investment strategy: Looking for ‘moat’ to pick stocks? Pat Dorsey tells you how to find it


Ace investor Pat Dorsey says investors should target 10 to 15 moated businesses that can compound at high rates over time and make long-term investment in them to create major wealth.

Dorsey is the Founder of the Chicago-based Dorsey Asset Management and is a former director of Equity Research at Morningstar. He is also the author of the highly acclaimed books
The Five Rules for Successful Stock Investing and
The Little Book that Builds Wealth.

He says moated businesses can drastically reduce the risk of permanent loss of capital. A ‘moat’ is a metaphor that investment legend Warren Buffett first used to convey the idea of a company’s competitive advantage.

“In most businesses you see high returns on capital decrease over time as competition comes in. However, there is a very small minority of businesses that enjoy many years of high returns on capital. They essentially beat the odds. They defy economic gravity. And the question simply becomes, how? And in my view, it’s because they’ve created structural advantages, economic moats — a way of insulating themselves, buffering themselves against the competition – which enables them to maintain supernormal returns on capital longer than academic theory,” he said in a presentation at Talks at Google, whose video is now available on YouTube.

What is not a ‘moat’
Dorsey says investors often mistake businesses with traits like quality products, strong market shares, great operational execution and great managements as one having ‘moats’. These traits do not guarantee a business long-term success, he says and advises investors to be careful and not fall into that trap of ‘mistaken moats’.

Dorsey says a great new product may take the market by storm initially, but it does not provide a durable advantage as it can be easily copied and can end up having a limited life span.

“Any highly profitable business that is easy to compete with will come down over time. So the basics of moats are that they are structural and sustainable qualities that are inherent to the business. A moat is part and parcel of a business that you’re looking at. It’s not a hot product. 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 gets created. But anything that one smart bunch of guys can develop, there’s probably another smart bunch of guys somewhere else trying to make it even better,” he says.

Also, a great management can certainly lead to short-term success in highly competitive businesses, but it cannot be considered a long-term competitive advantage as there can be changes in the team at any point of time and it is hard to know whether the new management team can run the business as successfully as the previous one.

Dorsey feels a company may be executing its operations very well, but it may be so because of tough working conditions in a competitive industry, where cutting costs is the only way to profit. So this also cannot be considered as a long-term competitive advantage.

A great market share of a business also doesn’t ensure long-term success as how a company got to being a market leader is more important to understand than just where it stands in the market share.

“It’s not the biggest market share. Big is not a moat. In fact, small is often a better moat than big. Moats generally manifest themselves in pricing power. A company that can’t raise prices is unlikely to have a strong moat,” says he.

Traits of a moated business

Dorsey says the concept of an economic moat has been one of the key reasons behind the success of investment legend Warren Buffett.

Dorsey reveals four major ways a company can establish an economic moat: intangible assets, high switching costs, network effect and cost advantages.

Investors should target companies having these moats to amass spectacular returns over a longer period of time.

Intangible assets: Dorsey is of the view that firms can create moats by preventing other companies from duplicating a good or service. This can be achieved by having intangible assets that do not have a physical form but do produce value. The examples of these assets are brands, patents and licences that are hard for competitors to match.

Dorsey feels one of the most common mistakes investors make is that they assume well-known brands offer competitive advantage. A brand can be considered a moat only if it increases the consumer’s willingness to pay, lowers search costs and attracts them to buy its product again.

“If a brand changes consumer behaviour by increasing the willingness to pay or reducing the search costs, then it has value. Just being well known doesn’t mean anything at all. Brands are valuable if they deliver a consistent or aspirational experience. Now, consistency lowers search costs and drives loyalty. Aspiration, by contrast, increases willingness to pay. So what you want to do is create scarcity and exclusivity,” he says.

According to Dorsey, patents are also good moats, but they are subject to expiration challenge and piracy. Also, having a license to do something that not many people can do is a pretty solid economic moat.

Switching Costs: Dorsey says there are businesses that have a valuable competitive advantage of having high switching costs and they outweigh the cost or product benefits of a new and better product. Customers find it difficult to switch to a competitor easily, giving these firms a pricing power. Most common examples of these businesses are banks and famous software vendors as customers do not want to go through the hassles of transferring an account or training an entire staff on a new piece of software.

“What you want to do is look for companies that integrate with the customer’s business. So the upfront cost of implementation gets a huge payback for renewals. So the switching costs are very high,” he says.

etwork Effect: Dorsey says the network effect is another form of moat that creates value for businesses. These types of companies have an already-running distribution network for their product and tend to create natural monopolies and oligopolies, because it is challenging in terms of cost and effort for other companies to get a distribution network set up.

These businesses work on the principle that the value of a particular good or service increases for both new and existing users as more people use that good or service.

Giving the example of eBay, he says there are millions of people who use it which makes its services incredibly valuable and that is why it is all but impossible for another company to duplicate its service. This is due to the fact that when someone wants to sell or buy something easily they can get a lot more items on eBay than by searching on some other online auction site with only a few hundred members.

