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  • 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.