At the book’s publishing, Dorsey was Morningstar’s Director of Equity Research. He has since gone on to start his own fund. This book, which reflects the Morningstar team’s development of the economic “Moat” ratings, argues that businesses with strong structural competitive advantages outperform over the long-term. The book dispels the notion of the star manager—it argues that moat is much more important than management, a point underestimated by the public and media, and the opposite of what is taught in business schools. The ‘little’ book is aimed at the average retail active stock investor, so is written in an approachable and concise way, using many recognizable company examples to illustrate points. I found the book a breeze to read and easy to understand, and the concept of moat to be compelling. It’s a different spin to the established ‘quality’ factor, and the book also espouses searching for growth and valuation in buying stocks. The book’s ideas could be useful when looking at a company’s competitive positioning to assess its future prospects.
- Goal: buy good companies at reasonable prices and let the compounding over time work for you.
- Identify companies that can generate high profits for many years.
- Wait to buy when shares are trading at a discount.
- Hold until business deteriorates or shares become overvalued.
- Highly profitable businesses quickly garner competition. High returns on capital will always be competed away. What about the company gives it a sustainable competitive advantage—a protective “economic moat”. Moats are structural characteristics of a business that is unlikely or difficult to be competed away.
- Moat companies are more valuable because they can compound intrinsic value over a longer time. They can be held longer, which reduces trading costs. Also, high quality businesses are more resilient, thus have better downside protection. Duration of profitability is what is important.
- In stocks, focus on the type of business not the management. “Better to have a good poker hand than a good poker player.” Some businesses are simply better structurally than others—a poorly managed bank will still be more profitable than a stellar-managed supermarket.
- Moat traps (mistaken, unreliable moats): great products, large market share, great execution, and smart management. These tend to be temporary.
- Sources of real moats:
- Intangible assets: strong brands, patents, regulatory licenses
- High customer switching cost
- Network effect
- Cost advantage: scale, efficient process, low cost location
- 1) Intangible assets
- Brands: look for pricing power not just at popularity—will the customer pay a premium (e.g. Tiffany jewelry, Bayer aspirin)?
- Patents: look for a portfolio of patents (always risk of being legally challenged) and a history of innovation (e.g. 3M).
- Regulation: regulated industry but not regulated prices (e.g. pharmaceuticals, slot machines, but not utilities).
- 2) High switching cost
- Tight integration with the customer: enterprise software, data processor (e.g. QuickBooks, Oracle).
- High potential switching risk: banking, precision parts, products requiring sophisticated training.
- Consumer-based businesses often have low switching costs (e.g. restaurants, retailers).
- 3) Network effect
- Powerful virtuous circle: tend towards monopolies/ oligopolies; the more others use the business, the more valuable it becomes (e.g. credit cards, Microsoft Office, Western Union).
- Mostly found in information-based businesses (non-rival goods).
- 4) Cost advantage
- Where price is dominant part of customer’s buying decision; mostly found in commodity-like businesses with easy substitutes (e.g. airlines, consumer products, steel).
- Process-based advantages (e.g. Dell computers) are hard to sustain long against competition.
- Prime location (e.g. waste management, cement, ice salt).
- Economies of scale (distribution: UPS, Coca-Cola, cable TV; manufacturing: Exxon, Chinese factories; dominating a niche market: industrial spray pumps, privatized airports).
- Focus on the relative size of the fish to the pond. Big fish in small pond is better than bigger fish in bigger pond!
- Moat erosion:
- Technological obsolescence: Kodak film, newspapers, land line telephone
- Industry landscape change: consolidation, big-box retailing, foreign labor outsourcing
- Corporate empire building: Microsoft: Zune, MSNBC, MSN
- Competition: it’s only a matter of time
- Management is overrated. Nine times out of 10, bet on the horse not the jockey. People are drawn to CEO stories, but CEOs who succeed in brutally competitive industries (e.g. Starbucks, Dell, Best Buy) are the exception, not the rule. It is very rare for managerial decisions to have a bigger long-run impact than industry dynamics and company structural characteristics.
- Some industries are just structurally more profitable (from good to bad):
- Business services: tight integration with customers lead to high switching costs
- Financials: sticky assets at asset managers, network effects at exchanges
- Media: broad distribution networks, but may be disrupted by new technology
- Healthcare: look for unique drugs or medical devices that dominate a niche, instead of health services (e.g. hospitals)
- Tech software: tends to be tightly integrated with clients and their other software
- Energy: OPEC and pipelines benefit from regulation but not oppressive price control
- Utilities: great scale but highly regulated prices
- Telecom: depends on regulations
- Consumer goods: some strong brands (e.g. Coca-Cola, Proctor & Gamble, Wrigley) but many fad retailers (e.g. Tommy Hilfiger)
- Tech hardware: standardized and commoditized
- Consumer services: price-conscious and many substitutes (e.g. restaurants)
- Industrial materials: highly commoditized; look for niche-dominating companies
- Profitability measures: look over a long period of time (e.g. >10 years)
- ROA: weakness it doesn’t factor in debt; look for ROA > 7%
- ROE: it can be distorted by high debt; look for ROE > 15%
- ROIC: best measure less common, several different ways to calculate it
- Business valuation drivers:
- Risk: how likely are future cash flows to materialize?
- Growth: how large will future cash flows likely be?
- Capital: how much investment is required to keep the business running?
- Moat: how long can the business generate excess profits?
- A stock is worth the present value of all future cash flows. Returns are generated from two sources:
- Investment return: the company’s financial performance. Focus on moat evaluation.
- Speculative return: P/E expansion, stock buying mood of other investors. Forecasting this is folly. Minimize speculation risk by buying only on low valuation.
- Valuation multiples
- P/S: valid only within industry; good for finding temporarily depressed margins.
- P/B: useful mostly for financial services companies (marked to market assets); value of assets for manufacturers (factory) is different than for servicers (human capital); does not include intangibles, but may include goodwill (likely overvalued).
- P/E: use “normalized” average over many years for “E”; can be distorted by accounting.
- P/CF: Dorsey’s favorite ratio; most useful generally but may be distorted by depreciation.
- Cash return: useful to compare to bond yields; = net cash flow (FCF + interest expense) / enterprise value; i.e. the cash yield after buying the whole company and paying off its debt.
- Buying: remember the four drivers: risk, growth, capital investment, and moat
- Buy when many valuation signals are positive, not just a few
- Be patient: “there are no called strikes in investing”
- Be contrarian: buy when others are selling
- Be yourself: do your own research, develop your own conviction
- Selling: write down original reasons for buying, then sell for these reasons:
- Mistake: is investment thesis wrong? Is the original buy reason no longer valid?
- Change: “when the facts change, I change”.
- Alternatives: is there a much better place for my money?
- Risk: has the position become too large for the portfolio? Exceeds risk tolerance.
- Investing is not just a numbers game. Qualitative business assessment is crucial. Best to read widely—annual reports, great investors’ shareholder letters, and good investment books.
Finished: 23-Jan-2011. Re-read: 16-Apr-2019. Rating: 7/10.