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TIMESTAMPS
  • 00:02
    MALE SPEAKER: Sowelcome, everyone.
  • 00:03
    My name is [INAUDIBLE], andI'm very pleased to welcome you for another special talk inour Value Investing series.
  • 00:11
    We have a very specialspeaker with us today.
  • 00:14
    But before I get into his introduction, I want to talk brieflyabout this term "moat," which you aregoing to be hearing a lot about in today's talk.
  • 00:24
    Well, according to Wikipedia, a moat is a deep, broad, ditch, eitherdry or filled with water, that surrounds a castle, otherbuilding, or town, historically to provide it with apreliminary line of defense.
  • 00:41
    However, thanks to Mr.Buffett and a legion of value investors,this word "moat" has become an excellentmetaphor to identify companies with durablecompetitive advantage.
  • 00:56
    Very few people,though, have managed to develop and synthesize a framework that systematically helps to identify moats froman investor's perspective.
  • 01:08
    Pat Dorsey, ourauthor for today, has done a greatservice to students and individual investorstrying to do exactly that.
  • 01:16
    In his bestselling book, "The Little Book That Builds Wealth," hehas shared actionable insights to identify modes inthe business world.
  • 01:23
    His book is also a great introduction for anyone interested in learning more about value investing.
  • 01:30
    We are very, very pleasedto have Pat here with us.
  • 01:32
    So without further ado,ladies and gentlemen, please join me in welcoming Pat Dorsey.
  • 01:38
    [APPLAUSE] PAT DORSEY: Thanksfor the kind intro.
  • 01:42
    I'm glad we have the technology,at least working mostly, here in one of the world'smost successful technology [LAUGHTER] You would have thoughtI was presenting in Redmond, Washington.
  • 01:54
    No, I'm joking.
  • 01:55
    Sorry, sorry, it was justright down the middle.
  • 01:58
    It was too easy.
  • 01:59
    It was too easy.
  • 02:00
    You give me a fatpitch, I'm going to hit it-- or investin it, I suppose.
  • 02:05
    So we've done the intros.
  • 02:06
    I'm Pat.
  • 02:07
    I used to run Morningstar'sEquity Research Group, currently have my owninvestment firm called Dorsey AssetManagement, which is a global firm, a global mandate.
  • 02:16
    We can invest anywhere inthe world, any market cap.
  • 02:20
    We're very concentrated.
  • 02:21
    And our goal reallyis to find 10 to 15 of the world'smost competitively advantaged businesses thatcan compound at high rates overtime, invest in them,and then leave them alone to make lots of money over time.
  • 02:33
    That's our job, andthat's what we're actively engaged in doing right now.
  • 02:36
    And the framework we useis in large part based on the work I did atMorningstar and the concept of economic moats andreinvesting capital at high rates of return.
  • 02:45
    And that's what I wantto talk about today.
  • 02:48
    So the basicfoundation of thinking about economic moats andcompetitive advantage is that-- shocker--capitalism works, and that capital seeks thehighest returns possible.
  • 03:00
    If a company ismaking a lot of money, others will seekto compete with it.
  • 03:04
    That intuitively make sense.
  • 03:07
    If I wrote each of you a $50million VC check and said, go start a business,you would probably try to do something profitable.
  • 03:15
    If you are smart, you probablywould not start airlines.
  • 03:18
    I hope.
  • 03:19
    I hope.
  • 03:21
    High profits attractcompetition, I mean, as surely as night follows day.
  • 03:25
    So intuitively this makes sense.
  • 03:28
    Empirically itmakes sense as well.
  • 03:30
    If you go back overtime and look at, say, take T1, companiesin the highest decile of returns on capital.
  • 03:37
    Then roll the clockforward 10, 15 years and look at thatcohort of companies.
  • 03:42
    Most will have lowerlevels of profitability.
  • 03:45
    Most will have lowerreturns on capital as their returns oncapital have drifted down to some mean ascompetition has come in.
  • 03:54
    Of course there is aminority of businesses where that's not the case.
  • 03:59
    So most businessesyou see high returns on capital decrease overtime as competition comes in.
  • 04:06
    However, there is avery small minority of businesses thatenjoy many years of high returns on capital.
  • 04:14
    They essentially beat the odds.
  • 04:15
    They defy economic gravity.
  • 04:18
    And the questionsimply becomes, how?
  • 04:21
    Companies that have succeeded in creating economic moats can evade competition for longer.
  • 04:21
    And in my view,it's because they've created structuraladvantages, economic moats, a way of insulating themselves,buffering themselves against the competition,that enables them to maintain supernormal returnson capital longer than academic theory andthe averages would suggest.
  • 04:41
    Because absent a moat, competition destroys excess returns-- period, end, full stop.
  • 04:49
    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?
  • 05:04
    [INAUDIBLE]?
  • 05:05
    They would swap market shares like every six months.
  • 05:08
    One had the best chip.
  • 05:09
    Oh, now I've got the best chip.
  • 05:10
    Do-do-do-do.
  • 05:11
    And there's no moat there.
  • 05:12
    The moat was just, what do I got that's great today?
  • 05:14
    And then you had a lot of smart engineers at the other place trying to make the next best thing.
  • 05:19
    So the basics of moats is that there are structural and sustainable qualities that are inherent to the business.
  • 05:25
    A moat is part and parcel of the business that you're looking at.
  • 05:29
    It's not a hot product.
  • 05:31
    We all probably remember the Krispy Kreme debacle.
  • 05:33
    They taste good, but sugar is not a moat.
  • 05:38
    Heelys-- anybody remember Heelys or have a kid?
  • 05:41
    Remember those little shoes with the wheel in the heel?
  • 05:43
    That was an $800 million company at one point.
  • 05:48
    I mean, yes, as Dave Barry would say, I am not making this up.
  • 05:53
    People were valuing Heelys as if it had a moat.
  • 05:56
    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.
  • 06:09
    And so that business went to hell pretty fast.
  • 06:13
    It's not just a cool piece of technology.
  • 06:15
    We talked about in video and the graphics companies a moment ago.
  • 06:18
    Remember Iomega?
  • 06:19
    Remember that was going to be the thing?
  • 06:22
    It's just a cool piece of technology.
  • 06:24
    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.
  • 06:36
    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.
  • 06:42
    Market share is not a moat.
  • 06:42
    And of course, it's not the biggest market share.
  • 06:44
    You'll often hear companies talk about, oh, we're the biggest.
  • 06:46
    We're going for market share.
  • 06:47
    Let's think about GM.
  • 06:48
    Let's think about Compaq.
  • 06:50
    It didn't work out so well.
  • 06:51
    Big is not a moat.
  • 06:53
    In fact, small is often a better moat than big.
  • 06:56
    Moats generally manifest themselves in pricing power.
  • 06:59
    A company that can't raise prices is unlikely to have a strong moat.
  • 07:03
    And in fact, if you invest, this is a test often that businesses are losing competitive advantage.
  • 07:09
    If you have a company who typically raises prices 2%, 3%, 4% every year.
  • 07:10
    Companies that traditionally raise prices every year, then stop raising prices mean that the company is loosing the advantage.
  • 07:16
    They're able to kind of keep pricing power moving up.
  • 07:18
    And then one year, suddenly they don't.
  • 07:19
    They say, well, the economy's tough or we want to take it easy on the customers this year.
  • 07:25
    That's a load of crap.
  • 07:27
    It means that something has changed in that industry.
  • 07:29
    There's a competitor out there.
  • 07:31
    There is some event going on that you may not be aware of that's causing them to lose that pricing power.
  • 07:37
    Because if you can take price, you will take prices as a business.
  • 07:40
    And so companies that lose that pricing power, that's usually the first sign that their moat is eroding.
  • 07:46
    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.
  • 07:53
    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.
  • 07:55
    Using ~50yrs historic data, those that held returns on capital above cost of capital for 15 years or more were considered to have created a moat.
  • 08:09
    It's not a huge data set.
  • 08:11
    And then you basically say, well, what are the common characteristics of these businesses?
  • 08:14
    What are the similarities of these businesses?
  • 08:17
    And that's where we kind of teased out these four categories.
  • 08:20
    And they've proven to work out pretty well.
  • 08:22
    We introduced the moat ratings at Morningstar in about '01.
  • 08:25
    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.
  • 08:37
    So the empirical results seem to bear out the theory.
  • 08:42
    The first kind of intangible asset is a brand.
  • 08:44
    And a brand is valuable if it either increases your willingness to pay or lowers your search costs.
