HVS 1Q22: WCM On Assessing Sustainable Competitive Advantages

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Hidden Value Stocks issue for the first quarter ended March 31, 2022, featuring an interview with WCM Investment Management, discussing how they assess a company’s sustainable competitive advantages.

Companies that pass the first screen are subjected to your “fundamental analysis.” You place particular emphasis on long-term tailwinds and competitive advantages. How do you assess if a company’s competitive advantages are sustainable?

Drew: We would actually take this one step further, Rupert, and suggest that a sustainable competitive advantage isn’t enough for us. We are actually looking for companies where we can make the case that the competitive advantage is growing relative to its peers, and importantly, that the corporate culture in place is aligned with the business strategy and will allow the company to continue growing its moat over the next 5-10 years.

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The distinction between a growing moat and a sustainable moat is crucial. Afterall, competitive advantages aren’t static, and every company is either getting stronger or weaker relative to its peers. We believe that understanding the direction—or trajectory— of the competitive advantage is critical to understanding business quality, avoiding value traps, and ultimately aiding downside protection.

When you think about the typical value investing playbook, investors are guided to:

  • Find a wide moat business that’s optically cheap based on price metrics, then apply rigorous discrete modeling—e.g., discounted cash flow (“DCF”), sum of the parts (“SOTP”), dividend discount—to uncover the business’s intrinsic value.
  • Apply a margin of safety to this intrinsic value to minimize downside risk.
  • If the business is trading at enough of a discount to its intrinsic value, it’s a buy.
  • Set your price target to the intrinsic value and sell once this target is reached, or go back and adjust your model to justify continued ownership.
  • Rinse and repeat.

Effectively, this approach encourages investors to seek companies trading at 60 cents on the dollar, then sell them at a profit when their stock prices reach their intrinsic values. This price-centric approach operates independently of time-horizon, and forces investors to sell their winners. And as you’re selling your winners, how many of your 60- cent dollars are actually on their way to becoming 40 or 30-cent dollars? This dynamic inevitably forces investors into “value traps”, which we believe can be avoided through by taking a long-term approach, along with an understanding the trajectory of a company’s competitive advantage.

There are several ways to assess moat trajectory, but often the best indicator of a strengthening competitive advantage is finding a company positioned to grow its ROIC over the next 5-10 years. In fact, if you look at any broad international index (e.g., MSCI ACWI ex US) on a rolling 5-year basis across every time period since its inception, there is a one-toone correlation between the delta in ROIC and stock performance, where the companies with the strongest positive ROIC deltas dramatically outperform the broader market, while the companies with the weakest (or negative) ROIC deltas substantially underperform.

And if our fundamental analysis suggests that a company is enhancing its various moat sources (i.e., switching costs, intangible assets, network effect, cost advantage, efficient scale), we believe this will often show up as growth in its ROIC over time.

Once we’ve uncovered a business with a strengthening economic moat, we need to have confidence that its moat will be able to continue to grow for the foreseeable future. Ultimately, we believe this all comes down to corporate culture, which is really just an extension of our moat trajectory analysis.

Andrew: WCM has focused on culture analysis for almost two decades. It’s an area that’s often overlooked, but where we think we have a massive competitive advantage, given that it is incredibly subjective, difficult to measure, and nearly impossible to model.

When we assess a company’s culture, we are trying to understand the DNA of the business. Who drives decision making? What are the incentives in place to promote the behavior necessary to drive forward the company’s strategy and grow its competitive advantage? We are trying to understand whether or not the company’s culture is aligned with its competitive advantage, if the culture allows for adaptable decision making to adjust to unforeseen challenges, and if the culture is strong enough to be pervasive and consistent across the entire company.

We conduct our culture work from a variety of angles, from onsite due diligence visits and meetings with executives, to scuttlebutt research through expert networks where we speak with former employees, competitors, and supply chain partners. While the direct dialogues with management are always insightful and useful, we find a greater deal of value in our conversations with former employees, which tend to be better insights into what’s actually happening within an industry and the innerworkings of a company.

What sort of tailwinds are you looking for as an indication of a firm’s longevity?

Andrew: The most important indication of a firm’s longevity is the adaptability of its corporate culture. We believe an adaptable culture is the ultimate margin of safety for a business. We may not be able to predict the next challenge that a business will confront, but our understanding of a company’s adaptability helps us assign a probability to how successful a business will be taking on new and unforeseen challenges.

From a more traditional tailwind perspective, our long-term approach to investing—paired with our high-quality emphasis—guides us toward multidecade themes such as the proliferation of wealth in the emerging middle class, aging populations, software eating the world, automation, e-commerce, electronification of everything, conspicuous consumption, and trends in health & wellness… to name a few.

You’re looking for firms that are in the “midst of becoming dominant, industry-leading companies.” What sort of markers are you looking for in a company at the beginning of this journey?

Andrew: I think this is an area where we have one of our strongest competitive advantages, Rupert. Companies that tend to meet this definition in our portfolio are categorized as what we call “transitional value” companies. These are businesses we believe are underappreciated by both the value and growth investor alike. These companies tend to live in a veritable “no man’s land”—too optically expensive for the deep value investor, but with too much hair on them for a growth investor. Within this subsection of the market, we are hunting for companies experiencing an inflection point that will allow the businesses to accelerate the growth of their economic moats, typically through a catalyst such as a product-mix shift, a narrative shift, or a cultural turnaround. As these companies inflect and begin to grow their economic moats, we believe their investor bases will inevitably shift from more traditional value investors to growth investors. Along with this shift, we ultimately expect to see multiple expansion: a subject typically considered taboo in the world of value investing.

Drew: I think a company like Royal DSM is a great example of this. DSM likes to call itself “the biggest company you’ve never heard of,” which at a ~$30 billion market cap is probably true today. DSM is a Dutch chemicals company, specializing in human and animal nutrition. The company works to grow yields for farmers across both developed and emerging markets through value-additive vitamin premixes for animal feeds, provides science-focused nutrition solutions for human consumption in various end markets (e.g., eubiotics), and works to bring innovative solutions to market to drive forward its goals of enriching people, planet, and profit. In effect, DSM functions as an outsourced R&D provider for various industries.