MALE SPEAKER: So
welcome, everyone.
My name is [INAUDIBLE], and
I'm very pleased to welcome you
for another special talk in
our Value Investing series.
We have a very special
speaker with us today.
But before I get into
his introduction,
I want to talk briefly
about this term
"moat," which you are
going to be hearing
a lot about in today's talk.
Well, according to
Wikipedia, a moat
is a deep, broad, ditch, either
dry or filled with water,
that surrounds a castle, other
building, or town, historically
to provide it with a
preliminary line of defense.
However, thanks to Mr.
Buffett and a legion
of value investors,
this word "moat"
has become an excellent
metaphor to identify companies
with durable
competitive advantage.
Very few people,
though, have managed
to develop and synthesize a
framework that systematically
helps to identify moats from
an investor's perspective.
Pat Dorsey, our
author for today,
has done a great
service to students
and individual investors
trying to do exactly that.
In his bestselling
book, "The Little
Book That Builds Wealth," he
has shared actionable insights
to identify modes in
the business world.
His book is also a great
introduction for anyone
interested in learning
more about value investing.
We are very, very pleased
to have Pat here with us.
So without further ado,
ladies and gentlemen,
please join me in
welcoming Pat Dorsey.
[APPLAUSE]
PAT DORSEY: Thanks
for the kind intro.
I'm glad we have the technology,
at least working mostly,
here in one of the world's
most successful technology
companies.
[LAUGHTER]
You would have thought
I was presenting
in Redmond, Washington.
No, I'm joking.
Sorry, sorry, it was just
right down the middle.
It was too easy.
It was too easy.
You give me a fat
pitch, I'm going
to hit it-- or invest
in it, I suppose.
So we've done the intros.
I'm Pat.
I used to run Morningstar's
Equity Research Group,
currently have my own
investment firm called
Dorsey Asset
Management, which is
a global firm, a global mandate.
We can invest anywhere in
the world, any market cap.
We're very concentrated.
And our goal really
is to find 10 to 15
of the world's
most competitively
advantaged businesses that
can compound at high rates
overtime, invest in them,
and then leave them alone
to make lots of money over time.
That's our job, and
that's what we're actively
engaged in doing right now.
And the framework we use
is in large part based
on the work I did at
Morningstar and the concept
of economic moats and
reinvesting capital
at high rates of return.
And that's what I want
to talk about today.
So the basic
foundation of thinking
about economic moats and
competitive advantage
is that-- shocker--
capitalism works,
and that capital seeks the
highest returns possible.
If a company is
making a lot of money,
others will seek
to compete with it.
That intuitively make sense.
If I wrote each of you a $50
million VC check and said,
go start a business,
you would probably
try to do something profitable.
If you are smart, you probably
would not start airlines.
[LAUGHTER]
I hope.
I hope.
High profits attract
competition, I mean,
as surely as night follows day.
So intuitively this makes sense.
Empirically it
makes sense as well.
If you go back over
time and look at, say,
take T1, companies
in the highest
decile of returns on capital.
Then roll the clock
forward 10, 15 years
and look at that
cohort of companies.
Most will have lower
levels of profitability.
Most will have lower
returns on capital
as their returns on
capital have drifted down
to some mean as
competition has come in.
Of course there is a
minority of businesses
where that's not the case.
So most businesses
you see high returns
on capital decrease over
time as competition comes in.
However, there is a
very small minority
of businesses that
enjoy many years
of high returns on capital.
They essentially beat the odds.
They defy economic gravity.
And the question
simply becomes, how?
And in my view,
it's because they've
created structural
advantages, economic moats,
a way of insulating themselves,
buffering themselves
against the competition,
that enables them to maintain
supernormal returns
on capital longer
than academic theory and
the averages would suggest.
Because absent a
moat, competition
destroys excess returns--
period, end, full stop.
Any highly profitable business
that is easy to compete
with, you will see that come
down over time-- very common
in the fashion industry,
very common, say,
in if you guys remember
back in NVIDIA,
and what was the other big
graphics company, chip company?
[INAUDIBLE]?
They would swap market
shares like every six months.
One had the best chip.
Oh, now I've got the best chip.
Do-do-do-do.
And there's no moat there.
The moat was just, what do
I got that's great today?
And then you had a
lot of smart engineers
at the other place trying
to make the next best thing.
So the basics of
moats is that there
are structural and
sustainable qualities that
are inherent to the business.
A moat is part and
parcel of the business
that you're looking at.
It's not a hot product.
We all probably remember
the Krispy Kreme debacle.
They taste good, but
sugar is not a moat.
Heelys-- anybody remember
Heelys or have a kid?
Remember those little shoes
with the wheel in the heel?
That was an $800 million
company at one point.
I mean, yes, as Dave Barry would
say, I am not making this up.
People were valuing Heelys
as if it had a moat.
Aside from the massive
product liability issues,
once basically schools
started banning them,
that's a problem if your
target audience of 12-year-olds
can't buy your product anymore.
And so that business
went to hell pretty fast.
It's not just a cool
piece of technology.
We talked about in video
and the graphics companies
a moment ago.
Remember Iomega?
Remember that was
going to be the thing?
It's just a cool
piece of technology.
And frankly, any cool
piece of technology
can be replicated by
other smart engineers,
unless there's some switch in
cost, some lock-in effect that
occurs or an industry
standard is created.
But anything that one smart
bunch of guys can develop,
there's probably
another smart bunch
of guys somewhere else trying
to make it even better.
And of course, it's not
the biggest market share.
You'll often hear companies talk
about, oh, we're the biggest.
We're going for market share.
Let's think about GM.
Let's think about Compaq.
It didn't work out so well.
Big is not a moat.
In fact, small is often
a better moat than big.
Moats generally manifest
themselves in pricing power.
A company that
can't raise prices
is unlikely to
have a strong moat.
And in fact, if you invest,
this is a test often
that businesses are losing
competitive advantage.
If you have a company who
typically raises prices 2%, 3%,
4% every year.
They're able to kind of keep
pricing power moving up.
And then one year,
suddenly they don't.
They say, well,
the economy's tough
or we want to take it easy
on the customers this year.
That's a load of crap.
It means that something has
changed in that industry.
There's a competitor out there.
There is some event
going on that you may not
be aware of that's causing them
to lose that pricing power.
Because if you can
take price, you
will take prices as a business.
And so companies that lose that
pricing power, that's usually
the first sign that
their moat is eroding.
So what I want to
do next is talk
about the four kinds of moats
that I identified when we were
at Morningstar and that I
still think make sense today.
The way we identified
these was by going back,
this would have been about
50 years of Compustat data,
and it was pretty simple,
just looking at businesses
that had maintained returns on
capital above cost of capital
for 15 years plus.
It's not a huge data set.
And then you
basically say, well,
what are the common
characteristics
of these businesses?
What are the similarities
of these businesses?
And that's where
we kind of teased
out these four categories.
And they've proven to
work out pretty well.
We introduced the moat ratings
at Morningstar in about '01.
And so now we've had about
12, 13 years, and the business
we initially identified as
being wide-moat businesses that
fell into these buckets
have maintained higher
returns on capital
than their peers.
So the empirical results
seem to bear out the theory.
The first kind of
intangible asset is a brand.
And a brand is valuable
if it either increases
your willingness to pay or
lowers your search costs.
And this is really important.
It's not just that
it's well known.
Because you think
about, say, Sony.
We've all heard of Sony, right?
Sony is often ranked as one
of the 20 most valuable brands
on the planet by the
Business Week brand week
thingy that happens every year.
But let me just do a
quick survey in this room.
How many of you would pay 20%
more for a Sony DVD player?
One hand?
Any hands?
AUDIENCE: Maybe 15 years ago.
PAT DORSEY: Maybe 15 years ago.
That's exactly it.
And right now you do see like
the Sony Bravia TVs getting
a little bit of a price
premium over others.
Because it's newer.