  • 08:47
    Intangible assets slide highlighting the 3 types of ecomonic moats; Brands, Patents, Licenses.
  • 08:50
    And this is really important.
  • 08:52
    It's not just that it's well known.
  • 08:54
    Brands can be a moat. Explanation about how the brand Sony is of little value today, but Tiffany&39;s is a high value brand.
  • 08:54
    Because you think about, say, Sony.
  • 08:55
    We've all heard of Sony, right?
  • 08:56
    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.
  • 09:04
    But let me just do a quick survey in this room.
  • 09:07
    How many of you would pay 20% more for a Sony DVD player?
  • 09:14
    One hand?
  • 09:15
    AUDIENCE: Maybe 15 years ago.
  • 09:17
    PAT DORSEY: Maybe 15 years ago.
  • 09:18
    That's exactly it.
  • 09:20
    And right now you do see like the Sony Bravia TVs getting a little bit of a price premium over others.
  • 09:25
    Because it's newer.
  • 09:26
    DVDs were newer.
  • 09:28
    But consumer electronics is fast-cycle stuff, right?
  • 09:31
    What's new today is old next week.
  • 09:33
    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.
  • 09:40
    In fact, I would argue Sony could probably save a heck of a lot of money by not advertising or advertising very little.
  • 09:47
    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.
  • 09:53
    And I'm sure they're paying God knows what in rent-- useless.
  • 09:57
    Because that brand doesn't change your behavior.
  • 10:00
    By contrast, let's look at Tiffany.
  • 10:03
    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.
  • 10:11
    20% is the value of that pale blue box.
  • 10:15
    I can guarantee you the cardboard ain't that expensive.
  • 10:17
    [LAUGHTER] OK?
  • 10:19
    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.
  • 10:30
    So they can charge it.
  • 10:32
    And so that brand has value, right?
  • 10:34
    That brand increases your willingness to pay.
  • 10:37
    And there's value there.
  • 10:38
    You also have brands that lower search costs.
  • 10:40
    Coke, or Heinz lowers search cost, so consumers will pay a premium.
  • 10:40
    So think about Coca-Cola or Wrigley gum.
  • 10:43
    You don't pay a lot more for Coke versus Pepsi, but you know you like Coke, so you go there.
  • 10:49
    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.
  • 10:55
    It's $3.
  • 10:57
    My kids like ketchup.
  • 10:58
    Let's go get the ketchup.
  • 10:59
    We go through ketchup in vats at my house.
  • 11:01
    I have twin seven-year-olds, and I think ketchup is like our fifth food group.
  • 11:04
    It's ridiculous.
  • 11:07
    So again, if a brand changes consumer behavior by increasing the willingness to pay or reducing the search costs, then it has value.
  • 11:17
    Just being well known doesn't mean anything at all.
  • 11:21
    Patents are a moat, but are high risk. If a company has one patent protected asset and it is challenged, there is an issue.
  • 11:21
    Patents-- obviously a patent is a legal monopoly.
  • 11:24
    But they are subject to expiration, challenge, and piracy.
  • 11:27
    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.
  • 11:37
    That patent gets challenged, you're dead.
  • 11:40
    And last time I checked, patent lawyers drive really nice cars.
  • 11:43
    And there's a reason for that, which is that patents are valuable to challenge.
  • 11:46
    And so if they can be challenged, they will be challenged.
  • 11:49
    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.
  • 11:50
    Patents are best used as a moat when there is a portfolio of patents.
  • 11:56
    Think of Qalcomm.
  • 11:57
    Think of ARM Holdings, where there's this huge portfolio of patents.
  • 12:00
    licenses or approvals are a moat.
  • 12:00
    And then finally, licenses and approvals.
  • 12:02
    You have a license to do something that not many people can do or an approval, that is a pretty solid economic moat.
  • 12:09
    Casinos-- not easy to get a casino license.
  • 12:12
    Six of them in Macau.
  • 12:13
    They ain't giving out any more.
  • 12:15
    Landfills-- no one likes to live near a landfill.
  • 12:18
    So municipalities don't give out tons of landfill licenses, because then nobody wants to live there.
  • 12:23
    And that reduces the tax base.
  • 12:24
    So once you have a landfill or a gravel pit, you probably aren't going to get a whole lot more of them.
  • 12:29
    Aircraft parts are the same thing, have to be FAA certified, and that's a huge moat to the aircraft parts industry.
  • 12:34
    Most aircraft parts are sole source.
  • 12:37
    They have one manufacturer who makes them.
  • 12:40
    And so they get about a 40% margin on aftermarket.
  • 12:42
    It's a beautiful business.
  • 12:45
    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.
  • 12:50
    The first type of an economic moat is a brand. Brands are only valuable if they deliver a consistent or aspirational experience.
  • 12:51
    Brands are valuable if they deliver a consistent or aspirational experience.
  • 12:55
    Now, consistency lowers search costs and drives loyalty.
  • 12:59
    So what you don't want to do is change the damn product.
  • 13:03
    That's the stupidest thing possible.
  • 13:04
    New Coke mistake in changing the taste.
  • 13:05
    Remember New Coke?
  • 13:08
    Schlitz used to be the second highest volume beer in US.
  • 13:08
    Idiotic.
  • 13:09
    Schlitz-- Schlitz used to be the second highest selling beer in the US, most volume the US.
  • 13:16
    Now not so much, right?
  • 13:19
    And the reason was they changed the way it was made.
  • 13:22
    They changed the taste of Schlitz.
  • 13:25
    Why would you do this?
  • 13:28
    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.
  • 13:34
    They were going to change the recipe.
  • 13:35
    And you just go, stop.
  • 13:37
    If people are buying this, why change it?
  • 13:41
    Aspiration, by contrast, increases willingness to pay.
  • 13:44
    Brands want scarcity if they are in the aspirational category.
  • 13:44
    So what you want to do is create scarcity and exclusivity.
  • 13:48
    A very interesting example is Tiffany stores.
  • 13:51
    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.
  • 14:00
    Weird, right?
  • 14:01
    You wouldn't think about that.
  • 14:02
    And it's brilliant.
  • 14:03
    They're one of the only companies that can hit volume and hit high price.
  • 14:08
    But here's how they do it, one of the ways they do it by maintaining the brand.
  • 14:11
    You would think that the stuff that drives 40% of your sales, that would be at the front of the store, right?
  • 14:15
    You want people to get easy access to that.
  • 14:17
    No, no, no, no, no.
  • 14:19
    Go into a Tiffany store.
  • 14:20
    The cheap stuff is at the back.
  • 14:22
    So the expensive stuff, the stuff that costs more than a Tesla, that's sitting in the front of the store.
  • 14:27
    Because that keeps the value of the brand up.
  • 14:29
    That maintains an aura of exclusivity and scarcity.
  • 14:34
    And so they keep the brand value up.
  • 14:36
    Or Patek Phillippe, very expensive watch brand-- the slogan, which I love, is, you don't own a Patek Phillippe.
  • 14:41
    You don&39;t own a Patek Philippe. You take care of it for the next generation.
  • 14:43
    You take care of it for the next generation.
  • 14:46
    I mean, what a great image, for those of us who can afford $50,000 watches.
  • 14:52
    But it maintains that scarcity, that exclusivity value.
  • 14:55
    And again, you have to look at, if you're looking at brand-based companies, aspirations differ.
  • 15:00
    So you want to think about companies that can adapt.
  • 15:02
    A great example is Jack Daniels, owned by Brown-Forman.
  • 15:06
    So these are two different Jack Daniels ads.
  • 15:08
    I'm going to do the translations based on what I've been told.
  • 15:11
    I don't speak Russian or Chinese.
  • 15:14
    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.
  • 15:24
    And in Russia, that works, because a lot of Russians own [INAUDIBLE].
  • 15:29
    They like to get out of the city and get back to kind of their sort of Slavic roots.
  • 15:33
    Now compare that with this Jack Daniels ad in China.
  • 15:39
    You're in a very high-end bar, very urban, very smooth, very cool.
  • 15:45
    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?
  • 15:52
    AUDIENCE: So it specifically means confidence is not by our mouth but from other people's eye.
  • 15:59
    PAT DORSEY: Confidence is not out of your mouth but comes from other people's eyes.
  • 16:03
    In other words, confidence is how people see you, right?
  • 16:07
    Totally different, right?
  • 16:09
    Because imagine in China if you had this ad that basically was like, you should go back to the village you came from.
  • 16:17
    That's going to sell a premium spirit, right?
