Yesterday, I listened to a podcast episode of “Invest Like the Best” that featured host Patrick O'Shaughnessy speaking with Pat Dorsey, an asset manager and long-time director of equity research at Morningstar, about his approach to investments. Dorsey has written well-received books on the subject and below are my notes from the discussion. If investing in companies with significant competitive advantages interests you, I recommend listening to the conversation between Patrick and Pat.
Economic Moat
Dorsey is known for developing Morningstar’s moat rating system which he derived from Warren Buffett; Buffett first described GEICO’s competitive advantage as a moat around an economic castle in his 1986 letter to shareholders of Berkshire Hathaway. Dorsey expanded on Buffett’s idea by defining an economic moat to be a structural characteristic of a business that insulates it from competitive forces. Such an advantage allows a company to reinvest capital at favorable rates of return by preventing competitors from entering the market and depressing margins.
Four Types of Moats
1. Intangibles
License
Must be enforceable
Subject to Regulatory Risk
Brand
Prestige
Display Status
Identify Culture
Identification
Simplifies a customer’s search cost
Driven by Awareness and Advertising
Formerly controlled by Mass Media
Under pressure from reduced cost of exposure due to the internet and social media
Trust
Build on reputation and past success
Social Proof
2. Switching Costs
- Captive Customers
- Plumbing/Infrastructure for specific/niche industries
- Abuse/neglect: products/services may suffer, without recourse for customers
3. Network Effects
- Returns to Scale: Customer/User experience improves with network growth
- Radial Vs. Interactive
- Radial - Hub and Spoke Networks
- No significant user benefit from larger networks
- Competitors may supplant incumbent by strategically focusing on individual connections
- Examples: Airlines, Western Union
- Interactive Networks
- Users benefit from interaction with others or the presence of other users
- Loss of a single user or network connection does not significantly impair the overall network
- Examples: Facebook, Mastercard
- Radial - Hub and Spoke Networks
4. Cost Advantages
- Manufacturing Efficiencies
- Scale
- Intangible Assets
- Research and Development
- Ability to Improve Products/Services
- Scope
- Experience
- Trade Secrets
The key to analyzing economic moats is to understand how a company can and will use its competitive advantage to deliver returns to shareholders. Not all moats are created equal. Some moats are more challenging to maintain, but, compared the alternatives, Dorsey prefers a business displaced only at significant cost to customers; a moat derived from high switching costs is most easy to defend. A network business like Mastercard or Facebook may have to spend more to defend the competitive advantage, but the potential to reinvest capital at high rates is also very intriguing.
Every business is unique, and each moat must be analyzed individually. When O'Shaughnessy asked him how to use statistics to identify businesses with competitive advantages, Dorsey explained a statistical approach restricts the investor’s analysis to past performance; greater emphasis should be on a business’ potential to maintain and expand its moat. Coach used to be a brand synonymous with prestige, but, in pursuit of revenue growth, its management allowed the brand’s position to deteriorate. Mastercard did not appear to be an exceptional business at the time of its initial public offering, but through strategic analysis, and, of course, hindsight, Dorsey explained generating a marginal dollar of revenue is particularly inexpensive.
Capital Allocation
A business whose customers have prohibitive substitution costs may deliver considerable operating cash flow but lack opportunities for reinvestment; in this case, managers and investors face a different challenge. Without organic growth opportunities managers must be skilled capital allocators and strategically return capital to shareholders or make accretive acquisitions that bolster or complement the existing business.
Thoughtfulness, Dosey posited, is the most important characteristic for a capital allocator. Generic strategies that divide capital equally across share repurchases, dividends and acquisitions are most off-putting. An opportunistic approach to share repurchases is most admired. Companies that blindly employ WACC as the hurdle rate for new projects, especially with historically low interest rates, need higher standards.
Investment Process
Finally, Dorsey shared with O'Shaughnessy the process his firm uses to analyze prospective investments. First, Dorsey eliminates from consideration all businesses with poor economic structures. Then, with a considerably smaller universe of companies, a brief description of the prospect outlines the business’ moat and opportunities. Once a promising idea is in one or two paragraphs and approved for further investigation, a first-pass memo is written to formally characterize reinvestment opportunities, structural advantages, and management’s ability to allocate capital. Dorsey’s team then commits to much more thorough research, considering what they have learned about the company and providing many more opportunities to reject the potential investment. Dorsey’s portfolio is extremely concentrated, so it seems safe to assume his team will dismiss the vast majority of prospective investments.
As a business-focused investor, I enjoyed this conversation and learning about Dorsey’s approach. One of the most useful points Dorsey made was comparing moat analysis to analysis based on Porter’s Five Forces. Porter was a management consultant – he was paid to analyze businesses and their structure. Investors, Dorsey explained, were not burdened to be so thorough: once a prospective investment is deemed unsuitable (for any particular reason), the investor should move on to the next prospect without further consideration.