Wide-Moat Investing
With Pat Dorsey of Dorsey Asset Management
Pat Dorsey is the founder of Dorsey Asset Management, a wide-moat, long-only investment manager that invests globally and is based in Chicago, IL. He is the former Director of Research at Morningstar, where he developed the moat framework for assessing quality companies from an investor’s perspective.
What’s a moat?
A moat is a structural attribute of a business that shields it from competition. With a moat, a business can generate a superior return on invested capital and reinvest at an above-average rate without facing challenges from rivals.
Only a limited number of businesses truly possess moats, and they tend to concentrate on a few industries. Under Dorsey’s moat framework (like Morningstar’s as well), moat comes in the following forms:
Intangible assets
Intangible assets, which can be off-balance sheet items (such as expensed R&D), can provide a business with pricing power. Examples include brands, patents, and licenses. However, an investor must ascertain whether they truly result in pricing power.
For instance, brands can instill trust in consumers, reducing uncertainty by signaling a minimum standard of quality ("uncertainty reduction" under 7 Power framework).
Examples include credit rating agencies' bond ratings, Morningstar mutual fund ratings, or Gartner IT Analyst's opinions. Although I'm not sure if any of the aforementioned are as credible as they were decades ago.
On the other hand, brands can hold "positional value" ("affective valence"). If you wear a Rolex while sporting an LV bag (a strange combo but whatever), you are perceived to be a member of a higher social class, evoking positive feelings (even when others might not care.
The advent of the internet has disrupted the value of traditional brands, making them more susceptible to challenges. Companies like Procter & Gamble (P&G) once used their scale to out-advertise start-ups on broadcast TV, but the rise of social media has democratized advertising, allowing even newcomers to reach vast audiences.
This shift has paved the way for the emergence of direct-to-consumer (DTC) brands like Dollar Shave Club and Chobani, which can achieve similar reach without the need for massive advertising budgets.
When a company's moat relies on licenses to coveted assets (referred to as "Cornered Resources"), you must examine the regulatory environment.
The regulatory regime that grants licenses can just as easily revoke them, especially in countries with weaker rules of law. The same regulatory regime can also introduce more licenses, intensifying competition and eroding the moat's strength.
Switch Cost
Dorsey believes that it's more important to assess the durability of switch costs rather than just their presence. He has seen too many businesses misuse their position of customer captivity by erroneously focusing on price maximization rather than market expansion, which is often unsustainable in the long run.
Instead, businesses endowed with switch costs should redirect their efforts toward enhancing their products and delivering ever-increasing value that justifies the price premiums they command.
Scale
Many often emphasize lower marginal costs as a source of competitive advantage, but modern businesses increasingly rely on intangibles such as the value of R&D and the value derived from a narrow scope.
For example, Google and Meta heavily invested in AI for many years. In the realm of machine learning, the scale of data inputs is pivotal – the more data available, the more refined the machine learning algorithms become. This advantage enhances the value of the product and increases the pricing power of solution providers like Google and Meta.
A narrow scope is another angle that businesses pursue. A business that has concentrated its efforts on a specific niche for an extended period, mastering all the intricacies of that domain—such as a company specializing in operating dollar stores for decades—possesses an edge that is hard to replicate.
Achieving such expertise requires significant processing power, and involves the acquisition of a wealth of trade secrets, making it a unique and enduring source of competitive advantage.
How many moats are good to have?
It's not just about the number of moats a business possesses, one needs to focus on the reinvestment runway. Less mature businesses with a moat in secular, growing industries often have the ability to reinvest capital at a higher rate of return.
On the other hand, businesses with static moats, like Coca-Cola, are undoubtedly great but do not have much room for growth. In such cases, prudent companies must return capital to shareholders, who can then seek opportunities elsewhere to deploy that capital effectively.
As an investor, it may not be productive to rigorously analyze a static moat business if you already know you'll have to find another avenue to invest the capital returned to you.
Ideally, investors want to find businesses with moats that widen over time with ample reinvestment opportunities, as this ensures that every incremental cash flow generated contributes to increasing returns.
What’s the best moat?
When asked about the best moat, Dorsey thinks the network effect is the best, if it can be guaranteed to continue. Without a guarantee (of sustained network effect), he believes switch cost is the best moat.
Businesses with high switch costs can struggle to grow once they have fully captured their addressable customer base, leading to capital allocation challenges. They either need to return the excess cash or, worse, management will allocate capital to ill-fated acquisitions that erode shareholder value.
Conversely, if the business has room to grow, signs of switch costs might not have surfaced at the time.
Examples of businesses with strong moats include:
Payment networks like Visa and Mastercard
Vertical market software companies like Veeva
Exchanges: Future exchanges enjoy higher margins due to the switch costs involved (future trades must begin and close at the same exchange)
Luxury brands and certain CPG companies exhibit strong economic moats, although their reinvestment runways tend to be shorter
Measuring moat
The measure of a moat often boils down to Return on Invested Capital (ROIC), calculated as the NOPAT Margin * Asset Turnover.
