Pat Dorsey is the guy who is at least partly responsible for democratising the use of Warren Buffett’s philosophy of moat in evaluating businesses. How, you may ask. He was instrumental in developing Morningstar’s economic moat ratings, as well as the methodology behind its framework for analysing competitive advantage. From 2000 to 2011, Dorsey was Director of Equity Research for Morningstar, where he led the growth of Morningstar’s equity research team from 20 to 90 analysts. Having authored two books — The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth, Dorsey now manages money as the founder of Dorsey Asset Management, based out of Chicago. Who better than him to ask the tough questions around moats?
#PatDorsey #DorseyAssetManagement ##Business #OutlookBusiness #OutlookMagazine #OutlookGroup
#PatDorsey #DorseyAssetManagement ##Business #OutlookBusiness #OutlookMagazine #OutlookGroup
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NewsTranscript
00:00 [MUSIC]
00:06 In a lot of ways, it really depends on the business.
00:08 I mean, you could have brands that last for 20, 30 years.
00:12 You could have brands that fade and go away very quickly.
00:15 Customer switching costs, network effects, and scale advantages.
00:19 There are the three kinds of boats.
00:21 And all of them are vulnerable in some way, shape, or form.
00:24 Network effects, people often hold as kind of the most durable boats,
00:30 when you think of MasterCard or Visa.
00:33 But we can all think of marketplaces that have lost customers and
00:36 then experienced negative network effects.
00:38 If I had to pick one, it would probably be customer switching costs.
00:41 Because once you become embedded in a customer's workflow and
00:45 integral to how they live their lives or how they do their job,
00:49 that's a very difficult thing to overcome.
00:52 But nothing is immutable.
00:53 So even when you have a mode based on customer switching costs,
00:57 you have to continuously monitor it to make sure that the company is continuing
01:01 to deliver consumer surplus and not abusing its mode by increasing prices
01:07 to the point where a competitor can come in underneath that pricing umbrella.
01:11 [MUSIC]
01:15 So to review, the four kinds of modes that we focus on at my firm and
01:20 that I've written about in my books are intangible assets, such as brands and
01:24 approvals and patents that give a business pricing power.
01:27 Customer switching costs that occur when the cost of switching from product A to
01:31 product B outweighs the benefit of doing so.
01:34 Cost advantages that occur from the benefits of either scale or
01:37 process based advantages.
01:39 And then network effects when the value of a product or
01:43 service increases with the number of users.
01:45 You might think about a credit card network or social media.
01:48 And when I think about modes that are becoming more or less durable over time,
01:52 certainly network effects are perhaps not more durable but
01:55 more common today than they were 20 or 30 years ago.
01:59 Simply because the availability, widespread availability of the Internet and
02:03 smartphones has enabled products and services to reach more people faster.
02:08 And you have very quick adoption curves, which means that network effects can build
02:12 much more quickly than say Visa or MasterCard built their network effects
02:17 over the 70s, 80s, and 90s.
02:20 In terms of modes that are diminishing in value, I would argue that possibly
02:25 the value of consumer brands, at least in the Western world,
02:30 may diminish somewhat over the next decade.
02:32 Because their barrier to entry,
02:35 which was spending hundreds of millions of dollars on advertising, has decreased.
02:40 Because now a business can use digital advertising to target a small number
02:45 of consumers at a much higher ROI and
02:49 essentially steal a small piece of the large CPG company's market.
02:53 Doesn't mean those brands have no value.
02:56 It simply means that the ability of a business to create a brand that reaches and
03:00 connects with some consumers is easier today than it was 20 or 30 years ago.
03:05 [MUSIC]
03:09 So I think the simplest way to tell whether a mode is really weakening is a company
03:13 that has had pricing power or no longer has it.
03:17 A business that has been able to raise prices 2, 3, 4, 5% in the past
03:21 is unable to raise them at a lower rate or not to raise them at all.
03:26 Because that clearly indicates that the customer value proposition is becoming
03:30 weaker or the competition is becoming stronger.
03:33 So when you see pricing power that has been historically strong diminish,
03:38 that is a clear sign that the mode is weakening.
