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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.

  • 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.

MALE SPEAKER: So welcome, everyone.

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パット・ドーシー"富を築く小さな本」|Googleで講演 (Pat Dorsey: "The Little Book that Builds Wealth" | Talks at Google)

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    Allen Ho に公開 2021 年 01 月 14 日
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