  • 16:19
    You know?
  • 16:20
    So again, you see this adaptation.
  • 16:23
    That's what you want to see in a brand-based company.
  • 16:26
    Second kind of economic moat is switching costs.
  • 16:28
    Second type of economic moat are switching costs.
  • 16:29
    It's very simple, just the cost of switching to a competing product outweigh the benefits.
  • 16:33
    What you want to do is look for companies that integrate with the customer's business.
  • 16:37
    So the upfront cost of implementation get huge payback for renewals.
  • 16:42
    Think about an Oracle database, for example.
  • 16:44
    If you're P&G, if you're Citigroup and you're running on an Oracle database, ripping that out is virtually impossible.
  • 16:51
    It's not impossible, but it's really, really, really, hard.
  • 16:56
    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.
  • 17:19
    So the switching costs are very high.
  • 17:21
    And so Oracle can raise the price 2% to 3% every year.
  • 17:24
    You see this a lot with enterprise software companies.
  • 17:26
    You also see it with data processors, people that integrate tightly with the customer's business.
  • 17:30
    You can also sell an ongoing service relationship.
  • 17:33
    So think of elevators.
  • 17:35
    Once you have an elevator in a building, it probably ain't coming out again.
  • 17:39
    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.
  • 17:52
    Because once that elevator's in there, it ain't coming out again.
  • 17:55
    And so you get this long service relationship.
  • 17:58
    Rolls Royce-- Rolls Royce typically sells its jet engines on what's called power by the hour.
  • 18:03
    They actually sell it, and then you pay for it based on how much you use it.
  • 18:06
    You don't just pay for it upfront and then someone else maintains it.
  • 18:09
    So that's a way of increasing the switching cost.
  • 18:12
    And then you can provide a product with a very high benefit-to-cost ratio.
  • 18:16
    Favorite example here is a company called Fastenal here in the US.
  • 18:20
    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.
  • 18:33
    And so that product doesn't have a very high economic cost in terms of how would you spend for the bolt.
  • 18:38
    But it has a huge benefit to your organization.
  • 18:41
    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?
  • 19:09
    So this high benefit/cost ratio is really a cool thing to look for when you're looking for businesses with switching costs.
  • 19:14
    Third type of economic moat is Networks.
  • 19:15
    You've got the network effect, which is simply providing a service that increases in value as the number of users expands.
  • 19:21
    You can aggregate demand between fragmented parties.
  • 19:23
    Think of distributors.
  • 19:24
    Henry Schein distributor example of bringing together the fragmented Dentist buyers with the fragmented suppliers.
  • 19:25
    Henry Schein is a dental distributor.
  • 19:27
    So basically most dentists are little owner-operators, two, three, four, five dentists at a practice.
  • 19:32
    And then they've got to buy stuff.
  • 19:33
    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.
  • 19:40
    They've got to buy dental drills and all kinds of stuff.
  • 19:42
    And basically what they're doing is aggregating.
  • 19:44
    Fragmented demand, fragmented supply, and they bring the two together and extract a lot of economic rents by doing that.
  • 19:52
    One thing to watch for here is that one reason the network effect works so well is the non-linearity of nodes versus connections.
  • 19:59
    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.
  • 20:09
    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.
  • 20:18
    One thing you want to watch for, though, is radial versus interactive networks.
  • 20:19
    Radial network(Western Union) less valuable than interactive network.
  • 20:22
    So the interactive network is what I just described, the web, where each node interacts with the other.
  • 20:28
    A radial network is less valuable.
  • 20:31
    So this is a good lesson I learned at Morningstar when we looked at Western Union.
  • 20:34
    So Western Union helps people send money from place to place.
  • 20:38
    And they talk about, we have the most number of branches of any money transfer organization in the world, which is true.
  • 20:44
    The problem is that no one is sending money from Bangladesh to Mexico City.
  • 20:49
    They're sending money for Mexico City to Chicago or from Mexico City to LA or from Bangladesh to Chicago.
  • 20:55
    We have a huge Bangladeshi community there.
  • 20:57
    No one is sending money from Bangladesh to Mexico City or vice versa.
  • 20:59
    So that route means nothing.
  • 21:01
    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.
  • 21:11
    So radial networks are much, much less robust than interactive ones, we found.
  • 21:15
    The final type of economic moat are cost advantages.
  • 21:16
    And then the final type of moat-- cost advantages.
  • 21:19
    This is kind of self-explanatory.
  • 21:22
    But the thing is, there's a couple differences here that you should look for when you're looking at companies.
  • 21:26
    A process-based advantage is basically inventing a cheaper way to do something that is hard to replicate quickly.
  • 21:33
    Southwest did this.
  • 21:34
    Ryanair did this.
  • 21:35
    Inditext, which owns the Zara brand you may be familiar with, is great example.
  • 21:41
    They had their clothes made in Sri Lanka, the clothes made in Bangladesh because it was really cheap.
  • 21:46
    But of course, because of transport links, you have to basically make a fashion bet six months in advance.
  • 21:53
    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.
  • 22:04
    Now, you can copy that, right?
  • 22:05
    You can copy that.
  • 22:06
    But it works pretty well while you're doing it.
  • 22:09
    And so process-based cost advantages tend to work well.
  • 22:14
    But then they get copied eventually.
  • 22:16
    Southwest no longer has the lowest cost per available seat mile.
  • 22:19
    People saw what they did and copied it.
  • 22:22
    Scale, by contrast, when you spread your fixed costs over a large base, that tends to be much, much more robust.
  • 22:29
    So think about this big network of brown UPS vans going around a neighborhood.
  • 22:33
    What's the additional cost of putting one more package on the UPS van?
  • 22:38
    De minimus, right?
  • 22:39
    And so your margin on that is very, very high.
  • 22:42
    It's very difficult to compete.
  • 22:44
    A good example is DHL, which is a wonderfully run business, has a very dense network in Europe.
  • 22:51
    They lost over a billion dollars trying to compete with UPS and FedEx in the ground market in the US.
  • 22:58
    They couldn't do it simply because they couldn't scale up.
  • 23:01
    There weren't as many yellow vans as there were brown vans and blue-and-white vans.
  • 23:05
    Scale-based advantages, especially in distribution, are incredibly robust.
  • 23:11
    And you can have a niche where you establish a minimum efficient scale.
  • 23:15
    There are some niches, some industries, that can only profitably support one or two players.
  • 23:20
    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.
  • 23:26
    What about management? "Good jockeys will go well on good horses, but not on broken-down nags." - Warren Buffet
  • 23:30
    The businesses often can't grow very well, because they're kind of trapped there, but they can be enormously profitable.
  • 23:36
    So what about management?
  • 23:37
    You notice I haven't said a word about management yet.
  • 23:40
    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.
  • 23:51
    He is a very good manager.
  • 23:53
    Sadly, he is on a bad vehicle called a goat.
  • 23:58
    So if you enter this in a race, he is probably going to lose.
  • 24:02
    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.
  • 24:09
    Because the horse is better suited for winning races than the goat.
  • 24:13
    You're not going to get much milk out of it.
  • 24:15
    The goat is better for that.
  • 24:16
    But it's very well suited for winning races.
  • 24:19
    So the key here is that you want to get a good horse.
  • 24:23
    You want to look for good horses.
  • 24:25
    Its not that the jockey is irrelevant.
  • 24:26
    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.
  • 24:32
    "The quality of management skill required is inversely proportional to the quality of the business".
  • 24:32
    Managers matter in the context of the moat.
  • 24:35
    And the way to think about this is very simple.
  • 24:37
    The required level of managerial skill is inversely related to the quality of the business.
  • 24:44
    The worst the business, the better the manager.
  • 24:46
    The better the business-- eh-- as long as management isn't that stupid, you'll do fine.
  • 24:53
    If it's a really bad business, you better have an awesome manager.
  • 24:56
    This is Ryanair.
  • 24:58
    O'Leary is a absolute genius.
  • 25:01
    He's a jerk and customers hate flying Ryanair, but he has created an amazing, amazing business.
  • 25:08
    Ryanair is scale advantages to die for.
  • 25:12
    By contrast, if you have a great business, genius is not needed.
  • 25:17
    You saw where this was going, I know.
  • 25:20
    What that actually means is, here's what's happened to Microsoft's moat while I've been in charge.
  • 25:26
    Again, it's an easy target here at Google, but it's true.
  • 25:29
    I mean, Steve Ballmer essentially spent 12 years setting money on fire at Microsoft as far as I can tell.
