Pat Dorsey’s little book-“THAT BUILDS WEALTH”
The Game Plan
- IDENTIFY businesses capable of generating above average returns over many years.
- WAIT to buy, until they begin to trade at OR below their intrinsic value.
- HOLD till
- business deteriorates
- shares are extremely overvalued
- a better investment is found
- REPEAT till you die.
- Keep asking yourself what prevents a smart, well financed competitor to enter into the companies turf.
If you are able to identify moats properly, your risk of permanent loss of capital comes down drastically.
Instead of becoming an expert in a set of industries, why not become an expert in firms with economic moats, regardless of what business they are in ?
A business that can generate above average cash for a long time is better than a company which can generate excellent cash flows only for a short time.
ROCE is the best way to judge a companies profitability. It measures how well the company is using Shareholder Funds to generate returns on it.
A company whose ROCE is just about to get leveraged is better than one whose ROCE is matured or deteriorating even if the ROCE is excellent.
High ROCE is ammunition to protect itself from competition.
High ROCE will eventually be competed away, this regression is generally extremely fast and very painful.
Some businesses are just better positioned than others, irrespective of managerial brilliance. A pig with lipstick is still a pig.
The most commonly mistaken moats or disguised moats
- Great Products
- Can create fantastic short term results. Eg. Fords EcoSport. Great car but this will be replaced soon by other similar offerings in the market.
- Compare this with PATENTED engine components from BOSCH.
- Strong Market Share
- Pure market share is not a moat. How a company got to being a market leader is more important to understand than just where it stands in marketshare.
- Flipkart got there by just handing out subsidies.
- A strong market share is just a competitive advantage.
- Great Execution
- It is a great strategy to have a fine execution strategy, but that in itself is not a moat, it is at most a competitive advantage that is not sustainable, unless its is based on a proprietary process that is bug free and cannot be easily copied. e.g. there have been many instances where the Big McD has suffered bad execution despite standardised practices.
- Great Management
- Smart people at the HELM are not sustainable. Sooner or later an idiot may be brought in to run the business.
- Even more important in the Indian scenario as most businesses are family owned and family run.
The Real Deal Moats
- Intangible Assets – MINI MONOPOLY
- Regulatory Licenses
These should be the REASON that the company is able to sell its products or services and they should be beyond reach of competition.
- Customer Switching Costs
- Addiction to certain flavour like cigarettes
- Very big replacement costs like SAP systems
- This inability for customers to change their minds easily should give the firm PRICING POWER. The high switching costs without pricing power is not really a moat.
- Network Economics
- Competition can be locked out for a long time.
- Networks also depend on trust and payments terms which can lead to huge advantages on the Working capital.
- Cost Advantages
- Unique asset or raw material
which are exclusive only to them and at a cost way lower than to the competition
Learn to differentiate MOATS from COMPETITIVE ADVANTAGES.
Sometimes “Greatness is largely a matter of circumstance.”
Become an expert in identifying these circumstances.
Competitive advantages are nice to have and super tempting at times, but, they alone are not enough for prolonged superior returns.
Intangible Asset – Brands – Pricing Power & Repeat business
- Brands cost a lot of money to create as well as to sustain, and if that investment does not generate return via Pricing Power, or Repeat Business, then the Brand simply isn’t doing its job.
- If a company can sell the same product that it’s peers are selling and still change more, that is an example of a Economic Moat
- Tiffany Diamonds
- Bayer’s Aspirin
- Well known brands that don’t influence customer behaviour are worth nothing.
Intangible Asset – Patents- Dissect the Monopoly
- Patents give you legal protection by completely barring competitors from selling your product.
- Patent life is always finite. Always check how long it is still valid.
- When you bet on a company based on a patent, their track record of cranking out patents and their ability to generate money off these patents is utmost importance.
- Companies with a wide network of patents such as Apple, 3M, Eli Lily etc are generally a better bet than companies who are one patent wonders, much like singers who are one hit wonders. e.g PSY(Gangam Style) versus say A.R. Rehman.
- Great Patents will always be challenged by the best lawyers in the industry. It is as important to be able to protect your patent as it is to create one.
- Patent lawyers drive the best cars.
Intangible Asset – Regulatory Control- License Raaj
- A Regulatory license makes it tough, if not nearly impossible for competitors to enter a market. This advantage is most effective when a company needs regulatory approval to operate in the market, but is not subject to economic oversight with regard to how it prices its products.
- Public Utilities Vs Pharma Companies
- Neither can sell their goods without approval, but the USFDA has no say about how the Pharma companies price their goods.
- If you find a company that can price like a monopoly, without being regulated like one, that is a long wide moat.
- Rating Companies like CRISIL, need regulatory approval to operate but are not subject to pricing regulations. Other Eg. Delta Corp – Casino, Airlines that have approval to fly overseas – Jet Airways.
- Sometimes the moat is not made of one big approval, but a lot of small mini approvals
Intangible Asset – Summary
- Brands – Pricing power or Repeat Business
- Patent – How much value & for how much longer. One ride pony or a diversified pipeline.
- Regulatory Control – Monopolistic market without regulated prices. Extremely high ROCE.
When switching is a royal pain, some companies have a royal gain !
Usually boring back-end companies are joined with companies at the hip and companies can find it almost impossible to get rid of them. e.g Ebay’s platform working on Oracle databases. Switching would not only mean transferring all the data seamlessly but alee reworking/ rebuilding all the programs that are based on the db and reattach all the programs to the web.