DVDs were newer.
But consumer electronics
is fast-cycle stuff, right?
What's new today
is old next week.
And so the fact that
Sony is well known
and we've heard a lot about
it does not contribute one bit
to its competitive advantage.
In fact, I would argue
Sony could probably
save a heck of a lot of
money by not advertising
or advertising very little.
On Michigan Ave in
Chicago where I work,
they have this super
expensive flagship store
with all kinds of cool
stuff you can play with.
And I'm sure they're paying God
knows what in rent-- useless.
Because that brand doesn't
change your behavior.
By contrast, let's
look at Tiffany.
Tiffany will charge you 20%
more for the exact same diamond
that you can buy from Blue
Nile or Zales or Helzberg
or wherever you want.
20% is the value of
that pale blue box.
I can guarantee you the
cardboard ain't that expensive.
[LAUGHTER]
OK?
But you know as the
giver of a diamond,
that you'll probably get a
bigger smile off the recipient
if it's in a Tiffany box than
if it's not in a Tiffany box.
So they can charge it.
And so that brand
has value, right?
That brand increases
your willingness to pay.
And there's value there.
You also have brands
that lower search costs.
So think about Coca-Cola
or Wrigley gum.
You don't pay a lot more
for Coke versus Pepsi,
but you know you like
Coke, so you go there.
You like Heinz, so you
grab it off the shelf
because you don't want
to sit there and compare
ketchup prices for 20 minutes
before buying the ketchup.
It's $3.
My kids like ketchup.
Let's go get the ketchup.
We go through ketchup
in vats at my house.
I have twin
seven-year-olds, and I
think ketchup is like
our fifth food group.
It's ridiculous.
So again, if a brand
changes consumer behavior
by increasing the
willingness to pay
or reducing the search
costs, then it has value.
Just being well known
doesn't mean anything at all.
Patents-- obviously a
patent is a legal monopoly.
But they are subject to
expiration, challenge,
and piracy.
And so you want to be very
careful of a business--
you see this a lot in like
specialty pharmaceuticals
where you have one
asset, one drug driving
all of your economic value.
That patent gets
challenged, you're dead.
And last time I checked, patent
lawyers drive really nice cars.
And there's a reason
for that, which
is that patents are
valuable to challenge.
And so if they
can be challenged,
they will be challenged.
So you want to rely
on patents as a moat
when you have a
portfolio of them,
that it's hard to
invalidate one or the other.
Think of Qalcomm.
Think of ARM Holdings,
where there's
this huge portfolio of patents.
And then finally,
licenses and approvals.
You have a license
to do something
that not many people
can do or an approval,
that is a pretty
solid economic moat.
Casinos-- not easy to
get a casino license.
Six of them in Macau.
That's it.
They ain't giving out any more.
Landfills-- no one likes
to live near a landfill.
So municipalities don't give
out tons of landfill licenses,
because then nobody
wants to live there.
And that reduces the tax base.
So once you have a
landfill or a gravel pit,
you probably aren't going to
get a whole lot more of them.
Aircraft parts are
the same thing,
have to be FAA
certified, and that's
a huge moat to the
aircraft parts industry.
Most aircraft parts
are sole source.
They have one manufacturer
who makes them.
And so they get about a
40% margin on aftermarket.
It's a beautiful business.
If you're selling a brand,
if you're a company,
here's what you want
to look for when you're
looking at
brand-based companies.
Brands are valuable
if they deliver
a consistent or
aspirational experience.
Now, consistency lowers search
costs and drives loyalty.
So what you don't want to do
is change the damn product.
That's the stupidest
thing possible.
Remember New Coke?
Idiotic.
Schlitz-- Schlitz used to be
the second highest selling
beer in the US,
most volume the US.
Now not so much, right?
And the reason was they
changed the way it was made.
They changed the
taste of Schlitz.
Why would you do this?
Recently there was
something like-- I
think it was either Heinz
or there was actually
a ketchup that
was going to lower
the amount of sugar content.
They were going to
change the recipe.
And you just go, stop.
If people are buying
this, why change it?
Aspiration, by contrast,
increases willingness to pay.
So what you want to do is
create scarcity and exclusivity.
A very interesting
example is Tiffany stores.
Tiffany is unique in that we
think of it as a very expensive
brand, but over 40%
of their revenue
comes from stuff that's
sells for under $200.
Weird, right?
You wouldn't think about that.
And it's brilliant.
They're one of the
only companies that
can hit volume and
hit high price.
But here's how they
do it, one of the ways
they do it by
maintaining the brand.
You would think
that the stuff that
drives 40% of your
sales, that would
be at the front of
the store, right?
You want people to get
easy access to that.
No, no, no, no, no.
Go into a Tiffany store.
The cheap stuff is at the back.
So the expensive
stuff, the stuff
that costs more
than a Tesla, that's
sitting in the
front of the store.
Because that keeps the
value of the brand up.
That maintains an aura of
exclusivity and scarcity.
And so they keep
the brand value up.
Or Patek Phillippe, very
expensive watch brand--
the slogan, which
I love, is, you
don't own a Patek Phillippe.
You take care of it for
the next generation.
I mean, what a great
image, for those of us
who can afford $50,000 watches.
But it maintains that scarcity,
that exclusivity value.
And again, you have
to look at, if you're
looking at brand-based
companies, aspirations differ.
So you want to think about
companies that can adapt.
A great example is Jack
Daniels, owned by Brown-Forman.
So these are two different
Jack Daniels ads.
I'm going to do the translations
based on what I've been told.
I don't speak
Russian or Chinese.
So this says, "Happy
Birthday, Mr. Jack."
And as you can look
at, see it, it's
the same image we have
of Jack Daniels here,
the frontier, the
cowboy, old school.
And in Russia, that works,
because a lot of Russians
own [INAUDIBLE].
They like to get out of the
city and get back to kind
of their sort of Slavic roots.
Now compare that with this
Jack Daniels ad in China.
You're in a very high-end
bar, very urban, very smooth,
very cool.
And I've got this translated,
but can anyone-- I
see a few folks here
who might speak--
you want to translate
that for me?
AUDIENCE: So it
specifically means
confidence is not by our mouth
but from other people's eye.
PAT DORSEY: Confidence
is not out of your mouth
but comes from
other people's eyes.
In other words, confidence
is how people see you, right?
Totally different, right?
Because imagine in China if
you had this ad that basically
was like, you should go back
to the village you came from.
That's going to sell a
premium spirit, right?
Uh-huh.
You know?
So again, you see
this adaptation.
That's what you want to see
in a brand-based company.
Second kind of economic
moat is switching costs.
It's very simple, just the cost
of switching to a competing
product outweigh the benefits.
What you want to do
is look for companies
that integrate with the
customer's business.
So the upfront cost
of implementation
get huge payback for renewals.
Think about an Oracle
database, for example.
If you're P&G, if
you're Citigroup
and you're running on an Oracle
database, ripping that out
is virtually impossible.
It's not impossible, but it's
really, really, really, hard.
I mean, if you showed up
today, if Google, for example,
built an amazing database and
showed up to P&G and said,
we've got Googlebase, and it's
50% faster and 20% cheaper
than Oracle's best
product, P&G would say,
yes, and I will have to spend
hundreds of millions of dollars
and however many man hours
ripping out what I have now,
and my business will probably
blow up when I do that.
So the switching
costs are very high.
And so Oracle can raise the
price 2% to 3% every year.
You see this a lot with
enterprise software companies.
You also see it with
data processors,
people that integrate tightly
with the customer's business.
You can also sell an ongoing
service relationship.
So think of elevators.
Once you have an
elevator in a building,
it probably ain't
coming out again.
And so you get
elevator companies
like Otis, which is part of
United Technologies, KONE,
which is a Finnish company,
Schindler which is German,
and their goal is to have a
high what's called attach rate,
to attach a service
contract to the elevator.
Because once that
elevator's in there,
it ain't coming out again.
