Pat Dorsey on Moats

MOI Global members have had the pleasure of learning from Pat Dorsey on several occasions in the past. Below, we share one of our earliest conversations with Pat, an exclusive interview with John Mihaljevic, recorded in 2012. Pat’s timeless wisdom and insights amount to a tour de force on the topic of competitive moats — what they are, how they come about, and what drives their sustainability.

Pat discusses the competitive position of numerous companies in the interview. It’s enlightening to think about how well his comments on those businesses have aged — perhaps itself a statement on the merits of investing in wide-moat businesses.

Pat is a recognized authority on moats, an acclaimed author, and founder of Dorsey Asset Management. Prior to launching his own investment firm, Pat was president of Sanibel Captiva Investment Advisers, where he led the investment team and helped guide capital allocation. Pat was previously director of equity research at Morningstar for over ten years. He is the author of The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth.

The following transcript of the full conversation has been edited for space and clarity.

John Mihaljevic, The Manual of Ideas: Please tell us about your background and how you became interested in the topic of moats.

Pat Dorsey: I was director of equity research at Morningstar for about ten years. I basically built the equity research team and process there, starting with about 10 analysts and building it to about 100 analysts when I left. I formed the intellectual framework that we use to evaluate companies. A big part of that is a focus on a competitive advantage, or an economic moat. I became interested in the topic because some companies essentially defy economic gravity and manage to maintain high returns on capital despite competition.

It’s a fascinating topic because economic theory suggests that all companies should just revert to mean over time. Competition shows up, capital seeks excess profits, and you drive returns down. But, both empirically and intuitively, we all know that’s not the case. We can all name a dozen companies off the tops of our heads who have basically defied the odds and maintained high returns on capital for decades at a stretch. What frustrated me when I got into the topic is that most of the literature on competitive advantage is written from a strategy standpoint. Most of your readers are familiar with Michael Porter’s Five Forces model, which is very useful and a great starting point, but it’s always from the perspective of a manager of a business. In other words, I manage a company or a unit of a company, and what can I do to make that piece of that company better? So, it’s all about maximizing the assets that you have.

As investors, we have a different challenge. We’re not stuck with a set of assets of which we need to maximize the value; we can choose from thousands of different sets of assets called companies. So we need more objective characteristics by which we can assess the quality of competitive advantage and then make some judgments about whether a company is likely to have high returns on capital in the future or not.

MOI: Let’s start from the beginning. Can you define what you mean by moat?

Dorsey: When you think of an economic moat—and let’s be clear I stole the term from Warren Buffett; he’s the one who coined it. If you’re going to steal, steal from the smartest guy around—a moat is structural and sustainable. I think those are the two key things for investors to think about. It’s structural in that it’s inherent to the business. The Tiffany brand is inherent to Tiffany [TIF]; you can’t imagine Tiffany without it. The switching costs of an Oracle [ORCL] database are inherent to the way databases are used in business. Contrast that with a hot product or a piece of a hot technology that may come or go.

Moats are also sustainable. They are likely to be there in the future. As investors, we are buying the future. Look at the investments we make today. How they turn out will depend largely on what happens three years from now, five years from now, or ten years from now. So, we need to think about sustainability of a competitive advantage. A company with a very hot product and a cool brand right now may have very high returns on capital, but the sustainability is in question. Whereas you can look at a railroad or a pipeline that would not have as high returns on capital as an Abercrombie & Fitch [ANF], but it’s very sustainable because you can predict the likelihood of that competitive advantage sticking around for many years, and that makes the investment process easier.

MOI: So it sounds like, almost by definition, good management would not qualify as a moat. Is that right?

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