03:41 So one area in which modes that have been really strong for a long time may,
03:47 and I emphasize may, become less strong over the next decade or so,
03:52 is if you think about consumer products companies, especially in the West.
03:56 Because it used to be that to build a big brand for cereal, soft drinks,
04:00 it required a huge advertising budget to go on network TV and
04:04 advertise to 50, 60 million people.
04:07 Today, you can use digital advertising and
04:09 other techniques that are much lower cost to reach a smaller audience, but
04:12 one which is much more targeted.
04:14 And so that means that the addressable audience for
04:18 the mass brand arguably becomes lower.
04:21 So that's an area where I think you may want to question
04:25 whether the inevitables still are inevitable in a way.
04:29 And in terms of a place where modes are widening, I think generally speaking,
04:34 you have more network effect businesses today than you did 20, 30 years ago.
04:39 And that's largely because of the access to information and the Internet,
04:43 where the ability to have a product quote unquote go viral or
04:48 increase in value to you as a single user as more and more people adopt it.
04:52 That's easier today because of the ability to adopt the product quickly
04:56 with smartphones in everybody's hand.
04:58 [MUSIC]
05:03 So a moat is, I would argue by definition,
05:05 something that's inherent to the business,
05:07 something that doesn't change very much.
05:10 Management can change.
05:11 And so betting that a manager is a moat is different from betting that
05:16 a manager will create a moat.
05:18 Berkshire Hathaway is a very good example.
05:21 You could have looked at Berkshire Hathaway in the 1970s or 1980s and
05:25 certainly made a strong argument that Mr.
05:27 Melvin was a good manager, a good capital allocator.
05:30 But if he had been hit by a bus, the moat would not have been there.
05:34 Now we go back, we look at today, we have a very low cost of capital.
05:38 We have businesses like Burlington, Northern, Santa Fe, and
05:43 Mid-American that have their own structural competitive advantages.
05:46 And so Mr. Buffett has created that moat over time.
05:49 Berkshire certainly has a moat today.
05:52 But if you look at Berkshire back before,
05:55 when it had owned Burlington Northern and Mid-American,
05:58 it was really just a collection of minority holdings in publicly traded
06:02 companies, going back 20 and 30 years, arguing that Mr.
06:06 Buffett was a moat when at any day, he could have had a heart attack,
06:10 he could have been hit by a bus.
06:12 I think that's a difficult argument to make, which is why management itself is
06:15 not a moat, though they can build moats over time.
06:18 [MUSIC]
06:22 As an investor, your returns are gonna be determined by future cash flows,
06:26 not past cash flows.
06:28 So if a business has been reinvesting very heavily, not making a profit because
06:32 it's acquiring customers at a low cost, building factories, laying cable,
06:36 laying railroad, whatever it might be, as long as that investment has a positive net
06:41 present value, and it's likely to generate cash in the future once that investment
06:45 declines, it's entirely possible for a business to be producing accounting
06:50 losses today and be very valuable at some point in the future.
06:54 Because the past is only really an indication of what the future may be.
06:59 There are many businesses that have generated lots of cash in the past that
07:02 are worthless today, and there are many businesses that don't generate a profit
07:06 today, but that are gonna be immensely profitable 10 or 20 years from now.
07:09 Well, think of a cable company.
07:11 I mean, if you're a cable company and you're laying lots and
07:13 lots of coaxial cable underneath the ground, you're investing a lot.
07:17 Paying people to dig up the ground and you're buying the coax and
07:20 you're laying it and connecting it to each house.
07:23 So you may not be generating a lot of value today, but
07:27 once the cable network is built out, you don't need to build the cable anymore.
07:31 You don't need to lay any more cable out, and it's got an economic life of 20,
07:35 30 years.
07:36 Well, your investments come down, your cash flow goes up, and
07:40 you create a lot of value.
07:41 Well, it certainly would be hard to argue that Amazon has not created any value,
07:45 despite the fact that it's plowed every dollar it's ever made back into more
07:50 distribution centers, back into its own claim network that displays UPS and FedEx.
07:55 And now, even into its own ground delivery network.
07:58 Those actions are creating an enormous amount of value for future shareholders and
08:03 for customers, even though they reduce reported gap profits today.
08:07 [MUSIC]