  • 25:34
    AUDIENCE: What do you think about Twitter?
  • 25:36
    PAT DORSEY: Well, Twitter-- I never followed it much.
  • 25:39
    And also that was no pun intended.
  • 25:43
    [LAUGHTER] The question was, what about Twitter?
  • 25:47
    I haven't figured out what the monetization model is.
  • 25:50
    I haven't figured out how they make money.
  • 25:51
    I mean, they may have some secret theory.
  • 25:52
    I just don't know what it is.
  • 25:53
    But I haven't spent much time on it, although I think it was founded by a guy named Dorsey, wasn't it?
  • 25:58
    Anyway, I probably should look at it.
  • 26:00
    So the key here is that moats can buffer management mistakes.
  • 26:03
    Microsoft minted money despite Steve Ballmer, despite them shoveling dirt in the moat every day.
  • 26:12
    The core office, the core Windows franchises were strong enough that the business overall maintained pretty high returns on capital.
  • 26:18
    New Coke didn't kill Coca-Cola because the business was robust enough.
  • 26:23
    The brand is strong enough.
  • 26:25
    Moody's put profits before integrity, actively screwed investors, and still cranked out a 40% operating margin.
  • 26:34
    That's a pretty good moat.
  • 26:37
    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.
  • 26:45
    I mean, he's an amazing manager.
  • 26:46
    If you've ever met him, read any of his books, seen him speak, he's incredible.
  • 26:50
    He's inspirational.
  • 26:52
    JetBlue was like 30-odd times earnings when it went public.
  • 26:54
    Because it had leather seats and TV?
  • 26:58
    I mean, an airline will never have lower costs than the day it opens for business.
  • 27:04
    Planes don't get newer.
  • 27:05
    They get older.
  • 27:08
    Employees don't get less seniority.
  • 27:10
    They get more.
  • 27:11
    So the planes cost more to run.
  • 27:13
    The employees want more money.
  • 27:14
    So the cost structure is inevitably bound to decline.
  • 27:18
    Again, great jockey on a goat.
  • 27:22
    Good managers are constantly looking for ways to widen a company's moat.
  • 27:26
    Think about Amazon's focus on the customer experience.
  • 27:29
    It's not so much about scale.
  • 27:31
    It's about the customer experience.
  • 27:33
    Here's a great-- let me try this here.
  • 27:35
    I've tried this at other talks around the world.
  • 27:37
    How many of you bought something off Amazon without checking the price elsewhere?
  • 27:44
    OK, that's like 2/3, 3/4 of the hands.
  • 27:46
    Isn't that an amazing statistic right there?
  • 27:49
    I mean, how hard is it to click to another website?
  • 27:52
    What's the caloric cost of moving your mouse?
  • 27:54
    It's not high, right?
  • 27:57
    But I've talked to about 45 CFA societies around the world.
  • 28:00
    I get about the same number of hands that go up, except in Germany.
  • 28:04
    The Germans didn't seem to-- Amazon has not been as-- there's more.
  • 28:09
    There's Zalando.
  • 28:10
    There's a lot of other etailers there.
  • 28:11
    But in the US, this is the response you get.
  • 28:13
    And a lot of this is the customer experience, right?
  • 28:15
    Amazon gets credit for figuring out early on that online business is all about trust.
  • 28:16
    Trust matters more online than offline.
  • 28:18
    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.
  • 28:29
    There's no trust involved.
  • 28:31
    Online, I have to trust you to send me what I ordered.
  • 28:34
    I have to trust you don't steal my credit card number.
  • 28:36
    I have to trust it arrives when you say it will.
  • 28:38
    I have to trust you'll take it back if you say you will.
  • 28:41
    There's a lot of trust involved.
  • 28:42
    And that enabled the ability to build a moat, build a brand in retailing, which is a really tough industry to do that in.
  • 28:51
    Think about Costco's focus on using scale to lower costs.
  • 28:54
    Costco gets bigger, cost savings go right back to the customer.
  • 28:58
    That brings in more customers, which allows more cost savings that go right back to the customer.
  • 29:02
    That's what drives their business.
  • 29:04
    That's all they think about every day.
  • 29:06
    Now by contrast, bad managers invest capital outside a company's moat, which lowers overall returns on capital.
  • 29:14
    This process is called de-worse-ification, or setting fire to large piles of cash, OK?
  • 29:21
    This is basically what you don't want to see a company doing.
  • 29:22
    Companies that invest outside of their moat will set fire to lots of $.
  • 29:24
    Example-- Cisco moving into consumer markets, the Netgear acquisition, I think it was.
  • 29:30
    What on earth was that?
  • 29:32
    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?
  • 29:42
    My set-top box at home used to be a Cisco, and I could just curse that thing every time I looked at it.
  • 29:46
    Because it was just the worst business to go into-- fast product cycles, no competitive advantage.
  • 29:52
    The whole network-centered comb.
  • 29:54
    So what?
  • 29:55
    Remember Garmin?
  • 29:57
    Anybody remember the Nuvi handset?
  • 30:01
    Nobody?
  • 30:02
    OK, so Garmin had this great franchise, partially in GPS devices in your car, but also a much better franchise in avionics.
  • 30:09
    So business jets, regional jets often have Garmin as the GPS device in there.
  • 30:16
    You own a plane, you really want to know where you are.
  • 30:18
    So that business was a very good, sticky business.
  • 30:21
    And so they see, oh, gosh, GPS is going from a product to a feature that's basically just a feature of a smartphone.
  • 30:30
    Oh, let's not relaxed to the inevitable and just get out of the business.
  • 30:34
    Let's double down and go into handsets and compete with Ericsson and Nokia-- completely moronic.
  • 30:41
    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.
  • 30:51
    It's a horrible sign.
  • 30:52
    Yep-- question?
  • 30:53
    AUDIENCE: How do you differentiate that from the innovator?
  • 30:56
    Like Good, for example.
  • 30:57
    PAT DORSEY: Great question, and I knew this was coming.
  • 30:58
    I knew this was coming.
  • 31:00
    So the question is how do you differentiate that from being innovative?
  • 31:03
    Because Google is doing it out of strength, right?
  • 31:05
    Google is not doing it to preserve growth or because their core business is dying.
  • 31:10
    Google is doing it as a way of planting seeds for hopefully a great business in the future.
  • 31:15
    And it's a subtle difference, but the key thing is it's coming out of strength.
  • 31:19
    Google's core business isn't going down.
  • 31:21
    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.
  • 31:34
    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.
  • 31:43
    Or you can just say, hey, guys, we'll grow at 6% and now 16% anymore.
  • 31:48
    That would have been the more rational response.
  • 31:50
    Instead, they go out and take a blow torch to dry pallets of cash by buying-- oh, remember the Flip?
  • 31:54
    Remember the Flip?
  • 31:56
    $800 million on basically a little video camera that will about six months be in your phone.
  • 32:05
    I mean, you know, again, out of weakness versus out of strength.
  • 32:09
    Yep, another question.
  • 32:10
    AUDIENCE: How much of this kind of stupidity is correlated with the fact that these businesses that are sometimes wide moats are not [INAUDIBLE]?
  • 32:18
    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?
  • 32:30
    I think it's a good-- John Chambers owned a decent chunk of Cisco.
  • 32:34
    But I do think you see it less frequently with owner-operator businesses.
  • 32:37
    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.
  • 32:50
    So I think by having an owner-operator, you lessen this chance.
  • 32:55
    But they're not infallible.
  • 32:57
    I mean, the danger is when you have businesses that can't relax to change.
  • 33:02
    And especially you see this a lot, actually, with tech companies.
  • 33:06
    Not, not just tech companies, but companies when they mature.
  • 33:08
    So this happened to McDonald's.
  • 33:09
    It happened to Home Depot, happened to Starbucks, happened to Cisco, happened to Microsoft.
  • 33:14
    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 It's like the 50-year-old guy who's trying to date a 20-year-old.
  • 33:27
    It's just inappropriate.
  • 33:29
    And it's the same thing when you're a super successful business like Starbucks.
  • 33:33
    And they just kept opening new stores, opening new stores.
  • 33:36
    I remember there was a great "Onion" story once, Starbucks opened Starbucks in Starbucks' bathroom.
  • 33:40
    [LAUGHTER] Because they were just everywhere, right?
  • 33:44
    And Howard Schultz came back and realized that the return on capital for these new stores was really not very high.
  • 33:50
    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.
  • 34:04
    So I mean, many businesses go through this transition.
