Today I thought I’d first share a few notes I made from the presentation that Pat Dorsey made made at the MIT Sloan Investment Conference I attended a couple weeks ago, since that’s the presentation that really had the most resonance for individual investors (and led to a few ideas that might be worth considering), then we’ll move on to some updates on stocks in my Real Money Portfolio and a bit of my typical navel-gazing and blatheration.
Pat Dorsey is well known mostly because of his years at Morningstar, where he built up the equity analyst corps to cover a huge array of stocks and is credited with much of their focus on economic moats and competitive advantage — he essentially created their equity research division and led it until he left in 2011, and has been managing money for other people since, most recently at Dorsey Asset Management.
He’s a fairly frequent presenter at these kinds of things, and he does a good job of focusing on a few key traits that he looks for in successful companies — and focus is a worthy word to use in reference to his holdings, because he really embraces Warren Buffett’s maxim that “diversification makes little sense for those who know what they’re doing.” Dorsey manages a very concentrated global equity fund with, he says, only 10 or 15 positions (he has far fewer than that in his current portfolio, at least according to 13F filings), and these are a few points he made in his presentation — note that I’ve paraphrased some parts, included a few of my own reactions, and also directly quoted a few pithy bits, so my apologies for the rough state of these lightly edited notes… I blocked them off a bit so you can skip past if you’re not interested:
“Runways for reinvestment” is critical. The value of competitive advantage is maximized when you can invest each dollar of cash flow at a higher rate of return.
“High profits attract competition… but a small minority of companies enjoy many years of high returns on capital. They do this by creating a structural advantage, a moat that lets them create high returns even when competition comes.”
“An extended period of excess return on investment (ROI) increases business value by lengthening the period during which capital can be reinvested at a high return. Time is key — Coke does it for decades, Crocs does it for a moment. You can pay more for competitive advantage that’s sustainable.”
So where is it that you find this “competitive advantage” or “moat?”
A few major categories: Intangible assets, like brands. They are not on the balance sheet, they give pricing power, they give either emotional value (luxury brands), confer legitimacy (Gartner, or Moody’s), and can include more tangible things like patents, legal monopolies, or legal oligopolies… but advantages that are given by regulation can be taken away as easily (examples include casinos, which become less valuable when more casinos open nearby or when legal gambling is scaled back, or the FDA changing its approval process or approving a drug that supplants yours).
Brands that convey your personal position or your status and legitimacy are based on a strong social consensus — Tiffany’s and Moody’s are valuable brands because everyone agrees that they’re valuable, so the incentive to try a different brand is low.
Other brands are more vulnerable — trying a new beer or a razor can be done without caring what other people think about it, and in this era the cost of reaching a mass market is not the impediment that it was 20 years ago. The next 20 years will be much harder for mass market brands.
Switching costs are another important competitive advantage — the cost can come in many forms, be it money or time or risk.
Amazon, for example, provides service that is reliable and beloved enough, with low enough prices and with the stickiness of the Prime membership program, that they can keep people from trying other brands or providers even though the switching costs (searching for someone else who sells the same thing online, usually for a similar price), are extremely low.
Products that are tightly integrated with business processes also have high switching costs — Oracle, Simcorp for asset management, Autodesk for design.
Products with high benefit/cost ratios also have a competitive advantage and implicit switching costs — Chr. Hansen in flavorings and ingredients and Abcam in life science research were examples given. The cost of the item is low compared to the end product, so there is no risk in pushing to cut costs and possibly losing the benefit of the known quality service or product.
Network Effect is another well-covered competitive advantage — Dorsey’s explanation is that network effects have to be maintained, and they are maintained by subsidizing one side of the network to keep it strong (like Adobe giving away their PDF viewer for free to make sure it’s used as the standard, which means the producers of documents have to license it).
The network effect is at risk when the user experience is degraded (like with MySpace — remember them?). Companies like Facebook have to drive engagement by innovating to make users want to be more involved… network effects are put at risk if pricing power gets abused, which opens up room for competition (he gave the example of the Bloomberg Terminal, which has raised prices so much that it brings in competitors that eat away at some of the business… or Costar, the commercial real estate network that Dorsey said is “loathed by users.”