And so you get this long
service relationship.
Rolls Royce-- Rolls Royce
typically sells its jet engines
on what's called
power by the hour.
They actually sell
it, and then you
pay for it based on
how much you use it.
You don't just
pay for it upfront
and then someone
else maintains it.
So that's a way of increasing
the switching cost.
And then you can
provide a product
with a very high
benefit-to-cost ratio.
Favorite example here is a
company called Fastenal here
in the US.
If you have one bolt on your
assembly line that goes down,
and then you have a whole bunch
of unionized guys standing
around basically getting
paid for not doing anything,
you will pay a lot of
money to get that bolt
back on the line really quickly.
And so that product doesn't
have a very high economic cost
in terms of how would
you spend for the bolt.
But it has a huge benefit
to your organization.
Fuchs Petrolube or Lubrizol,
which Berkshire bought a while
back, same thing-- lubricants--
if you have a lubricant that
can increase the uptime of
a giant mining machine down
in a hole by 10% so you
don't have to take it down
for maintenance as often,
you don't have to take it
apart and lube everything, and
you get more productivity out
of it, and that
lubricant costs even
20% more than the
competing lubricant,
it's such a tiny part of
the overall cost of running
that machine, why not?
So this high benefit/cost
ratio is really a cool thing
to look for when you're looking
for businesses with switching
costs.
You've got the network
effect, which is simply
providing a service
that increases
in value as the number
of users expands.
You can aggregate demand
between fragmented parties.
Think of distributors.
Henry Schein is a
dental distributor.
So basically most dentists are
little owner-operators, two,
three, four, five
dentists at a practice.
And then they've
got to buy stuff.
They've got to buy those
obnoxious cotton things that
stick in your mouth
and suck up the saliva
and give you cotton
mouth, literally.
They've got to buy dental
drills and all kinds of stuff.
And basically what they're
doing is aggregating.
Fragmented demand,
fragmented supply,
and they bring the two
together and extract
a lot of economic
rents by doing that.
One thing to watch for here
is that one reason the network
effect works so well
is the non-linearity
of nodes versus connections.
So if you have a web, and the
number of nodes in that web
goes from one to two to three to
four, the number of connections
increases exponentially.
So that is something that
makes it very hard to replicate
a network once the network gains
scale, something that Googlers
should be pretty
familiar with, I think.
One thing you want
to watch for, though,
is radial versus
interactive networks.
So the interactive
network is what I just
described, the web, where each
node interacts with the other.
A radial network
is less valuable.
So this is a good lesson
I learned at Morningstar
when we looked at Western Union.
So Western Union helps people
send money from place to place.
And they talk about, we have
the most number of branches
of any money
transfer organization
in the world, which is true.
The problem is that no one is
sending money from Bangladesh
to Mexico City.
They're sending money for Mexico
City to Chicago or from Mexico
City to LA or from
Bangladesh to Chicago.
We have a huge Bangladeshi
community there.
No one is sending
money from Bangladesh
to Mexico City or vice versa.
So that route means nothing.
So it's basically a series of
channels, a series of spokes,
off different nodes that
are easier for a competitor
to pick off by underpricing
service in that node.
So radial networks are
much, much less robust
than interactive ones, we found.
And then the final type
of moat-- cost advantages.
This is kind of
self-explanatory.
But the thing is, there's
a couple differences here
that you should look for when
you're looking at companies.
A process-based
advantage is basically
inventing a cheaper
way to do something
that is hard to
replicate quickly.
Southwest did this.
Dell did this.
Ryanair did this.
Inditext, which owns the Zara
brand you may be familiar with,
is great example.
They had their clothes
made in Sri Lanka,
the clothes made in Bangladesh
because it was really cheap.
But of course, because
of transport links,
you have to basically
make a fashion
bet six months in advance.
What Inditext figured out was
that if they near shore it,
if they get the stuff
made in North Africa,
get the stuff made
in Eastern Europe,
they can have much
faster response times,
much faster responses to
different fashion trends.
Now, you can copy that, right?
You can copy that.
But it works pretty well
while you're doing it.
And so process-based cost
advantages tend to work well.
But then they get
copied eventually.
Southwest no longer
has the lowest cost
per available seat mile.
People saw what they
did and copied it.
Scale, by contrast, when
you spread your fixed costs
over a large base, that tends
to be much, much more robust.
So think about this big
network of brown UPS vans
going around a neighborhood.
What's the additional cost
of putting one more package
on the UPS van?
De minimus, right?
And so your margin on
that is very, very high.
It's very difficult to compete.
A good example is DHL, which
is a wonderfully run business,
has a very dense
network in Europe.
They lost over a
billion dollars trying
to compete with UPS and FedEx
in the ground market in the US.
They couldn't do it simply
because they couldn't scale up.
There weren't as
many yellow vans
as there were brown vans
and blue-and-white vans.
Scale-based advantages,
especially in distribution,
are incredibly robust.
And you can have
a niche where you
establish a minimum
efficient scale.
There are some niches,
some industries,
that can only profitably
support one or two players.
If another player comes in,
spends the money to get in,
returns come down so that
nobody makes any money,
so that new entrant never
comes in the market.
The businesses often can't
grow very well, because they're
kind of trapped there, but they
can be enormously profitable.
So what about management?
You notice I haven't said a
word about management yet.
There's a great quote
from Warren Buffett
that, "Good jockeys will
do well on good horses
but not on broken-down nags."
So this is a professional
jockey on a goat.
He is a very good manager.
Sadly, he is on a bad
vehicle called a goat.
So if you enter this in a race,
he is probably going to lose.
By contrast, if you got
me, and I don't even
know how to ride a horse,
as long as I don't fall off,
I probably beat the goat.
Because the horse
is better suited
for winning races than the goat.
You're not going to get
much milk out of it.
The goat is better for that.
But it's very well
suited for winning races.
So the key here is that you
want to get a good horse.
You want to look
for good horses.
Its not that the
jockey is irrelevant.
It's that even the best
jockey, if he's on a goat,
isn't going to make you a lot
of money or win many races.
Managers matter in the
context of the moat.
And the way to think
about this is very simple.
The required level
of managerial skill
is inversely related to the
quality of the business.
The worst the business,
the better the manager.
The better the business--
eh-- as long as management
isn't that stupid,
you'll do fine.
If it's a really bad
business, you better
have an awesome manager.
This is Ryanair.
O'Leary is a absolute genius.
He's a jerk and customers
hate flying Ryanair,
but he has created an
amazing, amazing business.
Ryanair is scale
advantages to die for.
By contrast, if you have a great
business, genius is not needed.
You saw where this
was going, I know.
What that actually
means is, here's
what's happened to Microsoft's
moat while I've been in charge.
Again, it's an easy target
here at Google, but it's true.
I mean, Steve
Ballmer essentially
spent 12 years setting
money on fire at Microsoft
as far as I can tell.
AUDIENCE: What do you
think about Twitter?
PAT DORSEY: Well, Twitter--
I never followed it much.
And also that was
no pun intended.
[LAUGHTER]
The question was,
what about Twitter?
I haven't figured out what
the monetization model is.
I haven't figured out
how they make money.
I mean, they may have
some secret theory.
I just don't know what it is.
But I haven't spent
much time on it,
although I think it was
founded by a guy named Dorsey,
wasn't it?
Anyway, I probably
should look at it.
So the key here is that moats
can buffer management mistakes.
Microsoft minted money
despite Steve Ballmer,
despite them shoveling
dirt in the moat every day.
The core office, the
core Windows franchises
were strong enough that
the business overall
maintained pretty high
returns on capital.
New Coke didn't kill
Coca-Cola because the business
was robust enough.
The brand is strong enough.
Moody's put profits
before integrity,
actively screwed
investors, and still
cranked out a 40%
operating margin.
That's a pretty good moat.
But even a genius
like David Neeleman
couldn't change the fact that
JetBlue is an airline, which
is the worst industry
known to mankind.
