Mortgaging the Moat

Every now and then you hear a phrase that succinctly explains an idea that had been floating around in your head. One of my favorite examples is just keep buying, but a more recent one I stumbled upon was mortgaging the moat.

The idea behind mortgaging a moat is essentially that a company is eroding their moat through poor decision making. This can happen in a number of different ways, but primarily it happens through short term thinking. A huge portion of this is driven by companies maximizing their pricing power over the short term.

When the market recognizes a companies moat, they generally trade at a higher multiple. If that moat erodes, not only does the company experience multiple contraction, but also reduced earnings/cash flow. It’s a nasty combination.

Investors love to talk about moats, but they don’t often talk about how many companies are mortgaging their moats. Identifying a moat is hard enough, so many people choose not to take it to the next step to understand how a company is using the moat. Worse yet, many investors don’t recognize short term thinking because they judge companies by their stock price. In many instances short term thinking can cause a short term bump to stock prices, which only causes investors to be misled further.

Here are two examples of companies that I see possibly mortgaging their moat:

Apple

Apple has been delighting its customers for decades. They’ve built multiple huge moats. How could they be mortgaging it? Simple answer: short term profit maximizing. I won’t spend too much time on my concerns around Apple, but their practices around ads and the app store are mortgaging their moat. Simultaneously implementing the IDFA changes while building their ad business is at best questionable. Apple has been an incredibly innovative company, but when you combine stagnating innovation with increasing short term optimization, I see their moats being mortgaged. If the largest company in the world is mortgaging their moat, it’s definitely an idea I want to pay attention to.

Adobe

In many ways, Adobe is like Apple. The reaction from my wife is the same if I try to get her to stop using Photoshop or a Mac… a blank stare, then a quick explanation of why I’m dumb. This is what cult brands are and both Apple and Adobe have them. The problem with Adobe is that they really frustrated their user base by switching to a subscription model (then subsequently consistently raising the pricing). It was an amazing business decision, but absolutely a move that erodes their moats. I know lots of users who were frustrated by this switch, but they all still use Adobe. I even own Adobe, but the mortgaging of the moat does seem real to me. It is something that I am watching closely.

Wrap It Up

I’m picking on companies that have huge moats, so they have to have room for error. Management is supposed to maximize cash flows. Many of the decisions of what companies are doing is maximizing cash flows in the short run, not the long run. Yet, these companies moats are so large that they can be mortgaged at time without grave consequences. The problem is once you start mortgaging a moat, how do you stop?

Short term thinking can ruin even the greatest of businesses.