Cost advantages can be competitive advantages, but they’re more easily copied — process advantages that create a cheaper way to deliver a product or service are one kind of competitive advantage, Geico with direct-sold insurance, Dell’s custom computers, Inditex (best known for the Zara fast fashion brand).
But scale is a better advantage than simply lower costs — and relative size matters more than absolute size. You don’t need overwhelming market share, but you need high relative market share compared to your competitors.
What is NOT a moat?
High market share by itself.
Technology, in most cases — commoditization and disruption are inevitable if you can’t “lock in” your customers. Hardware is toughest, GoPro and Fitbit have no switching costs… it’s software that can create a lock-in.
A hot product. It can generate high returns for a short period of time, but needs a reason why it will sustain an advantage.
The key thing to look for is company management that puts every bit of their effort into widening the moat — for Amazon, that’s improving the customer experience, for Howdens Joinery (a UK kitchen remodel company) it’s solving problems for builders.
You want management that won’t use capital to buy overpriced shares or waste it on bad acquisitions — those things can add value or be neutral, but often they are bad. Management is often overly incentivized to create growth, regardless of whether growth is the best path for the company to take (often it isn’t).
He also noted that even internal growth is not necessarily a good thing — it’s just one way to create value. Focusing on growth can also destroy value if the end market isn’t growing — it has to be worth the investment in growth.
Other things can destroy value as well — dividends, M&A done by the companies who aren’t great at it (and there are few).
The general rule is that companies should invest in growth if they can. If they have internal investment opportunities that will generate a high return on capital, they should invest heavily.
But if you can’t grow, don’t try. Maturing companies have trouble acting t heir age, they continue to reinvest heavily even if returns on capital decline, because they’re focused on growing the top line at almost any cost. Cisco clung to its growth dreams, but it didn’t grow. McDonalds, Starbucks and Home Depot have all had points where they’ve spent too much to grow in places where there wasn’t enough return.
Hoarding cash is pilloried in the US, but the evil twin is just as bad and is common in Europe and Australia: The dividend fetish. Dividends are not good if they’re funded poorly or represent a large opportunity cost for a company that could be investing that money wisely. If you can do something great, keep the money and do it.
Defensive M&A deals are a recipe for disaster, a way to cause massive leakage — he gives the classic examples from the tech world that are fairly recent, Microsoft wasted $7 billion on aQuantive and $8 billion on Nokia, Cisco blew $600 million on the Flip camcorder business, HP spent billions on Autonomy. “The bigger the deal, the less similarity between buyer and target, the more likely money will be set on fire.”
Companies that are really good at M&A, with a disciplined process, generally do it a lot — companies that do an acquisition once every few years will probably screw it up.
He suggests looking back at a company for 10-15 years to see what it’s been doing — has it increased the share count? When did that happens and why? Did they make big acquisitions? The company will usually hide the cash flow cost of those if they didn’t work out. Also, did they pay a dividend while also selling equity? That’s a red flag (except, I would argue, for REITs or similar structures, where they can’t grow without selling equity).
But even a company with great mistakes can survive if it has a huge competitive advantage or a huge moat. He gave the example of Berkshire Hathaway, a terrible business that was saved by great capital allocation after Buffett took over, or Microsoft, a company with a huge moat that was big enough that they could easily survive Steve Ballmer’s awful acquisitions.
It’s hard to build a moat where you can’t control your selling price — that’s true for life insurance, auto parts, chemicals, mining, etc.
Asset management is an easy business to make money in because it scales very well.
Some industries are either tough to make money in, or tough to grow in — like the flavors industry, where there’s a good moat but not much growth or opportunity to reinvest profits.
If you’re interested in a quick read on competitive advantage or moats, I do recommend Dorsey’s “Little Book” — his is The Little Book that Builds Wealth, and it’s a bit dated now but still conveys his ideas pretty well.
I don’t know what Dorsey’s track record has been since he took off to run his own asset management company, but I find him interesting to follow because he so aggressively researches the real businesses behind the stocks and tries to get inside their skin and understand their moat and their competitive advantage — he goes to trade shows to interview internet advertisers to better understand how Facebook is meeting their needs, for example, and he concentrates the portfolio partly because he commits so much research and analysis to each name.
Which means, if you read between the lines, that his portfolio is an interesting place to dig about for ideas. It doesn’t change very fast, and it’s massively overweighted in just a few of his top stocks. So what does he have in his portfolio now?