I mean, he's an amazing manager.
If you've ever met him, read any
of his books, seen him speak,
he's incredible.
He's inspirational.
JetBlue was like 30-odd times
earnings when it went public.
Because it had
leather seats and TV?
I mean, an airline will
never have lower costs
than the day it
opens for business.
Why?
Planes don't get newer.
They get older.
Employees don't
get less seniority.
They get more.
So the planes cost more to run.
The employees want more money.
So the cost structure is
inevitably bound to decline.
Again, great jockey on a goat.
Good managers are
constantly looking for ways
to widen a company's moat.
Think about Amazon's focus
on the customer experience.
It's not so much about scale.
It's about the
customer experience.
Here's a great-- let
me try this here.
I've tried this at other
talks around the world.
How many of you bought
something off Amazon
without checking
the price elsewhere?
OK, that's like 2/3,
3/4 of the hands.
Isn't that an amazing
statistic right there?
I mean, how hard is it to
click to another website?
What's the caloric cost
of moving your mouse?
It's not high, right?
But I've talked to about 45
CFA societies around the world.
I get about the same
number of hands that go up,
except in Germany.
The Germans didn't
seem to-- Amazon
has not been as-- there's more.
There's Zalando.
There's a lot of
other etailers there.
But in the US, this is
the response you get.
And a lot of this is the
customer experience, right?
Trust matters more
online than offline.
And I give Amazon enormous
credit for figuring this out
early, that offline in a
regular physical store,
I give you money, you give me
a good, and we're finished.
There's no trust involved.
Online, I have to trust you
to send me what I ordered.
I have to trust you don't
steal my credit card number.
I have to trust it arrives
when you say it will.
I have to trust you'll take
it back if you say you will.
There's a lot of trust involved.
And that enabled the ability
to build a moat, build
a brand in retailing, which
is a really tough industry
to do that in.
Think about Costco's focus on
using scale to lower costs.
Costco gets bigger, cost savings
go right back to the customer.
That brings in more
customers, which
allows more cost savings that
go right back to the customer.
That's what drives
their business.
That's all they think
about every day.
Now by contrast, bad
managers invest capital
outside a company's moat,
which lowers overall returns
on capital.
This process is called
de-worse-ification, or setting
fire to large piles of cash, OK?
This is basically what you don't
want to see a company doing.
Example-- Cisco moving into
consumer markets, the Netgear
acquisition, I think it was.
What on earth was that?
You had this gorgeous, sticky
business in enterprise,
and you start selling consumer
electronics that any moron just
buys off the shelf
at Circuit City?
My set-top box at home
used to be a Cisco,
and I could just curse
that thing every time
I looked at it.
Because it was just
the worst business
to go into-- fast
product cycles,
no competitive advantage.
The whole network-centered comb.
So what?
Remember Garmin?
Anybody remember
the Nuvi handset?
Nobody?
OK, so Garmin had this
great franchise, partially
in GPS devices in
your car, but also
a much better
franchise in avionics.
So business jets,
regional jets often
have Garmin as the
GPS device in there.
You own a plane, you really
want to know where you are.
So that business was a
very good, sticky business.
And so they see, oh, gosh,
GPS is going from a product
to a feature that's basically
just a feature of a smartphone.
Oh, let's not relaxed
to the inevitable
and just get out
of the business.
Let's double down
and go into handsets
and compete with Ericsson and
Nokia-- completely moronic.
And so again, you see
investing outside the moat--
you see a business do
that out of weakness
as opposed to out of
strength when they're
trying to maintain
growth, like Cisco did.
It's a horrible sign.
Yep-- question?
AUDIENCE: How do you
differentiate that
from the innovator?
Like Good, for example.
PAT DORSEY: Great question,
and I knew this was coming.
I knew this was coming.
So the question is how
do you differentiate that
from being innovative?
Because Google is doing
it out of strength, right?
Google is not doing
it to preserve growth
or because their core
business is dying.
Google is doing it as a way of
planting seeds for hopefully
a great business in the future.
And it's a subtle
difference, but the key thing
is it's coming out of strength.
Google's core business
isn't going down.
It's when you see a company's
core business either slowing
or the competitive
advantage eroding,
and they try to basically invest
outside that to bump up growth.
So Cisco, one of
the reasons they
went into consumer
electronics, Netgear,
was to compensate for the
fact that the enterprise
market was slowing down.
Or you can just say, hey, guys,
we'll grow at 6% and now 16%
anymore.
That would have been the
more rational response.
Instead, they go out
and take a blow torch
to dry pallets of cash by
buying-- oh, remember the Flip?
Remember the Flip?
$800 million on basically
a little video camera
that will about six
months be in your phone.
I mean, you know,
again, out of weakness
versus out of strength.
Yep, another question.
AUDIENCE: How much of
this kind of stupidity
is correlated with the fact
that these businesses that
are sometimes wide moats
are not [INAUDIBLE]?
Imagine if you have an
owner-operator and he would
not--
PAT DORSEY: Yeah,
so the question
is sort of how much
of this stupidity
is correlated to businesses that
aren't run by owner-operators?
I think it's a good--
John Chambers owned
a decent chunk of Cisco.
But I do think you
see it less frequently
with owner-operator businesses.
You see it more frequently with
businesses run by hired hands,
where if the CEO
gets leaves, he'll
get a giant golden parachute
and he goes off and plays
golf and nobody's the worse
off, except the poor sacks who
owned the stock.
So I think by having
an owner-operator,
you lessen this chance.
But they're not infallible.
I mean, the danger
is when you have
businesses that can't
relax to change.
And especially you see
this a lot, actually,
with tech companies.
Not, not just tech companies,
but companies when they mature.
So this happened to McDonald's.
It happened to Home Depot,
happened to Starbucks, happened
to Cisco, happened to Microsoft.
As they get larger and have to
go from being growth companies
to be mature
companies, they start
continuing to act like
teenagers when they're actually
in their 50s.
It's like the
50-year-old guy who's
trying to date a 20-year-old.
It's just inappropriate.
And it's the same
thing when you're
a super successful
business like Starbucks.
And they just kept opening new
stores, opening new stores.
I remember there was a
great "Onion" story once,
Starbucks opened Starbucks
in Starbucks' bathroom.
[LAUGHTER]
Because they were just
everywhere, right?
And Howard Schultz
came back and realized
that the return on capital
for these new stores
was really not very high.
And so the better way
to allocate capital
was not to open crap
loads of new stores,
it was slow openings
and focus on making
more money, increasing ticket
sizes, introducing food
and so forth, at
existing stores.
So I mean, many businesses
go through this transition.
So we'll get the Joker
off the screen there.
Now there is, I should
say, an exception
to every rule about
sort of management
and the horse being more
important than the jockey.
There are a tiny
minority of managers
who can create enormous value
via astute capital allocation,
even if they don't
start with great horses.
Warren Buffett at Berkshire
started with a textile mill
for God's sake.
Brian Joffe at Bidvest, which
is a South African firm,
started with nothing.
And now they do logistics,
they do distribution,
they do food service--
amazing business.
Dick Kovacevich at Wells
Fargo-- and banking
is tough business,
really tough business.
But what Kovacevich
and Stomphe have done
is nothing short of amazing.
Steven M. Rales at
Danaher-- Danaher
has actually beaten Berkshire
in the past 20 years
in terms of shareholder returns.
It started off selling
industrial pumps.
And they bought Beckman
Coulter a few years ago,
big diagnostics firm.
So again, there is an
exception to every rule.
There is a tiny
minority of managers
that can make something
out of not much.
So keep an eye out for them.
They're hard to find,
false positives abound,
but these guys can create
enormous wealth over time.
So just to kind of sideline
from the moat conversation,
but my point here-- I
don't want you to go out
of here thinking management
is irrelevant, because there
is this tiny
minority of guys that
can just do amazing things.
Yeah, there's a question
there in the back?
