In Rubicoin’s latest Five Minute Read, we review Pat Dorsey’s examination of economic moats in The Little Book That Builds Wealth.
Pat Dorsey is the founder of Dorsey Asset Management – a wealth management firm focusing on 10-15 companies with sustainable competitive advantages. Dorsey believes that by concentrating on businesses that have a wide economic moat, shareholder value can be compounded at above-average rates for many years.
Before founding Dorsey Asset Management, Dorsey was Director of Equity Research at Morningstar, an independent research firm headquartered in Chicago. During his time at Morningstar, Dorsey developed the methodology behind the company’s framework for analyzing economic moats.
‘Economic Moat’ is a term first coined by Warren Buffett to describe the competitive advantage that one company has over others in the industry. The wider the economic moat, the more sustainable the advantage over the long-term.
Dorsey’s built his investment philosophy around this idea – noting that companies lacking an economic moat will see their returns eroded by competition over time. Companies that do have an economic moat can produce consistently higher returns on capital however, and can therefore reinvest and grow for longer periods.
With this is mind, The Little Book That Builds Wealth is an exercise in how to find these companies, how to identify and measure the strength of an economic moat, and how to use this information to build your own portfolio.
One of the biggest problems Dorsey identifies is that it’s easy to assume that a large or successful company has an economic moat. Many businesses have great initial success, but over time their formula is easily replicated and their high returns disappear. One example Dorsey gives is that of Chrysler in the 1980s:
“Chrysler virtually printed money for a few years when it rolled out the first minivan in the 1980s. Of course, in an industry where fat profit margins are tough to come by, this success did not go unnoticed at Chrysler’s competitors, all of whom rushed to roll out minivans of their own. No structural characteristic of the automobile market prevented other firms from entering Chrysler’s profit pool, so they crashed the minivan party as quickly as possible.”
On the other hand, a company called Gentex came out with an auto-dimming rearview mirror around the same time. But because Gentex had a slew of patents protecting its design from competitors, they were able to protect their business and still make good money on those rearview mirrors today.
The Four Sources of Economic Moats:
1. Intangible Assets
Intangible assets like patents, trademarks, and a strong brand can form an economic moat. However, patents and trademarks can be challenged and are subject to piracy. Therefore it’s best to find a company that has a portfolio of patents or trademarks, rather than relying on just one.
Just because a product is well known does not mean that it has a strong brand. Dorsey defines a strong brand as one that demonstrates pricing power or lowers your search costs. People who buy jewelry from Tiffany’s expect to pay more than they would at another store because Tiffany’s has a strong brand that commands a premium. In fact, Tiffany’s charge about 20% more than their competitors for the exact same product. As Dorsey says; “That’s an expensive blue box!”.
Meanwhile, most people will grab a bottle of Heinz ketchup because no one wants to be bothered trying out all the other varieties and figuring out which one is the best value. This lowers our search costs.
Plenty of big companies might say they have a strong brand, but fail to tick either of those two boxes. A company like Crocs thought they had a great brand because they were the first on the scene with their product. Unfortunately for them, most people looking for plastic shoes would happily buy a cheaper knock-off. Crocs were at one point valued at around $5 billion – now they’re closer to $500 million.
“The bottom line is that brands can create durable competitive advantages, but the popularity of the brand matters much less than actually affecting consumer behavior. If consumers will pay more for a product – or purchase it with regularity – solely because of the brand, you have strong evidence of a moat.”
2. Switching Costs
When it costs a customer money or time to switch to a competitor, they’re less likely to do so. Plenty of businesses have grown successfully because their business model includes high switching costs. Even if a competitor comes in with a better, cheaper alternative, it’s not worth the hassle to switch.
A good example is Oracle, who build databases for large enterprise clients. The cost of a big business ripping out that database would be so overwhelming that Oracle can just keep raising their prices year over year.
Or Intuit – the makers of QuickBooks and TurboTax. If you’re a small business and you’ve been entering all your tax information on QuickBooks, it’s going to take a huge amount of time and effort to transfer that data to a competitor. Hence, you stay with Intuit!
3. The Network Effect
It takes a lot of time and effort to establish a good network, and this can be a big barrier to entry for competitors.
Coca-Cola has a worldwide distribution network. If a new company came out with a competing soft drink, it would still take decades and billions of dollars to get that drink in front of the same customers as Coca-Cola.
Another good example is Mastercard and Visa. They have millions of customers and millions of vendors accept them as payment. A new credit card company could start tomorrow, but they wouldn’t instantly be accepted worldwide, and therefore consumer uptake would be slow. The more people that have a Mastercard, the more vendors will accept them – and the more vendors will accept them, the more people will want a Mastercard.
That’s a moat that’s very hard to replicate.
4. Cost Advantages
Finally, cost advantages play a big part in building an economic moat. Companies that make it cheaper to produce something than others can usually stave off competition.
Dorsey identifies 4 types of cost advantages – process, location, unique assets, and scale.
Process cost advantages are simply ways of doing things that make it cheaper to produce a product. These can be replicated, but in most cases, it takes a long time for others to catch on.
Southwest Airlines made air travel cheaper by only flying one type of plane and celebrating thrift. This was at a time when most airlines were trying to make their offerings more luxurious. Since then, plenty of competitors have come in and copied Southwest’s idea, but they were there first and became a $30 billion business in the process.
You can also have location-based advantages – like operating a country with low corporation tax or lower basic wages.
Companies that have unique assets also have cost advantages. If your company owns a lot of land with oil reserves underneath, you’ll be able to provide that oil cheaper than a company that has to lease out potential oil fields and pay a royalty.
Scale based advantages are much harder to replicate, and only occur when a company reaches a certain size. A company like UPS can deliver parcels much cheaper than a smaller competitor because they have such a wide distribution network. The cost of adding an extra parcel to the network is negligible – and that saving can be passed onto their customers.
Valuing Moats and Disregarding Management
After identifying the characteristics that create an economic moat, Dorsey goes on to highlight techniques for valuing those businesses.
The big indicator he’s keen on is a company’s long-term return on invested capital (which anyone can check on Yahoo Finance). Comparing that to competitors is a good way to find valuable moat businesses.
Depending on the sector, he also uses Price to Book Ratio (for financial services) or Price to Sales Ratio (for companies that are not profitable). Again, once you’ve found a business with a wide moat, you can compare it to other businesses to see if there’s value to be found.
Dorsey doesn’t seem to show a lot of faith in management however. He argues that businesses with integral moats will survive and that companies without moats will have a hard time regardless of who is leading the business.
“Long-term competitive advantages are rooted in the structural business characteristics that I laid out in Chapters 3 to 7, and managers have only a limited amount of ability to affect them.”
Hmmm…let’s agree to disagree on that one.
Should You Buy This Book?
If you’re interested in the qualitative side of analyzing companies, then this is a great book to have.
Dorsey is an authoritative voice on the subject, and though his findings are backed by data compiled while he worked at Morningstar, he doesn’t drone on with pages of figures.
Instead, he presents each case with interesting examples that most people can identify with. The book kind of leaves you with the feeling that, “this is all just common sense, but I never really thought about it that way”.
What Dorsey proposes is a very focused investment strategy, which for beginners is probably a great way to introduce yourself to the process of analyzing your own stocks. On the other hand, if you’ve ever had to sell for a loss before, this might open your eyes as to what went wrong in the first place.
And if you’re still not fully convinced, check out Dorsey’s ‘Talks At Google’ lecture where he explains the book on his own terms.
Learn more about economic moats and other signs you should look out for in a good investment with our free Learn app, available for iOS and Android.