He doesn’t have to file for stocks that he might hold outside the US, so that might be part of the reason that his 13F is very short — and very concentrated. (13F filings have to be made quarterly by any money manager who has a portfolio of over $100 million — but filing is required only for US-listed equities those managers own, not debt or options or short positions or stocks that are bought on international exchanges — that’s one reason, for example, that Warren Buffett’s large position the UK retailer Tesco a few years ago never showed up on Berkshire’s 13F… it wasn’t that they wanted to hide that eventually unsuccessful investment, it was just that they didn’t have to disclose it because they bought the shares in London, so they didn’t).
Here are Dorsey’s holdings as of Dec. 31, in order of position size (the table from his last filing is here if you want it direct):
Facebook (FB), no surprise there — they’ve got a powerful moat, they’re nurturing it, and both the market and their share of the market are increasing, with lots of potential to reinvest their cash flow to help them earn more in the future. Hard to disagree with that, and Zuckerberg has certainly made some huge acquisitions but so far they have not proven to be destructive ones… it’s my second largest position, for what it’s worth, essentially tied with Berkshire Hathaway at the top of my Real Money Portfolio, and certainly everyone knows Facebook (though I’d argue that they still underestimate it).
Cimpress NV (CMPR), relatively small and unknown (at least by me), with a $2.7 billion market cap, but Cimpress is the world leader in mass customization — they just bought National Pen, the world leader in those customized pens you steal from your insurance agent. Margins have drifted down and they aren’t currently growing, so I’d have to research this one more to understand the appeal.
Brookfield Asset Mgmt (BAM), one of the world’s great “alternative asset” management firms, a specialist in natural resources and energy as well as real estate and infrastructure. I’ve been meaning to take a look at BAM again, but haven’t done so recently. Not sure why their income is down recently, but foreign currencies could easily be having a substantial impact.
Roper Technologies (ROP), this is a stock I can’t remember ever looking at, but which has been a phenomenal performer — they are a fairly large conglomerate now ($20 billion market cap or so), and they dominate fairly small niche sectors by consistently buying more companies and rolling them into their management system. Like Berkshire Hathaway, they have an extremely decentralized business, with headquarters staff measured in the dozens that acquires a couple billion dollars worth of companies every few years. They’re clearly doing something right — since 2008 they’ve roughly tripled their operating cash flow but have only increased the share count by about 10%… you’d want to get a clear picture of their balance sheet, since they increased the borrowing pretty substantially to make the acquisitions that created that cash flow growth (debt went from about $1 billion to almost $6 billion over that time but the market cap went from about $5 billion to over $20 billion), and I’d want to dig in to make sure that their growth in free cash flow isn’t the result of just one or two strong businesses or products that could be at risk (their software businesses seem to be doing better than their industrial businesses right now, for example), but they seem to be really, really good at making and integrating acquisitions — revenue has grown only about 80% in the past decade, but free cash flow per share has grown by 170%… partly that’s the debt talking, but they’re also generating more and more profit out of those revenue streams over time. (Morningstar, if you’re curious, puts the “fair value” of Roper at $175… it’s at $207 or so as I type this).
Descarte Systems Group (DSGX), this is another smallish one (just under $2 billion), they provide software as a service for logistics and supply chain management. Presumably the advantages are that software is a fantastic business with high margins and, once you’ve integrated software to manage your logistics, high switching costs… but I don’t know this one at all. They are richly valued, at 23X forward earnings estimates, but are expected to grow earnings very fast.
So… some fodder for you to chew on as you seek out “high moat” companies who have some competitive advantage. On to the other minor updates and blatheration I’ve got for you today:
NI Holdings (NODK) — This newest of my holdings, the converted mutual insurance company that I bought on its IPO a few weeks ago, announced a delay in its 10K annual report filing. Presumably that’s not a big deal, they say the delay is due to their auditors reviewing the data in the relatively short time period between the IPO and the deadline for the report. I am interested to see this report, their first as a public company, but they did note that their financials during the final quarter were consistent with the September quarterly numbers that were public before the IPO. The 10-K should be out within a couple weeks (their deadline is 90 days after the end of the quarter, which was last weekend, and the delay notification indicates they will be releasing the data within 15 days of the deadline).