AUDIENCE: I was wondering
what's the role of chance
in all of this, in the
examples of products
that are created like New Coke.
Maybe they should not
have done that and so on.
For every New Coke
that did not work out,
maybe there is another
product by some other company
that did work out.
PAT DORSEY: Sadly,
investing does not
lend itself well to
statistical proof.
Because you have
individual examples
where you had highly
skewed results,
where you have this huge, long
tail where a few companies do
incredibly well, and a
very small number do OK.
You probably would
enjoy reading--
there's a recent book by
some Deloitte guys called
"Three Rules" where they did
a pretty rigorous statistical
analysis on returns on
capital and then went back,
and they did a whole bunch
of pairwise analysis.
They did a lot of controlling
for industry factors
to try to kind of eliminate
the odds of luck happening
with things and looking sort
of at what characteristics
identified businesses that
were likely to succeed over
a long period of time.
But there is a luck
component to this, right?
I mean, example from Berkshire
Hathaway-- Warren Buffett
early on went to Washington,
DC, on the weekend
to try to learn about
insurance at Geico.
He got the janitor.
He basically banged
on the door of Geico.
And I can't remember the
manager's name-- one of you
Buffett nuts probably
remembers-- let him in
and basically gave him
like a five-hour lesson
on how to do insurance well.
If that hadn't
happened, would he
have really gotten
the early tutelage
in insurance then created
what Berkshire became?
Maybe not.
So my point here is simply
luck happens, right?
Chance is part of it.
But your choice is either
say, this stuff is unknowable
and I'm just going
to index, which
is a completely rational
thing to do, by the way,
or if we want to try to
identify these businesses,
we look for common
characteristics
that seem to have held up
over long periods of time.
But there is a role of chance in
creating successful companies.
And that's a weakness
of like "Good to Great,"
the "Built to Last," and lot
of these success studies.
You would also enjoy a book
called "The Halo Effect,"
which really does a great
job kind of basically
disintegrating the
idea of the hero CEO.
It's a really good book.
Yeah.
AUDIENCE: So you talked about
two possible approaches.
What about the
third one where we
know for a large
number of businesses,
especially the
majority of businesses,
returns are going
to revert to mean,
and temporarily you can
see certain businesses
there are times extremely
low, and maybe the valuation
is even lower.
And it kind of does
not reflect the fact
that maybe over time
it will revert to mean.
And maybe you can identify
certain industry--
PAT DORSEY: So these are the--
AUDIENCE: [INAUDIBLE]
PAT DORSEY: --crappy businesses
that go to being semi-crappy.
AUDIENCE: Yeah.
PAT DORSEY: No, I
mean, I know what
you mean, the
businesses that are
sort of low returns on capital
that go up to the average.
Look, that's sort of traditional
value investing, right?
So to find the
business that's priced
as if it's going to go out of
business, and if it survives,
you do pretty well, right?
Or it goes from a
2% margin business
to a 5% margin business.
That is a fine way to invest.
Typically these are not
kind of moat-y businesses.
It's more what we call kind
of cigar button investing.
Again, you can make
plenty of money that way.
It's not how I choose to
invest, but plenty of people
make lots of money that way.
What I would say
is the only issue
if you're going to
pursue that approach
is time is not your friend.
Because the intrinsic
value of those
businesses is
declining over time.
And if they don't
turn around quickly,
you're left with
a declining asset.
Whereas there's a great
quote from Bob Goldfarb
at the Sequoia
Fund that "time is
the friend of the wonderful
business," which is true.
Because it builds
value over time.
And that becomes a sort of an
additional margin of safety.
So again, if you are going to go
kind of for deep value dumpster
diving, you can
make a lot of money,
but just be aware of
timing is all I'm saying.
Because what you're buying is
probably declining in value.
So just in a global
context, I think
it's important to remember local
differences can create moats,
OK?
Foreign companies aren't
allowed to own banks in Canada.
Thus, the Canadian
banks will always
be insanely profitable,
much more profitable
than banks in almost any
other part of the world.
In Germany-- this
is a great one.
Most German
municipalities don't allow
you to wash your car in your
driveway or on the street.
These are environmental
regulations.
So car washing is actually
a pretty good business
in Germany.
Because Germans
like cars, and you
can't wash in your
driveway, right?
And so there's a
pretty good business
called WashTec that makes
money basically providing
all the consumables, the
detergents and stuff,
in car washes.
This business could
not exist in the US.
So that's a local difference.
So they can create moats.
You also see minimum efficient
scale being more common.
So retailing is a tough
business in the US.
Because it's a huge
market, easy to come in.
South African retailers
have returns on capital
that make Costco
look like an airline.
It's not entirely
true, but they're
great returns on capital.
And the reason is simple.
It's a relatively small market.
And once you've got the
two or three big players,
it's really hard for
anybody else to compete.
And global players
aren't going to come in,
because it's just not
that big a market.
Why am I going to
bother spending a ton
of money coming in
to South Africa?
Walmart recently came
in, but they just
bought a local player.
They didn't try to
come in on themselves.
BEC World is the
largest producer
of Thai language media.
So if you want to watch a
soap opera in Thailand, a news
broadcast, they own most
of the pay TV channels.
It's awesome business.
I mean, Thailand
is a big country.
Thai is not as commonly
spoken as, say, English.
So now you have
minimum-efficient scale.
The odds that you have a
competitor coming in there
are lower than if you created,
say, English-language content.
And then you also have
cultural preferences.
For example, beer travels--
beer can often be exported.
I mean, when I was
in Macau last week,
Carlsberg all over the place.
It's crappy beer.
I don't know why.
But Carlsberg seemed
to be doing well there.
Beer travels pretty well.
Spirits travel pretty well.
Candy and snacks don't.
The snacks you grew up with,
the candy you grew up with,
is what you will probably
eat the rest of your life.
You try to sell
Hershey's in the UK,
and they say it basically
tastes like cardboard.
Whereas Cadbury to most
Americans is much too sweet.
And like the Mexicans had
this chocolate bar called
Carlos Quinto,
which basically is
cardboard as far as I can tell.
[LAUGHTER]
Like the bar,
actually, because they
have to change the
packaging in the US,
actually says,
chocolate-style bar.
It's like Kraft and
"cheese product."
Esh.
But anyway, Calbee
is a company in Japan
that makes Japanese
snacks that are never
going to see in the US.
But Frito Lay ain't gonna
sell much in Japan, either.
So these cultural
differences can create moats
in different countries.
So why does all this matter?
Why am I talking about moats?
Who cares?
Pretty simple-- moats
add intrinsic value.
A company that can compound cash
flow for many years is simply
worth more than a
firm that can't.
And you can think
about this here simply
with you've got
returns on capital
on the vertical axis, time
on the horizontal axis.
And for the no-moat
business, returns on capital
come down pretty fast
as competition comes in.
So there's less time
for value to compound
as you reinvest cash.
For the wide-moat business,
you have longer span of time
to reinvest capital at a high
incremental rate of return.
Now this brings up the
question of valuing moats.
And if you're looking
at a business thinking
about investing in
a moat-y company,
the value is largely dependent
on reinvestment opportunities.
The ability to reinvest cash
at a high incremental rate
of return is a
very valuable moat.
If you can plow that cash
back into the business,
continue to take market share,
expand your addressable market,
give a long runway
ahead of you, that
makes a business worth paying
a pretty high multiple for.
Somebody mentioned to me Whitney
Tilson was here a while ago.
He said he didn't buy
Google kind of early
on because the PE was high,
that Google had this opportunity
to reinvest in the
moat in a huge way.
Fastenal has this.
XPO, which is a
logistics company
that does truck
brokerage-- same thing.
By contrast, if a firm has
little ability to reinvest,
the moat doesn't add
much to intrinsic value.
It adds certainty.
It adds confidence.
It narrows the range
of possible outcomes.
But it doesn't add
much to the value
because they can't reinvest.
