I've been thinking about the role of competitive advantage in evaluating investment opportunities after watching this interview with Clayton Homes CEO, Kevin Clayton (here is the YouTube video). As a subsidiary of Berkshire Hathaway, Clayton benefits from such horse's-mouth management wisdom from Warren Buffett as..."Deepen and widen your moat - that competitive advantage that keeps your opponents at bay - everyday."
It occurs to me that "generate loads of profits" is neither an inspiring rally cry for the troops nor an enduring moat. Herein lies a flaw with so much focus on concepts like Economic Value Add (EVA) or Total Shareholder Return (TSR). While noble - and I believe accurate - in principle, these ideas are often bastardized by management in their execution at the business level. Oftentimes managers become enamored of sending so much cash back to shareholders that they stop protecting their moats, opening themselves to attacks by capable foes.
Dun & Bradstreet (DNB) comes to mind. I spent some time looking at the business last November when it was trading around 61 per share, its 52-week low, while sporting a respectable ROIC, nice dividend payment, low capital requirements and demonstrating a willingness to throw plenty of cash (even in the form of new debt) at buying back its shares.
On face value alone, it was a compelling investment candidate...The DUNS Right number is supposedly the ubiquitous mechanism for businesses to evaluate the credit worthiness of trading partners. DNB has honed its process for a century, and - according to them - created a proprietary database of such size and sophistication as to be impossible for a competitor to replicate. In a previous life, I remember my CFO turning to DNB immediately if he had questions about a partner, competitor, or new customer.
That sounds like a good moat, right?
Well, I believe it really was at one time. But over the years DNB has allowed this resource to wither. They have starved the golden goose in the name of total shareholder returns.
Assuming that the DUNS Right process was the dominant way to evaluate your potential trading partners at one time, what should DNB have done to deepen and widen that moat everyday?
1. DNB should have continued investing behind the data and its uses, employing the best engineers and marketing minds available to make it better and expand its uses.
2. DNB should have priced it out reasonably and looked for opportunities to reduce its price to make it impossible for new entrants to even attempt a competitive offering.
What did DNB do instead?
They handed all the golden eggs back to investors (and management) and stopped feeding the goose. They turned a powerful tool with long-term earnings prospects into a dwindling asset. They sought to return cash to shareholders first - reducing capital investment, cutting expenses to the bone, and increasing prices on customers - and ignored their competitive advantage.
In the process they alienated customers with an arrogance that suggested a belief in "where else will they go?" They chopped away research and development, choosing to squeeze existing assets instead. (Not coincidentally for a company no longer investing in itself, a quick dig through the scuttlebutt demonstrates that DNB is not considered a good place to work.) They preyed upon their sources of data, calling small business and extorting them for $500 to monitor and update their Paydex scores so other companies saw them as credit worthy. (This makes the input for DUNS Right data suspect, destroying the air of impartial data needed for customers to really trust DNB as trustworthy source of credit info.)
DNB has returned a lot of cash to shareholders, no question. Not investing sufficiently to protect the competitive advantages of the business can feel really good to short-term investors. Since I considered the investment, the stock price has soared over 30 percent! But for those holding on for the long haul, they must consider the damage done by management. They have taken what should have been an impenetrable fortress surrounding their competitive advantage, neglected it in the name of TSR, and weakened the defenses to a point where competition is entering the market. (Equifax is treating business credit as an adjacent expansion of its consumer credit offerings, Cortera is a start-up exploiting the distrust of DNB and its high cost to crowd-source an alternative at a much cheaper price, and trade associations are pooling information on creditworthiness for their members.)
I passed on DNB despite its apparently cheap price tag. It started with such a strong position in the market, but in neglecting its moat has lost its advantage. While I can't say the competition will prevail, I can say that DNB's neglect has increased their odds considerably.
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