  • 34:08
    So we'll get the Joker off the screen there.
  • 34:11
    Now there is, I should say, an exception to every rule about sort of management and the horse being more important than the jockey.
  • 34:18
    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.
  • 34:27
    Warren Buffett at Berkshire started with a textile mill for God's sake.
  • 34:31
    Brian Joffe at Bidvest, which is a South African firm, started with nothing.
  • 34:35
    And now they do logistics, they do distribution, they do food service-- amazing business.
  • 34:41
    Dick Kovacevich at Wells Fargo-- and banking is tough business, really tough business.
  • 34:46
    But what Kovacevich and Stomphe have done is nothing short of amazing.
  • 34:49
    Steven M. Rales at Danaher-- Danaher has actually beaten Berkshire in the past 20 years in terms of shareholder returns.
  • 34:55
    It started off selling industrial pumps.
  • 34:58
    And they bought Beckman Coulter a few years ago, big diagnostics firm.
  • 35:01
    So again, there is an exception to every rule.
  • 35:04
    There is a tiny minority of managers that can make something out of not much.
  • 35:10
    So keep an eye out for them.
  • 35:11
    They're hard to find, false positives abound, but these guys can create enormous wealth over time.
  • 35:16
    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.
  • 35:27
    Yeah, there's a question there in the back?
  • 35:28
    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.
  • 35:36
    Maybe they should not have done that and so on.
  • 35:38
    For every New Coke that did not work out, maybe there is another product by some other company that did work out.
  • 35:43
    PAT DORSEY: Sadly, investing does not lend itself well to statistical proof.
  • 35:48
    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.
  • 35:58
    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.
  • 36:00
    "The Three Rules: How Exceptional Companies Think" is a book that attempts to do statistical analysis of the success of business.
  • 36:18
    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.
  • 36:31
    But there is a luck component to this, right?
  • 36:34
    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.
  • 36:36
    Warren Buffet was taught how to do insurrance well by the one Geico manager at work after hours after the janitor let Warren in. The manager was Lorimer "Davy" Davidson, who would become the company&65533;s CEO seven years later.
  • 36:45
    He got the janitor.
  • 36:46
    He basically banged on the door of Geico.
  • 36:49
    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.
  • 37:00
    If that hadn't happened, would he have really gotten the early tutelage in insurance then created what Berkshire became?
  • 37:08
    Maybe not.
  • 37:10
    So my point here is simply luck happens, right?
  • 37:16
    Chance is part of it.
  • 37:17
    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.
  • 37:36
    But there is a role of chance in creating successful companies.
  • 37:40
    And that's a weakness of like "Good to Great," the "Built to Last," and lot of these success studies.
  • 37:47
    "The Halo Effect" is a book that busts the myth of the hero CEO.
  • 37:47
    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.
  • 37:56
    It's a really good book.
  • 37:58
    AUDIENCE: So you talked about two possible approaches.
  • 38:00
    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.
  • 38:20
    And it kind of does not reflect the fact that maybe over time it will revert to mean.
  • 38:24
    And maybe you can identify certain industry-- PAT DORSEY: So these are the-- PAT DORSEY: --crappy businesses that go to being semi-crappy.
  • 38:31
    AUDIENCE: Yeah.
  • 38:32
    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.
  • 38:38
    Look, that's sort of traditional value investing, right?
  • 38:41
    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?
  • 38:48
    Or it goes from a 2% margin business to a 5% margin business.
  • 38:52
    That is a fine way to invest.
  • 38:54
    Typically these are not kind of moat-y businesses.
  • 38:57
    It's more what we call kind of cigar button investing.
  • 38:59
    Again, you can make plenty of money that way.
  • 39:03
    It's not how I choose to invest, but plenty of people make lots of money that way.
  • 39:07
    What I would say is the only issue if you're going to pursue that approach is time is not your friend.
  • 39:14
    Because the intrinsic value of those businesses is declining over time.
  • 39:18
    And if they don't turn around quickly, you're left with a declining asset.
  • 39:22
    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.
  • 39:30
    Because it builds value over time.
  • 39:32
    And that becomes a sort of an additional margin of safety.
  • 39:35
    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.
  • 39:46
    Because what you're buying is probably declining in value.
  • 39:50
    So just in a global context, I think it's important to remember local differences can create moats, OK?
  • 39:58
    Foreign companies aren't allowed to own banks in Canada.
  • 40:01
    Thus, the Canadian banks will always be insanely profitable, much more profitable than banks in almost any other part of the world.
  • 40:08
    In Germany-- this is a great one.
  • 40:10
    Most German municipalities don't allow you to wash your car in your driveway or on the street.
  • 40:14
    These are environmental regulations.
  • 40:16
    So car washing is actually a pretty good business Because Germans like cars, and you can't wash in your driveway, right?
  • 40:22
    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.
  • 40:30
    This business could not exist in the US.
  • 40:33
    So that's a local difference.
  • 40:35
    So they can create moats.
  • 40:37
    You also see minimum efficient scale being more common.
  • 40:40
    So retailing is a tough business in the US.
  • 40:42
    Because it's a huge market, easy to come in.
  • 40:45
    South African retailers have returns on capital that make Costco look like an airline.
  • 40:50
    It's not entirely true, but they're great returns on capital.
  • 40:53
    And the reason is simple.
  • 40:54
    It's a relatively small market.
  • 40:56
    And once you've got the two or three big players, it's really hard for anybody else to compete.
  • 41:01
    And global players aren't going to come in, because it's just not that big a market.
  • 41:03
    Why am I going to bother spending a ton of money coming in to South Africa?
  • 41:06
    Walmart recently came in, but they just bought a local player.
  • 41:09
    They didn't try to come in on themselves.
  • 41:11
    BEC World is the largest producer of Thai language media.
  • 41:16
    So if you want to watch a soap opera in Thailand, a news broadcast, they own most of the pay TV channels.
  • 41:22
    It's awesome business.
  • 41:26
    I mean, Thailand is a big country.
  • 41:28
    Thai is not as commonly spoken as, say, English.
  • 41:31
    So now you have minimum-efficient scale.
  • 41:32
    The odds that you have a competitor coming in there are lower than if you created, say, English-language content.
  • 41:37
    And then you also have cultural preferences.
  • 41:40
    For example, beer travels-- beer can often be exported.
  • 41:45
    I mean, when I was in Macau last week, Carlsberg all over the place.
  • 41:48
    It's crappy beer.
  • 41:49
    I don't know why.
  • 41:50
    But Carlsberg seemed to be doing well there.
  • 41:53
    Beer travels pretty well.
  • 41:54
    Spirits travel pretty well.
  • 41:56
    Candy and snacks don't.
  • 41:58
    The snacks you grew up with, the candy you grew up with, is what you will probably eat the rest of your life.
  • 42:04
    You try to sell Hershey's in the UK, and they say it basically tastes like cardboard.
  • 42:09
    Whereas Cadbury to most Americans is much too sweet.
  • 42:12
    And like the Mexicans had this chocolate bar called Carlos Quinto, which basically is cardboard as far as I can tell.
  • 42:19
    Like the bar, actually, because they have to change the packaging in the US, actually says, chocolate-style bar.
  • 42:25
    It's like Kraft and "cheese product." Esh.
  • 42:30
    But anyway, Calbee is a company in Japan that makes Japanese snacks that are never going to see in the US.
  • 42:37
    But Frito Lay ain't gonna sell much in Japan, either.
  • 42:40
    So these cultural differences can create moats in different countries.
  • 42:43
    So why does all this matter?
  • 42:45
    Why am I talking about moats?
  • 42:46
    Who cares?
  • 42:47
    Pretty simple-- moats add intrinsic value.
  • 42:50
    A company that can compound cash flow for many years is simply worth more than a firm that can't.
  • 42:56
    And you can think about this here simply with you've got returns on capital on the vertical axis, time on the horizontal axis.
  • 43:03
    And for the no-moat business, returns on capital come down pretty fast as competition comes in.
  • 43:08
    So there's less time for value to compound as you reinvest cash.
  • 43:11
    For the wide-moat business, you have longer span of time to reinvest capital at a high incremental rate of return.
  • 43:18
    Now this brings up the question of valuing moats.
  • 43:21
    And if you're looking at a business thinking about investing in a moat-y company, the value is largely dependent on reinvestment opportunities.
  • 43:29
    The ability to reinvest cash at a high incremental rate of return is a very valuable moat.
  • 43:35
    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.
  • 43:46
    Somebody mentioned to me Whitney Tilson was here a while ago.