Think about McCormick.
McCormick owns the
spice market in the US.
They own most of
the private label
spices you get from
McCormick, and then they
have the M-labeled
ones that you see.
But you know what?
The consumption of turmeric is
not going up 20% next year, OK?
Not happen, all right?
And so McCormick has to
pay out most of the money.
So that moat is valuable in
creating stability, in creating
confidence, but
doesn't really say,
I want to pay 30 times
for this business.
Because they can't
reinvest it back in.
Microsoft, Oracle--
very similar things.
The cash has to come out because
they have no where to put it.
And another important
takeaway is that moats are not
limited to these super stable
companies your grandkids can
own, the Warren
Buffett inevitables.
Those are a fairly small subset
of the investable universe.
And as I just mentioned, they
have very limited reinvestment
opportunities.
Moat-y businesses that
pay out cash are goods.
But moat-y businesses that
can reinvest cash back
into the business are
truly awesome things.
And when you've confined those
at reasonable valuations,
it is very likely they'll
make you a lot of money.
And so when you think
about investing in moats,
the last takeaway I'll leave you
is that overestimating the moat
means you'll pay for
value creation that
never materializes.
Underestimating the moat means
you have a large opportunity
cost.
So let's look at a real
cost example, Motorola, OK?
This is a chart of
Motorola from '03 to 2012.
Remember the Razr?
How many you owned a Razr?
A fair amount.
How many of you owned a
Razr three years later?
And that would be nobody.
OK, exactly-- so the razor
Razr is released, right?
And everybody goes bananas.
And Motorola goes
to 22% market share.
And the market says,
wow, this is fantastic!
You've got a moat!
You've got this
great Razr franchise!
It's a piece of hardware.
There's no proprietary software.
There's no switching cost.
As soon as the next
cool phone comes out,
you're gonna go buy that,
which is exactly what happened.
And so we see what happens.
Stock craters.
Motorola has 10% market share.
People basically overestimated
the value of the moat
and got hosed on the
stock because of that.
Hosed is a technical term we
use in the financial industry.
[LAUGHTER]
Now, there's an opportunity
cost example in Walmart.
So this is Walmart
from about '95.
'97 it went bananas
to '99 through today.
Buffett-- and this is a story
he told to the Berkshire meeting
about '04, '06-- they started
to buy several million shares
of Walmart back in '95.
And then he said, the
price has moved up by 1/8.
Let's wait a bit.
Let's not buy any more.
And look what
happened to the stock.
Stock went from 10
to 50, basically.
That decision-- this is the
number he gave at the meeting.
He said that what he
called thumb sucking
on Walmart, basically
not buying enough,
cost Berkshire $8 billion in
money they could have made.
And the reason was at that
time he said, eh, Walmart's
a good retailer.
He didn't say Walmart
is an awesome retailer
and so we'll pay up a little
bit for that, the point
here being that when you find
a truly awesome business,
don't pay 100 times earnings,
which is what Cisco was trading
for in 1999, but you pay more.
It's worth more.
It's going to compound
at a high rate.
Because then you suffer
opportunity cost.
And most investors, I've
found, spend a lot of time
on margin of safety and not
a lot on opportunity cost.
And it's something to really
think hard about, I think.
And people often ask me, isn't
the moat already priced in?
We already know these are
great businesses, right?
Well, less often than you
think, because most investors
own securities for very
short time periods.
The average US mutual fund
has a turnover of about 100%.
It's about a one-year
holding period.
That's the average.
There's plenty of folks who
three months is a long holding
period.
Moats matter in the long
run, not the short run.
Most investors also assume
the current state of the world
persists for longer
than it really does.
And so when things are
tough for a great business,
they say things will
be tough forever,
not that this moat will help
the business bounce back.
And finally, most investors
focus on short-term changes
in price, not long-term
changes in moats.
Because finding motes means
finding an efficiency.
What I've found is that
quantitative data in the market
tends to be very
efficiently priced.
Qualitative insight,
understanding
the structural characteristics
of the business,
the switching costs,
why the customers
behave the way they do, why
can this company raise prices
a little bit every
year-- that tends
to be less efficiently priced.
Because, great quote from Bill
Miller, "all of the information
is in the past, but all of
the value is in the future."
So the future value
creation will often
come from things
you can see today,
not necessarily the information
that occurred in the past.
And with that, we'll
do more questions.
Thanks, guys.
AUDIENCE: The question
is about the process
you follow once you have
identified the moat companies.
And once you have
these companies,
do you try to do an analysis
as to what this company could
be worth and what cash it can
bring in in 10 years or 15
years to compare between the
two companies that have not
have the moats?
And now once you have
selected a set of companies
that have a good moat,
what is the next step?
PAT DORSEY: Sure.
So that's a good question
about just process in general.
And I think establishing
that mental database,
that database of companies
that I would like to own this
at some price because the
competitive advantages
and the compounding potential
are things that I think
are above average or solid.
I think it's a good
idea to sort of at least
get kind of a rough idea.
Like would I want to buy
this at a 5% free cash yield?
Would I want to buy this
at an 8% free cash yield
because it's not
growing very much?
Just something super rough.
And then you just wait.
And as it gets closer
to that valuation,
then you really
ramp up the work,
then you do the really
hard-core analysis,
maybe put together a
discounted cash flow and say,
OK, was my initial idea right?
But you kind of have to
establish some kind of stake
in the ground,
some initial idea,
or you don't know when
to really dig deep.
And you can't dig
deep on everything
even if you do this for
a living, which I do.
AUDIENCE: So a follow-up
question just on that.
Now, if you are
following that approach,
once you have identified
the moat companies then
do some kind of analysis
and get a rough estimate,
then it doesn't really matter.
You have two classes
of moat over there.
One of more that's investing in
itself and one or more that's
just giving the share
of the money out.
PAT DORSEY: Yep, yep.
Good way to segment it.
AUDIENCE: Then that
distinction doesn't matter
much if you're doing a formal
analysis where you're coming up
with these numbers and--
PAT DORSEY: It only
matters in what
you would want to pay
for it, probably, right?
Because a business
like a McCormick,
for example, you're not going to
pay 30 times earnings for this.
Because it's never going
to compound at a huge pace.
A business, whether it's
Google or a company--
I better put it up there--
is [INAUDIBLE], which
is doing for-profit
secondary education in South
Africa, which has a huge
dearth of schools-- insanely
profitable.
There you'd pay a
lot, because there's
this massive runway ahead of it.
And also I think the thing
to heed, bear in mind
there is that for the mature
business that's probably
paying out a lot,
you're probably
going to make most of your
money on the closing of price
and value.
Because intrinsic value is only
growing at a very steady pace,
whereas for the business
that can reinvest in itself,
that has that long
runway ahead, you're
probably going to make
more of your money
over time on the compounding
of intrinsic value.
So then a smaller
margin of safety
makes more sense,
because you're going
to make all this
money from it growing
and not in that closing
of price and value.
And also, like if you were
to wait for, say, Visa to get
to 10 times earnings,
you'd just never own it.
And that's the opportunity
cost I was referring to.
AUDIENCE: If you can give
us a little bit more insight
in the process that you
guys followed at Morningstar
and maybe what you follow.
One of the interesting
things is Morningstar
has made it really
accessible for us to go
and figure out what are the
wide-moat businesses, kind
of reverse engineer
some of these things
by looking at the analysis.
But I think the real value is in
going and doing your own work.
I've heard you talk about
following the value chain.
So maybe if you can just talk
about how do you actually
go about finding things
that are not well
recognized even as a wide moat.
There's a standard list
of things that are widely
recognized as wide-moat
companies in the US.
But say you want to
do your own work.
How would you go about it?
PAT DORSEY: Great
example-- so I'll
give you a couple
value chain examples.
So the Cokes and the
[INAUDIBLE] and the Wrigleys
and the Nestles-- these are all
pretty good businesses, right?
So let's think about this.