This one’s quite illiquid, there’s little media coverage or attention, and I do think there’s a decent chance of some selling pressure, since the policyholders who bought shares at $10 in the conversion are sitting on big gains, but I’m still happy with the valuation here and will watch to see what comes out of their actual financials. If they opt to fully convert to stock ownership at some point (the mutual company still controls 55% of the shares, but the mutual company is really just a representation of policyholders — they don’t take dividends, which will likely be announced soon), or if investors grow comfortable with the fact that stockholders, who own only 45% of the company, get essentially all the economic benefit of the company at this point, it could fairly easily drift up above $20, but it’s hard to predict how sentiment will emerge about a new (and tiny) company. They could also collapse back to $10 if they make a bad acquisition or have a bad accident year in the upper midwest.
Medical Properties Trust (MPW) announced the not-entirely-unexpected bankruptcy filing by their major tenant, Adeptus (ADPT), which operates standalone emergency rooms and “outpatient centers” mostly in Texas and Louisiana. MPW’s price rose a little bit on the news, perhaps because of relief that the news is finally out after MPW spent the past six months or more not being all that publicly worried about the Adeptus portfolio. The early indication is that the bankruptcy will not result in those facilities being abandoned (though MPW also moves around in sympathy with the various health insurance debates in Washington, since “more insured people” is generally a strong positive for hospitals), which jibes with MPW’s stated lack of concern in the past (they were convinced that the facilities could easily be leased to local operators, mostly hospitals in those regions, if Adeptus failed to turn things around).
When I last looked in detail at the Adeptus situation, last Fall, Adeptus was generating about 6% of MPW’s lease income, and represented about 6% of its pro forma assets… so the impact on cash flow of even a complete shutdown would be somewhat limited, but there was also the lingering concern about the fact that new Adeptus facilities either planned or under construction also represented a meaningful portion of Medical Properties Trust’s growth pipeline.
Nothing seems to have really changed, Deerfield Management looks like it’s going to acquire Adeptus out of bankruptcy, and they have agreed to assume the master leases of most of the facilities (about 20% will sold or re-leased to others by MPW), and MPW is providing a small one-time rent credit that shouldn’t have a meaningful impact on results. They haven’t talked at all about the under-development projects, but presumably the “to be developed” pipeline should be considered moribund at this point. That doesn’t worry me at this valuation, MPW has a sustainable 7% yield and should be able to slowly grow revenue and the yield — and they’ve had no trouble accessing the capital markets, including another debt offering in Euros that helps to further hedge some of the currency risk from their German rehab hospital assets. I still like MPW’s prospects, and buying below $13 seems reasonable for those willing to take a little risk for a substantial dividend that should be able to grow fast enough to keep up with inflation (like almost all relatively high-yield REITs, it will be sensitive to interest rates — so if the 10-year note goes to 4% in a hurry, for example, shares will almost certainly fall… but in general I think the interest rate risk of REITs is overstated, a gradual rise in rates still doesn’t bother me).
This week I also did make one portfolio adjustment — I increased my position in Amazon (AMZN) very slightly. I would prefer to build that holding at better prices, if it drops by 25% on some kind of bad news, but Amazon doesn’t seem capable of generating bad news this year — every story reiterates the death of traditional retail and the rise of Amazon, or the increasing dependence of every cloud startup on Amazon’s AWS “internet as a utility” business… and Amazon is even starting to make enough money to actually have a PE ratio.
Granted, it’s still a ridiculously high PE (about 70X forward 2018 earnings estimates), but the revenue growth will still keep people focused on this stock — they’re getting up there to be one of the larger companies in the world, and they’re still growing their top line at ridiculous rates that analysts can only guess at.
You can tell they’re guessing, because they basically just took the 2016 revenue of $135 billion and add about $35 billion more for each year — so the 2017 revenue estimate is $165 billion, 2018 is $200 billion, and the 2019 estimate is for revenue of $235 billion — which makes an assumption, one I think is probably too conservative given Amazon’s ability to ramp up revenue, that Amazon is suddenly going to head into an era of steadily decelerating revenue growth. Possible, for sure, but probably too conservative. That 2019 estimate is still only half of Wal-Mart’s current annual revenue number, so it’s obviously huge but there’s not necessarily an obvious end to the revenue growth, not while they’re still opening up new avenues of business with local deliveries, groceries, and more.
