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.Are you getting our free Daily Update
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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 simi