They probably have to get their
ingredients from somewhere,
right?
Well, there's a
group of companies.
One is called Givaudan.
One is called International
Food and Flavors.
It's the only one in the US.
One's called Symrise.
There's one in
Ireland called Kerry.
They're flavor specialists.
And when a company wants a
particular characteristic,
like a particular
kind of mouth feel,
a particular kind of
flavor, sometimes they'll
do it themselves.
Oftentimes they'll turn
to these companies that
are ingredient
companies, basically.
And there's about four or
five of them in the world,
insanely profitable.
Because of course, once you
have like the component that
makes Fritos crunch
the way they crunch,
you're not changing that, right?
You're done.
Or another example
would be there's
a company called Novozymes,
another one called
Christopher Hanson,
both European.
They make enzymes, enzymes that
will help your beer stay fresh,
enzymes that will accelerate the
process of yogurt development,
again, things that are
massively important
to the eventual experience
that the customer has,
but that are pretty tiny
costs to the overall input.
And that's a value chain thing,
just following that value chain
back-- aircraft, another thing.
So we know that airlines kind
of are a stinky industry.
But they've got to get
the parts from somewhere.
OK, so then you look
at Boeing and Airbus.
Those are OK businesses.
And the reason is very simple.
People think these should be
awesome businesses, right?
Because they're huge
and only two companies
can make airplanes, right?
And they're wide bodies.
But at the end of the day, an
airplane is a commodity, right?
If I'm Emirates or I'm
United, I want the airline
that gets the most people
the furthest distance
at the cheapest price.
I don't care if it's
from Boeing or Airbus.
You don't care.
Do any of you care if you
fly a Boeing or an Airbus?
Who cares, right?
I mean, I guess the
A380 is kind of cool.
I've always wanted
to fly on one.
But I'm not going to pay
some massive premium just
to fly on it.
So they're-- eh-- a
commodity business.
OK, so let's follow
that right back.
Aircraft-- they got to get
parts from somewhere, right?
Hm.
Well, the parts tend to be
pretty specialized and highly
engineered.
They're customized for
every different air frame.
The fuel pumps in the 737
are different than the fuel
pumps in the 757 or the A320.
And they tend to be sole-source.
Because they're developed when
the aircraft is developed.
Boeing and Airbus
are just assemblers.
That's really all
they're doing is
assembling for the most part.
And so then you get these
aftermarket businesses
that are sole-source.
And as long as that
airplane is flying,
you've got one guy you
can get the part from.
And he is going to
have you over a barrel,
charge you whatever he wants.
And so that's another kind
of value chain example.
You almost just do a map,
like look at the company
and say, OK, these
guys, they got
to get this input
from somewhere,
this input from somewhere,
this input from somewhere.
Where's the money made?
I mean, every industry,
you just do a value map.
And sometimes there's almost
nowhere-- I mean, auto parts.
Eh.
Almost no one makes
money in this industry.
Except Johnson Controls
does pretty well,
because they'll do like
a whole interior and just
kind of slot it in.
Or there's a company
called Gentext
that does auto dimming
and rear view mirrors.
And they have some
patents on that
that make it pretty profitable.
But those are just a
couple of examples.
AUDIENCE: [INAUDIBLE]?
PAT DORSEY: Auto retailing
is not a bad business.
AUDIENCE: I mean
auto part retailers.
PAT DORSEY: Oh, auto
part retailers--
yeah, yeah, AutoZone.
And again, you go back, and
the reason is pretty simple.
Because if you're the
mechanic, the cost of that part
is passed through.
If you take your car
in to get repaired,
you're not shopping
for the part.
The mechanic is
shopping for the part.
He just passes through
the cost to you.
So there's a margin made on it.
You don't know what
a fan belt costs.
Maybe you do know
what a fan belt costs.
I don't know.
But I barely know
what a carburetor is,
much less could I
price the darn thing.
So again, you have
this disconnect
between the payer and the buyer.
AUDIENCE: So you talked about
the valuation in the last part.
And there are a
couple of questions.
When it's an emerging
moat, it looks
like some of those signs of
emerging moats are there,
often the return
ratios are poor.
The valuation is
optically seemed higher.
Because the company has not
started shelling cash out.
How would you value a
business in that state
or value a moat in that state?
PAT DORSEY: Yeah,
sure, great question.
So that's where a discounted
cash flow analysis really
becomes useful.
And it's not that DCF is a
magic bullet and it's better.
It just forces you to think
through the cash economics
of the business over
the long run as opposed
to the gap counting
characteristics
of the short run, which
is what a PE will do.
So in the case of a business
that, say, is growing quickly,
returns are poor today but it
looks like there's something
there, it looks
like there could be
a moat, what I
would say is this.
Think about three
things-- opportunity
set, fixed and
variable costs, OK?
So what is the opportunity
set here, right?
How big could this thing get?
What could they sell to
people in three year's
time, five years'
time, whatever?
And then say, OK,
to get there, they
will need to invest
something, right?
There's some number amount.
They'll need to build new
plants, hire new engineers,
whatever it might be.
And then there will be
a flow-through, too.
Some amount will drop
to the bottom line.
And over time, more should
drop to the bottom line
if it's a decent
business, right?
Who knows if it is.
And you just kind of math
that out, just DCF it out.
And then say, OK,
this company could
go from a 6% percent
return on capital
to a 12% return on
capital in five years
and start generating
free cash flow.
And then we get a
hockey stick after that,
as you kind of do it out.
So for example, we're looking
at a business right now called
SimCorp, which
does basically very
expensive back-end software
for huge asset managers,
like $100 billion
plus asset managers,
runs the whole
back-end office suite.
Now, basically they've
been growing about 5%,
6% per year for
the past few years.
Because they've not done
well in the US market
for a bunch of reasons that
we think may be fixable.
That's what we're
trying to figure out.
But basically we've
talked to them,
and that 5%, 6%
growth pretty much
covers their cost
structure now and gets them
about a low 20s margin.
But every bit of incremental
growth over that,
so going from 5% to 10%, you
get an 80% to 90% drop-through.
And then that, then,
takes your margins
from probably low 20s up a lot.
But you don't know
what that number
is until you think it through.
Another example-- so when
Morningstar initiated
on MasterCard, when it went
public at $40, $50 a share,
I remember our analyst
wanted to put like $100, $110
price target on it.
And I was like, dude,
you're nuts, man.
This thing is coming
public at like $40.
We're not going to stick
our necks out that far.
Come on.
How good a business is this?
And what he did
is he just walked
through fixed versus
variable, that basically,
OK, very little variable
costs in this business.
You've got a fixed cost of a
network, the data processing
network.
But then of the
incremental revenue,
tons will flow down
to the bottom line.
And this is where-- and this
is a geek thing-- when you're
modeling out a
high-growth company,
don't model in percentages.
Model in dollars.
So it optically
looks weird to say,
margins are going to
go from 13% to 25%.
Ah!
This is huge.
My God, that's never
going to happen.
So don't do it in percentages.
Don't do operating
margins doing from x to y.
Think about, OK,
fixed versus variable.
How many dollars will
they need to spend
to get each dollar of
additional revenue?
And then see what operating
margin falls out of that.
And you may come to a
very different conclusion.
AUDIENCE: Is that like
operating leverage that you--
PAT DORSEY: Yeah, it's
operating leverage.
And I have found that operating
leverage is frequently
one of the most mispriced
things in the market
because nobody wants to like
hand their boss the portfolio
manager or the
director of research
a model that shows something
going from 13% to 30% margins.
Because they're going to get it
back, and they're going to say,
you're nuts, man.
There's no way.
Forget about it, like, nah.
But it can happen.
It happened with C&E. It
happened with MasterCard.
It's happened with Google.
It happened with OpenTable.
When you get these
network effect businesses
with very high
incremental returns
because you get this
high flow-through ratio
of additional revenue
dollars, margins
can do some pretty
interesting things.