Further Dorsey says credit card companies also work on the same principle. Giving the example of Visa, he says as it is accepted at so many places, more the number of users signing up for it, the bigger the size of the moat it builds up.

Dorsey believes the network effect works well due to non-linearity of nodes v/s connection and radial network is less valuable than interactive network.

“If you have a web, and the number of nodes in that web goes from one to two to three to four, the number of connections increases exponentially. So that is something that makes it very hard to replicate a network once the network gains scale. One thing you want to watch out for, though, is a radial versus interactive networks. A radial network is less valuable as a series of channels, a series of spokes of different nodes are easier for a competitor to pick off by underpricing service in that node. So radial networks are much, much less robust than interactive ones,” says he.

> Cost Advantage: Dorsey says if a business can figure out ways to provide a good or service at a relatively low cost then it can create a cost advantage from its competitors, especially in an industry where price is the most important factor.

Dorsey says these businesses can be termed as moats as they can undercut their rivals on price. There are a number of ways companies can accomplish this like having a better business model than the competitors, having a unique asset over competition, having better locations, better access to resources, and better processes. All these factors help a company to cut costs in ways that their competitors cannot.

Dorsey feels that a process-based cost advantage tends to work well but they get copied eventually by competitors. But scale-based cost advantage, by contrast, tends to be much, much more robust.

“There’re a couple differences here that you should look for when you’re looking at companies. A process-based advantage is basically inventing a cheaper way to do something that is hard to replicate quickly. So process-based cost advantages tend to work well. But then they get copied eventually. Scale, by contrast, is when you spread your fixed costs over a large base, that tends to be much, much more robust. Scale-based advantages, especially in distribution, are incredibly robust. And you can have a niche where you establish a minimum efficient scale,” he says.

Look for quality businesses with good managers

Dorsey says it is essential to pick quality businesses for investment even if the management of that business is not up to the mark as the required level of managerial skills to run a business is inversely related to the quality of business.

“So the key here is that you want to get a good horse. You want to look for good horses. It’s not that the jockey is irrelevant. It’s that even the best jockey, if he’s on a goat, isn’t going to make you a lot of money or win many races,” says he.

Dorsey does believe that managers are a critical part of turning a business into a moated one, as good managers are constantly trying to widen a company’s moat, whereas bad managers make decisions that are not favourable for moated businesses, hence they lower the overall ROIC (
return on invested capital).

“Managers matter in the context of the moat. The way to think about this is very simple. The worse the business, the better the manager. The better the business – eh — as long as management isn’t that stupid, you’ll do fine. If it’s a really bad business, you better have an awesome manager. So it is important to note that moats can buffer management mistakes,” he says.

Moats do erode eventually
Dorsey says moats can erode over time, and if investors can get an early hint on eroding moats, it can help them preserve their gains and cut future losses.

Technological change is one of the biggest factors why there can be erosion in a moat. When a new technology arrives, there is usually a big chance for a competitor to erode the moat of another company. Also, some bad management decisions can also lead to erosion of moat.

Why do moats matter?
Dorsey says it is essential to find moated businesses for successful returns, as moats add intrinsic value and businesses that can compound cash flow for many years are worth more than a firm that cannot.

This intrinsic value that a moat can add is largely dependent on reinvestment opportunities. So if a firm has a limited reinvest ability, the moat adds little to intrinsic value.

“The ability to reinvest cash at a high incremental rate of return is a very valuable moat. If you can plow that cash back into the business, continue to take market share, expand your addressable market, and give a long runway ahead of you, that makes a business worth paying a pretty high multiple for. By contrast, if a firm has little ability to reinvest, the moat doesn’t add much to intrinsic value. It adds certainty. It adds confidence. It narrows the range of possible outcomes. But it doesn’t add much to the value because they can’t reinvest,” he says.

Are moats already priced in?
Dorsey says many investors often ask him whether moats are already priced in, as information on great businesses is readily available.

He says moats are not always priced in as most investors own securities for short time periods, and moats usually matter in the long run. He believes most investors assume the prevailing market conditions in the world will persist longer than they usually do.

“So when things are tough for a great business, they say things will be tough forever; very few people think that this moat will help the business bounce back,” he says.

Also, most investors target short-term price changes, and not long-term changes in moats, because finding moats means finding an efficiency, which is a challenging task.

“Quantitative data in the market tends to be efficiently priced, but qualitative insights like understanding the structural characteristics of a business, switching costs, why customers behave the way they do and why a particular company raises prices are often priced in less efficiently,” he says.

Dorsey feels investors can get these qualitative insights by reading more about the companies and such sound knowledge about a business can help them identify moats better than reading about short-term market movements, macroeconomic trends or interest rate forecasts.

(Disclaimer: This article is based on Pat Dorsey’s book
The Little Book that Builds Wealth
and his presentation at Talks @ Google, whose video is available on YouTube).


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