Where there is LOW TOLERANCE FOR FAILURE, costs advantages are low priority. e.g medical devices, defence equipment, heavy engineering equipment and companies are more willing to pay a little extra and be sure of quality rather than take a change. i.e the risk reward relationship to switch is totally skewed.
Sometime the switching costs themselves are not large, but the benefits are so uncertain that people take the PATH OF LEAST RESISTANCE to simply stay where they are.
Industries with traditionally low switching resistance:
- Packaged Goods companies. They may have good brands, but the switching costs aren’t in a strong position here.
Examples of high switching costs:
- Adobe’s Photoshop and Illustrator
- Autodesk’s AutoCAD
- Gas connections in India, Mobile operators before the Portability Option
The Network Effect- Sharing Information or Connecting users
“Of networks, there will be few!”
Network based businesses tend to create natural monopolies and oligopolies.
As dominant networks get bigger, they also get stronger.
Network effect in business models are more likely to be found in businesses based on
sharing information or
connecting users together
rather than in businesses that deal with physical goods.
To benefit from the network effect, the company needs to work in a closed network. i.e if the network is regulated or requires govt clearances, its all the more in favour of the company.
The benefits of larger networks are NON-LINEAR. i.e the economic value of the network increases, at a faster rate than the absolute increase in size.
Blue Dart and Gati
CRISIL and CIBIL
This moat is not really easy to find, but its worth a lot of investigation when you find it because its non-linear characteristic is a breeding ground for compounding growth.
Cost matters the most in which Price is a major factor of consumer decision.
What one company can invent, the other can always copy, therefor invention ( unless protected ) is more of a first mover advantage.If a process or a low cost resource is available to anyone who wants them, it is more of a first mover advantage rather than a moat.
Usually stem from the following:
- Cheaper Processes – tread carefully as these are not as durable as they appear to be
- These are more theoretical in nature as most of these advantages can be replicated over time. The only reason some might last longer are due to its combined effect with other factors.
- Sometimes competitors cant compete with new technology operating costs due to sunk costs. E.g Solar Energy plants, Old Steel Mills etc
- Better Locations
- Sometimes cause mini monopolies. Way more effective than better/cheaper processes.
- Cement Plants, Quarries
- Unique Assets – Cheap land/ pre-booked raw materials / resource deposits / forests etc.exclusive mines,climatic conditions ( Darjeeling Tea ).
- Greater Scale –
- The absolute size of a company matters, much less that the its size relative to its rivals i.e the fish to pond ratio is much more important than the absolute size of the fish.
- The higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be, because the size of benefits are that much greater.
- Scale based cost advantages can further be broken down into
- Distribution –
- In the trucking business, since trucks, salaries and overheads are fixed costs, the larger delivery network and delivery points, the larger the profits.
- A dense ground delivery network has much better returns on capital than an overnight express service as a delivery van only half full is still likely to cover its costs, whereas a half-full cargo with time-sensitive packages likely will not.
- Manufacturing – e.g. china and eastern Europe low cost pools. However, this is becoming common in the global economy and is becoming less relevant day by day.
- Niche Markets –
- domination of a niche market i.e big fish small pond.
- even by making absolutely mundane products companies with niche market moats can generate fabulous return on capital.
- Distribution –
Signs of Eroding Moats
An early read on weakening / eroding moats can greatly improve your chances of preserving your gains on a successful investment – or cutting your losses on an unsuccessful one.
- Technological Disruption – not of tech companies, but of companies that are enabled by a certain technology. – e.g long distance phone calls, newspapers, music, kodak polaroids, cameras.
- Concentration of customer base – customers gain bargaining power.
- Crazy competition – competition from people looking for something other than money – social causes, ego, emotion or simply regulation.
- Bad Growth – When companies have more money than they need and venture into areas where they have no moat whatsoever, it is better to return that money to shareholders.
It is just easier to build moats in some industries. Stick to them. Life is not fair.
Measure moats on an absolute basis and not on a relative basis. i.e a company could be the one with the deepest moat in an industry, but if the industry itself is a hyper competitive one, its of no use.
Industries with high moats
- Health Care Services
- Consumer Services
- Business Services
- Financial Services
- Consumer Goods
- Industrial Materials
Management does not matter as much as you think
Investing is all about the odds, and a wide moat company managed by an average CEO will give you better odds of long run success than a no-moat company managed by a superstar.
Management matters, but within boundaries set by companies’ structural competitive advantages.
The best engineers in the world can’t build a 10 storey sand castle
Competitive Dynamics > Management Capacity
How much to Pay for your Moat
How much you pick up a good stock for is almost as important as how good the stock is.
You need to consider to value your moat
- Risk – likelihood that you estimated future earnings will happen
- Growth – how large are those cash flows
- Capex – what re-investment will be needed to keep the ROCE intact
- Tenure – how long can the company continue to keep making money
Market price is based on
- The Investment Return – Earnings, Growth and dividends
- The Speculative Return – Changes in the PE valuation
Hunt for Investment returns, and many times speculative returns will come along as bonus. Hunt for speculative returns and both of them can ditch you.
When and Why to Sell
Assuming you have followed your rules of investing, sell only if you answer yes to anyone of these questions:
- Have you made a mistake in purchasing ?
- Has the company changed for the worse ?
- Is there a better place for your money ?
- Has the stock become too large in our portfolio ?
Other books that Pat Dorsey recommends. ( i dont plan to summarise them, so you better order them 🙂 )
- Why smart people make big money mistakes – and how to correct them by Gary Belsky and Thomas Gilovich
- The Halo Effect by Phil Rosenweig
- Your Money and Your brain by Jason Zweig