It might not carry this valuation forever, of course, which is why it’s still a small position for me — I wouldn’t feel comfortable putting more than about 2% into AMZN unless the stock gets a meaningful dip in its price (as it tends to do every once in a while, usually when the popular story of their continued reinvestment in growth and expansion moves from an optimistic bet on Bezos to a pessimistic “why won’t they ever make a profit” rant.) The recent news keeps interest high in the stock, with notice that they’re beginning to accept cash through a new partnership with retailers, and that they’ve won the right to stream Thursday Night Football games for their Prime members next season, though neither of those things by itself will have any meaningful impact on the financials right away — it’s just more evidence that they’re continuing to seek new lands to dominate.
As with Shopify (SHOP), which I wrote more about last week, this is a bet on growth and the movement of more and more shopping to the web — it’s just that SHOP, with its far smaller size, has a lot more ways to grow easily than Amazon does (Amazon, in contrast, has a lot more strength to withstand any challenge or challenger than SHOP does… and, of course, it has dramatically lower margins than SHOP does because Amazon, unlike Shopify, is actually a merchant itself).
Despite the fact that every portfolio needs a good dose of growth, and despite the fact that growth stocks are often more fun to write and dream about, I typically find myself more comfortable on the other end of the spectrum from Amazon and its pure “growth and dominance” business plan — buying “cheap” and “value” stocks just feels better.
Oddly enough, though, the stock in my top ten holdings that is closest to being a pure “value” stock at these prices… is also the stock that makes me the most nervous at this point. That’s Apple (AAPL), which is obviously a fantastic consumer products company and a great technology brand, but it’s also a stock that has reached the point where growth is a struggle… and margins are challenging and, I have to believe, unlikely to expand. So, after a big run, is it cheap enough to keep owning if you’re worried about that growth?
I don’t want to be too negative, and I don’t know if there has ever been a company that’s as good at creating and rolling out strong, stable and beloved products as Apple is — thanks both to the legacy of Steve Jobs’ passionate design and customer experience aesthetic and Tim Cook’s managerial and supply chain prowess as the CEO since Jobs’ retirement and passing… but it is very difficult to see Apple returning to above-market earnings growth without some dramatic new product line.
There is absolutely a chance… there are even a few specific catalysts that could help Apple surge to higher valuations: There’s India, where Apple is making a big play to become a larger presence as high-end smart phones really begin to take over that market (though given the per-capita spending power, it will likely be slower to build there than in China); there’s the potential for a tax repatriation holiday or significant corporate tax cut, which would benefit Apple considerably and make it easier for them bring a lot of capital back to the US; and there’s the next iPhone, which is widely expected to be the first “significantly different look-and-feel” phone for them since the iPhone 6 in 2014.
And, of course, there’s the extra imprimatur of Warren Buffett’s suddenly large shareholding — Berkshire Hathaway (BRK-B) has held Apple shares for a while, thanks to the new investment managers Buffett brought in to work under him, but Buffett himself endorsed the stock more recently and beefed up Berkshire’s position dramatically (Berkshire now reportedly holds about 2.5% of Apple shares, more than twice as many as they owned at their December 31 13F filing… they’re the largest non-index-fund shareholder).
That probably helps, though Apple really didn’t need the help — it’s already the largest stock in the world, the largest position in every broad index fund, and usually the most popular stock among individual investors, so we’re arguably all overweight in Apple shares (3.7% of all the money in all the S&P 500 index funds is in Apple shares — the only other names that are over 2% are Microsoft (MSFT) and Alphabet (GOOG and GOOGL)).
My inclination, with Apple pushing all-time highs at around $145 and again a popular idea because of tax reform and the next iPhone, is to think that most of the good news is in the stock, and it’s time to begin to shave a little bit off of my Apple position… after all, with the stock here at $145 the analysts are still just keeping up (Pacific Crest, for example, just raised the price target to $150 because of that optimism about the iPhone 8… which would imply that they see only 3.5% upside from here over the next year). But selling is still a challenge for me, because Apple is still a very reasonably priced dividend growth stock, and I hate to sell dividend growth stocks.