  • 43:48
    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.
  • 43:57
    Fastenal has this.
  • 43:58
    XPO, which is a logistics company that does truck brokerage-- same thing.
  • 44:02
    By contrast, if a firm has little ability to reinvest, the moat doesn't add much to intrinsic value.
  • 44:09
    It adds certainty.
  • 44:11
    It adds confidence.
  • 44:12
    It narrows the range of possible outcomes.
  • 44:15
    But it doesn't add much to the value because they can't reinvest.
  • 44:18
    Think about McCormick.
  • 44:20
    McCormick owns the spice market in the US.
  • 44:23
    They own most of the private label spices you get from McCormick, and then they have the M-labeled ones that you see.
  • 44:29
    But you know what?
  • 44:30
    The consumption of turmeric is not going up 20% next year, OK?
  • 44:34
    Not happen, all right?
  • 44:37
    And so McCormick has to pay out most of the money.
  • 44:39
    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.
  • 44:46
    Because they can't reinvest it back in.
  • 44:48
    Microsoft, Oracle-- very similar things.
  • 44:50
    The cash has to come out because they have no where to put it.
  • 44:54
    And another important takeaway is that moats are not limited to these super stable companies your grandkids can own, the Warren Buffett inevitables.
  • 45:02
    Those are a fairly small subset of the investable universe.
  • 45:06
    And as I just mentioned, they have very limited reinvestment opportunities.
  • 45:10
    Moat-y businesses that pay out cash are goods.
  • 45:13
    But moat-y businesses that can reinvest cash back into the business are truly awesome things.
  • 45:18
    And when you've confined those at reasonable valuations, it is very likely they'll make you a lot of money.
  • 45:24
    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.
  • 45:33
    Underestimating the moat means you have a large opportunity cost.
  • 45:37
    So let's look at a real cost example, Motorola, OK?
  • 45:41
    This is a chart of Motorola from '03 to 2012.
  • 45:44
    Remember the Razr?
  • 45:47
    How many you owned a Razr?
  • 45:49
    A fair amount.
  • 45:50
    How many of you owned a Razr three years later?
  • 45:53
    And that would be nobody.
  • 45:55
    OK, exactly-- so the razor Razr is released, right?
  • 45:57
    And everybody goes bananas.
  • 45:59
    And Motorola goes to 22% market share.
  • 46:02
    And the market says, wow, this is fantastic!
  • 46:04
    You've got a moat!
  • 46:05
    You've got this great Razr franchise!
  • 46:07
    It's a piece of hardware.
  • 46:09
    There's no proprietary software.
  • 46:10
    There's no switching cost.
  • 46:12
    As soon as the next cool phone comes out, you're gonna go buy that, which is exactly what happened.
  • 46:16
    And so we see what happens.
  • 46:18
    Stock craters.
  • 46:19
    Motorola has 10% market share.
  • 46:20
    People basically overestimated the value of the moat and got hosed on the stock because of that.
  • 46:26
    Hosed is a technical term we use in the financial industry.
  • 46:28
    [LAUGHTER] Now, there's an opportunity cost example in Walmart.
  • 46:33
    So this is Walmart from about '95.
  • 46:36
    '97 it went bananas to '99 through today.
  • 46:40
    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.
  • 46:50
    And then he said, the price has moved up by 1/8.
  • 46:54
    Let's wait a bit.
  • 46:55
    Let's not buy any more.
  • 46:57
    And look what happened to the stock.
  • 46:58
    Stock went from 10 to 50, basically.
  • 47:02
    That decision-- this is the number he gave at the meeting.
  • 47:04
    He said that what he called thumb sucking on Walmart, basically not buying enough, cost Berkshire $8 billion in money they could have made.
  • 47:15
    And the reason was at that time he said, eh, Walmart's a good retailer.
  • 47:19
    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.
  • 47:32
    It's worth more.
  • 47:33
    It's going to compound at a high rate.
  • 47:35
    Because then you suffer opportunity cost.
  • 47:37
    And most investors, I've found, spend a lot of time on margin of safety and not a lot on opportunity cost.
  • 47:42
    And it's something to really think hard about, I think.
  • 47:44
    And people often ask me, isn't the moat already priced in?
  • 47:47
    We already know these are great businesses, right?
  • 47:49
    Well, less often than you think, because most investors own securities for very short time periods.
  • 47:56
    The average US mutual fund has a turnover of about 100%.
  • 48:00
    It's about a one-year holding period.
  • 48:01
    That's the average.
  • 48:03
    There's plenty of folks who three months is a long holding period.
  • 48:06
    Moats matter in the long run, not the short run.
  • 48:09
    Most investors also assume the current state of the world persists for longer than it really does.
  • 48:14
    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.
  • 48:20
    And finally, most investors focus on short-term changes in price, not long-term changes in moats.
  • 48:26
    Because finding motes means finding an efficiency.
  • 48:29
    What I've found is that quantitative data in the market tends to be very efficiently priced.
  • 48:35
    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.
  • 48:48
    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.
  • 49:03
    And with that, we'll do more questions.
  • 49:05
    Thanks, guys.
  • 49:06
    AUDIENCE: The question is about the process you follow once you have identified the moat companies.
  • 49:11
    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?
  • 49:24
    And now once you have selected a set of companies that have a good moat, what is the next step?
  • 49:29
    PAT DORSEY: Sure.
  • 49:30
    So that's a good question about just process in general.
  • 49:32
    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.
  • 49:47
    I think it's a good idea to sort of at least get kind of a rough idea.
  • 49:52
    Like would I want to buy this at a 5% free cash yield?
  • 49:56
    Would I want to buy this at an 8% free cash yield because it's not growing very much?
  • 50:00
    Just something super rough.
  • 50:02
    And then you just wait.
  • 50:04
    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?
  • 50:14
    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.
  • 50:20
    And you can't dig deep on everything even if you do this for a living, which I do.
  • 50:25
    AUDIENCE: So a follow-up question just on that.
  • 50:27
    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.
  • 50:37
    You have two classes of moat over there.
  • 50:38
    One of more that's investing in itself and one or more that's just giving the share of the money out.
  • 50:43
    PAT DORSEY: Yep, yep.
  • 50:44
    Good way to segment it.
  • 50:45
    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?
  • 50:55
    Because a business like a McCormick, for example, you're not going to pay 30 times earnings for this.
  • 51:01
    Because it's never going to compound at a huge pace.
  • 51:07
    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 There you'd pay a lot, because there's this massive runway ahead of it.
  • 51:23
    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.
  • 51:32
    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.
  • 51:45
    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.
  • 51:53
    And also, like if you were to wait for, say, Visa to get to 10 times earnings, you'd just never own it.
  • 52:00
    And that's the opportunity cost I was referring to.
  • 52:02
    Question: How to find a moat company and do your own analysis. How to follow the value chain?
  • 52:02
    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.
  • 52:09
    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.
  • 52:19
    But I think the real value is in going and doing your own work.
  • 52:23
    I've heard you talk about following the value chain.
  • 52:26
    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.
  • 52:34
    There's a standard list of things that are widely recognized as wide-moat companies in the US.
  • 52:38
    But say you want to do your own work.
  • 52:40
    How would you go about it?
  • 52:41
    PAT DORSEY: Great example-- so I'll give you a couple value chain examples.
  • 52:45
    So the Cokes and the [INAUDIBLE] and the Wrigleys and the Nestles-- these are all pretty good businesses, right?
  • 52:53
    So let's think about this.
  • 52:54
    They probably have to get their ingredients from somewhere, right?
  • 52:58
    Well, there's a group of companies.
  • 52:59
    One is called Givaudan.
  • 53:00
    International Flavors & Fragrances make many of the flavorings used in food products.
  • 53:00
    One is called International Food and Flavors.
  • 53:02
    It's the only one in the US.
  • 53:05
    One's called Symrise.
  • 53:06
    There's one in Ireland called Kerry.
  • 53:09
    They're flavor specialists.
  • 53:11
    And when a company wants a particular characteristic, like a particular kind of mouth feel, a particular kind of flavor, sometimes they'll Oftentimes they'll turn to these companies that are ingredient companies, basically.
  • 53:23
    And there's about four or five of them in the world, insanely profitable.
  • 53:28
    Because of course, once you have like the component that makes Fritos crunch the way they crunch, you're not changing that, right?
  • 53:34
    Or another example would be there's a company called Novozymes, another one called Christopher Hanson, both European.
  • 53:35
    Novozymes and Chr. Hansen are Enzyme companies.
