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