But you'll only figure that
out if you model in dollars.
You've got to just
think about that.
What do I need to spend for each
additional dollar in revenue?
AUDIENCE: So for network
effect, you read anything
about like eBay or Alibaba,
but those kind of networks
seems like they're
[INAUDIBLE] digital network.
You're talking about
it's radial network,
not something like Facebook.
So it appears the only
seller is the buyer.
It's not like buyers sell
stuff to another buyer and all
this stuff.
PAT DORSEY: Oh, OK, that's
a really interesting way
to think about it.
OK, I see what you're saying.
You're right.
It is just seller to buyer.
But the more buyers
who are there,
the more sellers are going to
want to be on the platform,
right?
It's not as if it's
just selling one good.
Like let's imagine that eBay
could only sell baseball cards.
I don't know, whatever.
Then you could have
someone say, OK, I
could pick that market off.
I could invent a better platform
for selling baseball cards.
Whereas if you know
that whatever I want,
I'm probably going
to find it there,
and whatever I want to sell,
I'm going to find it there,
that creates all
those connections.
But I kind of see-- I had never
thought about you could mistake
that for being a radial network.
I wouldn't characterize
it that way.
Because any buyer can
interact with-- that's
the best way to describe it.
Any buyer on eBay can interact
with any seller, right?
And depending on what
they want to buy or sell,
that transaction could occur.
Whereas although I can
send money from Bangladesh
to Mexico City, to go
back to that example,
there's no reason to, right?
I mean, you don't have
people immigrating.
And immigrants are one of the
biggest users of Western Union
network to send money back
home, remittances, right?
You just don't have people
who move from Mexico City
to Bangladesh or vice versa.
There may be a huge Mexican
population in Bangladesh.
I don't know.
I don't think there is.
[LAUGHTER]
But that was a cool way
of thinking about it.
Yeah.
AUDIENCE: Thank you.
So I have one question, Pat.
I'm always very curious about
when, just from a learning
perspective, what would
you say, looking back
10 years, what have been some
of your prominent mistakes
and sort of what you've
learned from them?
PAT DORSEY: Yeah, thank you.
That's a good one.
Thank you for forcing me to air
my dirty laundry, [INAUDIBLE].
I appreciate that.
[LAUGHTER]
AUDIENCE: It will go on YouTube.
PAT DORSEY: No, no, it's OK.
It's OK.
Yes, hello, YouTube.
How are you?
[LAUGHTER]
No, seriously.
No, actually, it's a
very good question.
And I would say that I've
gotten that operating leverage
thing right a couple of times.
I've missed it more
times than I should have.
So that's one that annoys
me when I think about it,
is that thinking carefully about
operating leverage, thinking
carefully about network
effects and runways,
I've done OK at that, but
not as well as I should have.
There's some pitches I missed
that would have been home runs,
I think.
The bigger one, though,
is probably management.
Definitely as I've done more
work on businesses that are not
making caps, that are
smaller-- because management
can have a bigger effect
on a smaller business.
It's just easier to drive a
sports car versus a Mack truck.
And as I've done
more work on what
I would call capital allocator
business models like Brookfield
Asset Management or
Onyx in Toronto or Roper
or PSG in South
Africa, which we own,
I've gained a much
greater appreciation
for what the truly
exceptional managers can do.
And I think as I reflect
on it, I think some of this
came from kind of a reaction
to the kind of 1990s hero CEO
thing, where John
Chambers was God,
Howard Schultz of Starbucks
was God, and this sort
of cult of the hero CEO
that we've developed,
especially in the US, where
pretty much every CEO in the US
is vastly overpaid for
the value they deliver.
And option expensing, you
remember, was a huge battle.
And so I think some
of that management
doesn't matter as much.
Some of it was probably just
a kind of a knee-jerk reaction
to a lot of that, it's
probably fair to say.
But with time, hopefully the
knee is not jerking as much.
And I guess I've just developed
a better appreciation for what
the truly exceptional
manager can do.
And again, I do want to
emphasize truly exceptional.
And you're not truly
exceptional because you
were on the cover of
"Forbes" or "Fortune."
You are not truly exceptional
because you have a giant pay
package.
You are truly
exceptional because you
are passionate
about your business
and you understand how
to allocate capital.
That's what makes an
exceptional manager.
But I would say
that's something I
wish I had appreciated
earlier in my investing career
but something we're working
hard to correct right now.
I mean, in our current
portfolio of 14 companies,
five are what I would call
this capital allocator model.
AUDIENCE: Thanks.
Actually, that brought
to mind one of the books,
"The Outsiders."
PAT DORSEY: Yeah, great book.
AUDIENCE: Yeah, about
capital allocatin.
PAT DORSEY: Yeah.
"Outsiders" is a great book.
If you haven't read
"The Outsiders,"
it's an awesome
book on management.
Will Thorndike wrote it.
Yeah, definitely that
would be in the top 10
the past coupld of years.
AUDIENCE: So while we're
talking about emerging moats
and like good
capital allocators,
one example that you
brought up is Danaher.
The Rales brothers,
they have Colfax,
which right now is in
the news quite a bit
because they sell to
oil and gas quite a bit.
And this is one of kind
of an emerging moat, where
we don't really see
it in the numbers yet.
Would you have any
thoughts that you
would like to share with us?
PAT DORSEY: Yeah,
well, one is don't
bet against the Rales brothers.
That that's a low-odds bet.
No, Colfax is
getting interesting.
We need to ramp
up our work on it
right now, because we sort of
have a list of great businesses
that sell into oil and
gas that are kind of just
gotten whacked lately.
I have not followed
Colfax too closely.
I mean, we owned it after
the charter acquisition
when they basically
bought a company three,
four times their size and
created enormous value almost
overnight with what they
did with that business.
I think I would say the
Rales are amazing managers,
and it's very fertile ground
for more research and more work.
What I would say, the
Colfax model currently
is buy solid businesses and
make them better businesses
via lean manufacturing
techniques,
for the most part, the
Colfax business system.
It's different than, say, like a
Roper or a PSG, both businesses
we do own, which tend to own
great businesses that they want
to make even better via
additional investment
or better capital allocation.
But the Rales brothers are
tough ones to bet against.
AUDIENCE: The hard
part is when you
are kind of watching it as it as
its stands as a snapshot today.
Do these underlying
businesses really
have any kind of moat or not?
And since there's no
numerical evidence, it's hard.
How do you actually go out
and do independent research
and say, yes, these businesses
actually have a moat
now that they are in the Colfax.
PAT DORSEY: Yeah, so there's a
couple things to look at there.
One is looking carefully at
the end markets there, I think.
Because you're looking for
what the numbers could become,
not what they are today.
And so there, you want to almost
get in the customer's head,
right?
And say, why does a customer
buy a pump from Dahaner?
What does it by a
fan from Howden?
Why does it buy welding
equipment from ESAB?
And then get in
the customer's head
and then see what
their behavior is.
And maybe there's
reasons why they're
sticking-- I don't know.
That would be a way to
kind of go down that path.
But then also, and
this kind of goes back
to the one slide about the
truly amazing managers,
operational excellence can
become strategic advantage
rarely.
But in the hands of like an
ITW would be a good example,
in the hands of a truly
four-standard-deviation
manager, operational excellence,
the Danaher business system
back at Danaher, can
become strategic advantage.
Because you just do everything
so much more efficiently
than everybody else.
You manage to eke out an
economic moat out of that.
Not common, not
something I would
try to have a whole
portfolio of those,
because they're
pretty tough to find.
But I would say that the track
record of the Rales brothers
is good enough that if anyone
can turn operational excellence
into strategic
advantage, it would
be on the pretty short list.
MALE SPEAKER: All
right, thanks, Pat.
With that, thank you very much
for such an enlightening talk.
PAT DORSEY: Thanks, Surat.
This has been fun.
Awesome, thanks.
[APPLAUSE]
This has been fun.