  • 53:40
    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.
  • 53:56
    And that's a value chain thing, just following that value chain back-- aircraft, another thing.
  • 54:02
    So we know that airlines kind of are a stinky industry.
  • 54:08
    But they've got to get the parts from somewhere.
  • 54:10
    OK, so then you look at Boeing and Airbus.
  • 54:12
    Those are OK businesses.
  • 54:13
    And the reason is very simple.
  • 54:15
    People think these should be awesome businesses, right?
  • 54:17
    Because they're huge and only two companies can make airplanes, right?
  • 54:20
    And they're wide bodies.
  • 54:21
    But at the end of the day, an airplane is a commodity, right?
  • 54:25
    If I'm Emirates or I'm United, I want the airline that gets the most people the furthest distance at the cheapest price.
  • 54:31
    I don't care if it's from Boeing or Airbus.
  • 54:33
    You don't care.
  • 54:34
    Do any of you care if you fly a Boeing or an Airbus?
  • 54:35
    Who cares, right?
  • 54:36
    I mean, I guess the A380 is kind of cool.
  • 54:38
    I've always wanted to fly on one.
  • 54:39
    But I'm not going to pay some massive premium just to fly on it.
  • 54:40
    Sole sourced aircraft parts value chain example.
  • 54:43
    So they're-- eh-- a commodity business.
  • 54:45
    OK, so let's follow that right back.
  • 54:46
    Aircraft-- they got to get parts from somewhere, right?
  • 54:50
    Well, the parts tend to be pretty specialized and highly engineered.
  • 54:53
    They're customized for every different air frame.
  • 54:55
    The fuel pumps in the 737 are different than the fuel pumps in the 757 or the A320.
  • 55:00
    And they tend to be sole-source.
  • 55:02
    Because they're developed when the aircraft is developed.
  • 55:04
    Boeing and Airbus are just assemblers.
  • 55:06
    That's really all they're doing is assembling for the most part.
  • 55:09
    And so then you get these aftermarket businesses that are sole-source.
  • 55:13
    And as long as that airplane is flying, you've got one guy you can get the part from.
  • 55:17
    And he is going to have you over a barrel, charge you whatever he wants.
  • 55:22
    And so that's another kind of value chain example.
  • 55:26
    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.
  • 55:34
    Where's the money made?
  • 55:36
    I mean, every industry, you just do a value map.
  • 55:39
    And sometimes there's almost nowhere-- I mean, auto parts.
  • 55:43
    Almost no one makes money in this industry.
  • 55:45
    Except Johnson Controls does pretty well, because they'll do like a whole interior and just kind of slot it in.
  • 55:50
    Or there's a company called Gentext that does auto dimming and rear view mirrors.
  • 55:54
    And they have some patents on that that make it pretty profitable.
  • 55:56
    But those are just a couple of examples.
  • 55:57
    AUDIENCE: [INAUDIBLE]?
  • 55:59
    PAT DORSEY: Auto retailing is not a bad business.
  • 56:03
    AUDIENCE: I mean auto part retailers.
  • 56:05
    PAT DORSEY: Oh, auto part retailers-- yeah, yeah, AutoZone.
  • 56:07
    And again, you go back, and the reason is pretty simple.
  • 56:11
    Because if you're the mechanic, the cost of that part is passed through.
  • 56:16
    If you take your car in to get repaired, you're not shopping for the part.
  • 56:19
    The mechanic is shopping for the part.
  • 56:21
    He just passes through the cost to you.
  • 56:23
    So there's a margin made on it.
  • 56:27
    You don't know what a fan belt costs.
  • 56:28
    Maybe you do know what a fan belt costs.
  • 56:30
    But I barely know what a carburetor is, much less could I price the darn thing.
  • 56:35
    So again, you have this disconnect between the payer and the buyer.
  • 56:39
    AUDIENCE: So you talked about the valuation in the last part.
  • 56:42
    And there are a couple of questions.
  • 56:44
    When it's an emerging moat, it looks like some of those signs of emerging moats are there, often the return ratios are poor.
  • 56:54
    The valuation is optically seemed higher.
  • 56:56
    Because the company has not started shelling cash out.
  • 56:59
    How would you value a business in that state or value a moat in that state?
  • 57:03
    PAT DORSEY: Yeah, sure, great question.
  • 57:04
    So that's where a discounted cash flow analysis really becomes useful.
  • 57:09
    And it's not that DCF is a magic bullet and it's better.
  • 57:12
    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.
  • 57:23
    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.
  • 57:34
    Think about three things-- opportunity set, fixed and variable costs, OK?
  • 57:40
    So what is the opportunity set here, right?
  • 57:42
    How big could this thing get?
  • 57:44
    What could they sell to people in three year's time, five years' time, whatever?
  • 57:48
    And then say, OK, to get there, they will need to invest something, right?
  • 57:53
    There's some number amount.
  • 57:54
    They'll need to build new plants, hire new engineers, whatever it might be.
  • 57:57
    And then there will be a flow-through, too.
  • 57:59
    Some amount will drop to the bottom line.
  • 58:02
    And over time, more should drop to the bottom line if it's a decent business, right?
  • 58:06
    Who knows if it is.
  • 58:08
    And you just kind of math that out, just DCF it out.
  • 58:12
    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.
  • 58:23
    And then we get a hockey stick after that, as you kind of do it out.
  • 58:25
    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.
  • 58:41
    Now, basically they've been growing about 5%, 6% per year for the past few years.
  • 58:46
    Because they've not done well in the US market for a bunch of reasons that we think may be fixable.
  • 58:50
    That's what we're trying to figure out.
  • 58:51
    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.
  • 58:59
    But every bit of incremental growth over that, so going from 5% to 10%, you get an 80% to 90% drop-through.
  • 59:08
    And then that, then, takes your margins from probably low 20s up a lot.
  • 59:12
    But you don't know what that number is until you think it through.
  • 59:17
    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.
  • 59:28
    And I was like, dude, you're nuts, man.
  • 59:30
    This thing is coming public at like $40.
  • 59:32
    We're not going to stick our necks out that far.
  • 59:34
    Come on.
  • 59:36
    How good a business is this?
  • 59:38
    And what he did is he just walked through fixed versus variable, that basically, OK, very little variable costs in this business.
  • 59:44
    You've got a fixed cost of a network, the data processing network.
  • 59:48
    But then of the incremental revenue, tons will flow down to the bottom line.
  • 59:53
    And this is where-- and this is a geek thing-- when you're modeling out a high-growth company, don't model in percentages.
  • 59:59
    When modelling a high growth company don&39;t model in percentages, model in dollars.
  • 01:00:01
    Model in dollars.
  • 01:00:02
    So it optically looks weird to say, margins are going to go from 13% to 25%.
  • 01:00:08
    My God, that's never going to happen.
  • 01:00:11
    So don't do it in percentages.
  • 01:00:12
    Don't do operating margins doing from x to y.
  • 01:00:15
    Think about, OK, fixed versus variable.
  • 01:00:17
    How many additional dollars are needed to spend to get each additional dollar or revenue.
  • 01:00:17
    How many dollars will they need to spend to get each dollar of additional revenue?
  • 01:00:24
    And then see what operating margin falls out of that.
  • 01:00:27
    And you may come to a very different conclusion.
  • 01:00:30
    AUDIENCE: Is that like operating leverage that you-- PAT DORSEY: Yeah, it's operating leverage.
  • 01:00:32
    Operating leverage is one of the most frequently mispriced things in the market.
  • 01:00:33
    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.
  • 01:00:45
    Because they're going to get it back, and they're going to say, you're nuts, man.
  • 01:00:48
    There's no way.
  • 01:00:49
    Forget about it, like, nah.
  • 01:00:54
    But it can happen.
  • 01:00:55
    It happened with C&E. It happened with MasterCard.
  • 01:00:58
    It's happened with Google.
  • 01:00:59
    It happened with OpenTable.
  • 01:00:60
    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.
  • 01:01:12
    But you'll only figure that out if you model in dollars.
  • 01:01:14
    You've got to just think about that.
  • 01:01:16
    What do I need to spend for each additional dollar in revenue?
  • 01:01:19
    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.
  • 01:01:28
    You're talking about it's radial network, not something like Facebook.
  • 01:01:32
    So it appears the only seller is the buyer.
  • 01:01:35
    It's not like buyers sell stuff to another buyer and all this stuff.
  • 01:01:38
    PAT DORSEY: Oh, OK, that's a really interesting way to think about it.
