor and these are my personal thoughts on investing, behavioral finance, markets, and sports viewed through the prism of a Latticework