Apple is a $750 billion company, and the real risk is that it’s unique among huge companies in its reliance on a single, physical, high-margin consumer product that has lots of competition and should be commoditized and crushing margins lower by now… but isn’t. You’re not supposed to be able to dominate a competitive market sector like Apple does for this long, with this kind of profitability… it’s something of a management miracle that they’ve managed to keep margins as high as they have despite constant pressure from Samsung and the Chinese phone makers — but their loyal customer base and closed-silo operating system has kept things pretty “sticky” for iPhone users, and over time we’re starting to see services grow to become a bigger business (though that won’t matter enough to absorb the impact if the new iPhone disappoints in its upgrade cycle in the Fall).
I was having similar thoughts about Apple last Summer, as well, but the Samsung train wreck as they bungled the worst consumer recall in a long time gave me some confidence that Apple would have a chance to keep its market share and possibly even grow it against their huge Korean competitor… and that may still be true, though Samsung’s latest Galaxy phone looks like it will again take a technological lead from Apple’s current model (they do this with some regularity, but have never gotten the hardware and software to work as seamlessly as Apple does, so Apple gradually catches up on the cutting-edge hardware and feels little pain), I expect the Samsung brand damage will continue to help Apple for some time — people remember when they’re told not to bring a Samsung phone on an airplane, and we have yet to see a global competitor emerge to the two of them on the high end (there’s a ton of competition on the low end, and high-end competition from Xiaomi in China, but unless Google’s Pixel emerges as a bigger player the field is still quite tilted in favor of the established and dominant manufacturers). Perhaps we’ll end up with a duopoly that keeps margins sustainable… not the worst thing for an investor.
Apple is still priced at a substantial discount to the market, at about 16X 2017 expected earnings and 14X 2018 earnings forecasts even if you don’t give them credit for the fact that 20% of their market cap is net cash (mostly untaxed cash, but still cash)… but with Apple rising faster than the market recently, the discount has narrowed a bit (though the market has gotten more expensive, too).
That strong recent performance from AAPL is thanks largely to their earnings “beat” at the end of January, a building “story” about the possibility of a really strong upgrade cycle for the next iPhone, but I think a lot of it is the optimism in the market that Apple will be the biggest beneficiary of a possible foreign-cash tax holiday that would free them up to return more of their now $246 billion in cash (more than $150 billion in net cash, even after accounting for the debt they took on to do share buybacks under pressure from Carl Icahn a couple years ago — they’ve bought back almost 20% of their shares in the past couple years, which has been a huge boost to earnings per share).
So what to do? My inclination would be to begin shaving my position as the stock rises beyond the high $140s, and it’s still possible that I’ll do that, but as I dig deep within my troublesome brain I think I’m really just looking for an excuse to sell a long-term profitable position because of my nervousness about their continued reliance on a single product (that being the iPhone, which accounts for essentially all of Apple’s profits). So for now I’m putting my overactive melon in the back seat and will give the edge to inertia, sticking with a rule that I wish I could consistently follow: Don’t sell successful companies who have reasonable valuations and strong dividend growth — qualms are not enough, you need real red flags to justify selling gems like this.
I could take this opportunity to sell some covered calls against AAPL, and I may well do that in the future, but premiums are pretty low and the potential for Apple to jump 5% on news of any kind of tax reform or repatriation “holiday” and a possible ensuing special dividend or large buyback means that covered calls on the super-cash-rich tech companies right now will come with a large dose of FOMO (Fear Of Missing Out). I don’t know if my fragile little psyche can handle that in exchange for earning an extra 1% a quarter on covered call selling. I’ll let you know if I change my mind on that, or on anything else in my portfolio.
And actually, though I wrote most of this piece before I got on the plane, I’m in Ireland today for a quick visit and a few pints of Guinness… but work always calls, so I swung by Apple’s European HQ here in the tax haven of Dublin to see if viewing their imposing edifice would provide some inspiration. Here’s a picture:
P.S. OK, fine, just kidding with the picture. That’s the Guinness typing. Have a great weekend, and I’ll be back to chatter at you on Monday!
Disclosures: I own shares of Amazon, Apple, Facebook and Berkshire Hathaway among the stocks noted above, and call options on Shopify. I will not trade in any covered stock for at least three days after publishing an article, per Stock Gumshoe’s trading rules.
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