  • 01:01:41
    OK, I see what you're saying.
  • 01:01:42
    You're right.
  • 01:01:43
    It is just seller to buyer.
  • 01:01:44
    But the more buyers who are there, the more sellers are going to want to be on the platform, It's not as if it's just selling one good.
  • 01:01:52
    Like let's imagine that eBay could only sell baseball cards.
  • 01:01:58
    I don't know, whatever.
  • 01:02:00
    Then you could have someone say, OK, I could pick that market off.
  • 01:02:03
    I could invent a better platform for selling baseball cards.
  • 01:02:07
    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.
  • 01:02:16
    But I kind of see-- I had never thought about you could mistake that for being a radial network.
  • 01:02:23
    I wouldn't characterize it that way.
  • 01:02:25
    Because any buyer can interact with-- that's the best way to describe it.
  • 01:02:30
    Any buyer on eBay can interact with any seller, right?
  • 01:02:35
    And depending on what they want to buy or sell, that transaction could occur.
  • 01:02:40
    Whereas although I can send money from Bangladesh to Mexico City, to go back to that example, there's no reason to, right?
  • 01:02:50
    I mean, you don't have people immigrating.
  • 01:02:52
    And immigrants are one of the biggest users of Western Union network to send money back home, remittances, right?
  • 01:02:59
    You just don't have people who move from Mexico City to Bangladesh or vice versa.
  • 01:03:03
    There may be a huge Mexican population in Bangladesh.
  • 01:03:05
    I don't know.
  • 01:03:06
    I don't think there is.
  • 01:03:07
    [LAUGHTER] But that was a cool way of thinking about it.
  • 01:03:11
    AUDIENCE: Thank you.
  • 01:03:12
    So I have one question, Pat.
  • 01:03:14
    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?
  • 01:03:29
    Mistakes made over the years -- missed operating leverage often. Underestimating what truely exceptional management can do.
  • 01:03:29
    PAT DORSEY: Yeah, thank you.
  • 01:03:30
    That's a good one.
  • 01:03:31
    Thank you for forcing me to air my dirty laundry, [INAUDIBLE].
  • 01:03:34
    I appreciate that.
  • 01:03:35
    AUDIENCE: It will go on YouTube.
  • 01:03:36
    It's OK.
  • 01:03:37
    Yes, hello, YouTube.
  • 01:03:38
    How are you?
  • 01:03:39
    [LAUGHTER] No, seriously.
  • 01:03:42
    No, actually, it's a very good question.
  • 01:03:43
    And I would say that I've gotten that operating leverage thing right a couple of times.
  • 01:03:49
    I've missed it more times than I should have.
  • 01:03:52
    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.
  • 01:04:06
    There's some pitches I missed that would have been home runs, I think.
  • 01:04:11
    The bigger one, though, is probably management.
  • 01:04:16
    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.
  • 01:04:27
    It's just easier to drive a sports car versus a Mack truck.
  • 01:04:34
    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.
  • 01:04:53
    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.
  • 01:05:22
    And option expensing, you remember, was a huge battle.
  • 01:05:26
    And so I think some of that management doesn't matter as much.
  • 01:05:28
    Some of it was probably just a kind of a knee-jerk reaction to a lot of that, it's probably fair to say.
  • 01:05:34
    But with time, hopefully the knee is not jerking as much.
  • 01:05:39
    And I guess I've just developed a better appreciation for what the truly exceptional manager can do.
  • 01:05:44
    And again, I do want to emphasize truly exceptional.
  • 01:05:47
    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.
  • 01:05:54
    You are truly exceptional because you are passionate about your business and you understand how to allocate capital.
  • 01:05:59
    That's what makes an exceptional manager.
  • 01:06:01
    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.
  • 01:06:08
    I mean, in our current portfolio of 14 companies, five are what I would call this capital allocator model.
  • 01:06:17
    Actually, that brought to mind one of the books, "The Outsiders." PAT DORSEY: Yeah, great book.
  • 01:06:23
    AUDIENCE: Yeah, about capital allocatin.
  • 01:06:24
    PAT DORSEY: Yeah.
  • 01:06:25
    "Outsiders" is a great book.
  • 01:06:26
    If you haven't read "The Outsiders," it's an awesome book on management.
  • 01:06:28
    Will Thorndike wrote it.
  • 01:06:31
    Yeah, definitely that would be in the top 10 the past coupld of years.
  • 01:06:35
    AUDIENCE: So while we're talking about emerging moats and like good capital allocators, one example that you brought up is Danaher.
  • 01:06:44
    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.
  • 01:06:52
    And this is one of kind of an emerging moat, where we don't really see it in the numbers yet.
  • 01:06:58
    Would you have any thoughts that you would like to share with us?
  • 01:07:01
    PAT DORSEY: Yeah, well, one is don't bet against the Rales brothers.
  • 01:07:04
    That that's a low-odds bet.
  • 01:07:07
    No, Colfax is getting interesting.
  • 01:07:09
    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.
  • 01:07:19
    I have not followed Colfax too closely.
  • 01:07:21
    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.
  • 01:07:35
    I think I would say the Rales are amazing managers, and it's very fertile ground for more research and more work.
  • 01:07:44
    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.
  • 01:08:01
    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.
  • 01:08:16
    But the Rales brothers are tough ones to bet against.
  • 01:08:19
    AUDIENCE: The hard part is when you are kind of watching it as it as its stands as a snapshot today.
  • 01:08:26
    Do these underlying businesses really have any kind of moat or not?
  • 01:08:31
    And since there's no numerical evidence, it's hard.
  • 01:08:35
    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.
  • 01:08:41
    PAT DORSEY: Yeah, so there's a couple things to look at there.
  • 01:08:43
    One is looking carefully at the end markets there, I think.
  • 01:08:46
    Because you're looking for what the numbers could become, not what they are today.
  • 01:08:50
    And so there, you want to almost get in the customer's head, right?
  • 01:08:53
    And say, why does a customer buy a pump from Dahaner?
  • 01:08:56
    What does it by a fan from Howden?
  • 01:08:59
    Why does it buy welding equipment from ESAB?
  • 01:09:03
    And then get in the customer's head and then see what their behavior is.
  • 01:09:06
    And maybe there's reasons why they're sticking-- I don't know.
  • 01:09:09
    That would be a way to kind of go down that path.
  • 01:09:11
    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.
  • 01:09:22
    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.
  • 01:09:38
    Because you just do everything so much more efficiently than everybody else.
  • 01:09:44
    You manage to eke out an economic moat out of that.
  • 01:09:49
    Not common, not something I would try to have a whole portfolio of those, because they're pretty tough to find.
  • 01:09:55
    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.
  • 01:10:06
    MALE SPEAKER: All right, thanks, Pat.
  • 01:10:08
    With that, thank you very much for such an enlightening talk.
  • 01:10:10
    This has been fun.
  • 01:10:11
    Awesome, thanks.
  • 01:10:12
    [APPLAUSE] This has been fun.

Pat Dorsey: "The Little Book that Builds Wealth" | Talks at Google

What does it mean for a company to have a moat? What are the key drivers to valuation? Pat Dorsey will use examples to shed light on these, and more questions. About the Book: Capitalism works. Thats why most businesses with high returns on capital attract competition that forces down profitability over time. However, a small minority of companies are able to defy the laws of economic gravity by creating competitive advantages, or economic moats that insulate them from competition and allow them to maintain high returns on capital. After spending fifteen years analyzing thousands of companies, Pat has identified a handful of structural characteristics that create competitive advantage. He will discuss these characteristics, how management teams can create and destroy competitive advantage, and how he applies competitive analysis in managing institutional capital at Dorsey Asset Management. About the author: Pat is the founder of Dorsey Asset Management, which manages concentrated global portfolios for institutional investors. Prior to starting Dorsey Asset, Pat was Director of Research for Sanibel Captiva Trust, an independent trust company with approximately $1 billion in assets under management serving high net worth clients. From 2000 to 2011, Pat was Director of Equity Research for Morningstar, where he led the growth of Morningstars equity research group from 10 to over 100 analysts. Pat developed Morningstars economic moat ratings, as well as the methodology behind Morningstar's framework for analyzing competitive advantage. Pat is also the author of two books The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth and has been quoted in publications such as the Wall Street Journal, Fortune, the New York Times, and BusinessWeek. Pat holds a Masters degree in Political Science from Northwestern University and a bachelors degree in government from Wesleyan University. He is a CFA charterholder.






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