Some achieve it through a high NOPAT margin (such as luxury goods), while others rely on Asset turnover (like Walmart and Costco).
It's crucial to remember quality businesses need a growth runway to reinvest, which can manifest in various forms, such as:
Gaining market share in a non-growing market, or
Maintaining market share in a rapidly expanding market
Modeling and Valuation
Dorsey is not a traditional value investor who seeks to buy "60-cent dollars." The firm’s modeling and valuation process involves a full 3-statement model and discounted cash flow (DCF) analysis to understand the value drivers that influence a business's intrinsic value. Rather than focusing on a single output of DCF, they employ scenario analysis to frame a range of possible outcomes.
To complement the DCF analysis, Dorsey applies relevant multiples to a 3 to 5-year projection of operating profit (EBIT) and free cash flows and triangulates the outputs of both valuation outputs to decide on the actionability of the idea, with a 15% hurdle rate.
On modeling, Dorsey emphasizes the importance of quality inputs and avoiding the "garbage-in, garbage-out" pitfall. Inputs such as growth, margin, and working capital efficiency are rigorously debated, shaping the firm's confidence in the base rates for the business.
Dorsey points out that human beings tend to excel in forecasting linearly, which results in actionable ideas rarely emerging from a linear extrapolation of the past.
Instead, opportunities lie in non-linear developments such as operating leverage and addressable market expansion. For example, Dorsey discovered Chegg CHGG 0.00%↑ as an attractive investment. At the time, Chegg just divested the asset-heavy physical textbook rental business to focus on an under-the-radar asset-light digital textbook solutions business, echoing famed value investor Bill Miller’s saying “all data are in the past, all the value is in the future.”
Wide-moat businesses often have a future that diverges significantly from the company's past, a factor that traditional statistical valuations may fail to capture.
For instance, Mastercard went public with a 13% operating margin but has since transformed into a business with a 60% operating margin. This kind of aggressive margin expansion may not have been accurately modeled by Wall Street consensus, particularly for businesses with virtually no incremental costs in servicing additional customers.
Dorsey underscores the importance of understanding normalized trends, exemplified by the luxury goods sector, which experienced accelerated growth driven by China's increasing appetite for them, partially due to the rise of bribery.
For luxury goods, Dorsey uses a figure of 4-6% volume growth annually, which excludes the China factor. By doing so, one can avoid mistakenly deeming a valuation as cheap based on abnormal trends that should not be extrapolated indefinitely.
When facing a drawdown, assuming the moat is not impaired, stocks of quality businesses are worth digging into as potentially actionable.
Right way to allocate capital
Dorsey cautions against the pitfall of adopting a mechanical approach to capital allocation. He finds the notion of splitting capital allocation into thirds—buybacks, dividends, and accretive M&A—indicative of a company's lack of strategic clarity.
Does that sound familiar? I swear I just read an analyst day transcript where the CFO mentioned that as their capital allocation policy. Don’t want to name names, because feelings get hurt.
Instead, the optimal approach involves assessing the best return on capital decision for the specific circumstances. Maximizing the return on allocated capital should be the sole criterion for value creation.
Neither the fascination for dividends in the UK, Australia, and some parts of Europe nor the obsession with buybacks in the US makes sense to him.
Effective management, Dorsey insists, should establish a high yet reasonable hurdle rate. He shared a story of meeting a management team in London where he heard the company absurdly targeting merely beating its WACC in the third year, as this signifies zero economic value creation.
Simplistically, if I give you $100, and you generate $2 by deploying the $100, and I can earn $5 investing in the US Treasury, why would I entrust you with my money?
Diligence process
The diligence process is as follows:
Filter out sectors with unfavorable economics (commodity businesses such as basic materials and life insurance), which naturally leads to businesses with favorable unit economics. It's not an automatic win for businesses with tailwinds, but it just makes life easier—why swim against the tide? Lee Ainslie similarly talked about investing in companies facing secular tailwinds, where good things tend to happen.
"Quick idea": Condense investment ideas into a brief paragraph detailing the moat and opportunity.
"First-pass memo": Takes one day to assess the reinvestment potential, structural advantages, and management's capital allocation skills. The firm does 6-7 first-pass memos each month, but only 1-2 get approved for further work.
Dorsey Asset Management values diversity in its team, drawing individuals from various backgrounds.
The firm has a team-based approval process. To make the PM's job of allocating time easier, the firm implements explicit deadlines for completing deep-dive memos. If an analyst comes back in three days and discovers something that kills the idea, they won't waste the next month researching a dead-end stock.
If the instruction was instead "go write that memo," the analyst could go down a rabbit hole and spend months on a dead-end idea with a poor return on time.
A network effect needs to be nurtured. Dorsey invested in Facebook META 0.00%↑ after ascertaining the superior return on investment (ROI) for advertisers, a benefit they couldn't find elsewhere due to the personal data provided by Meta users for targeting.
The firm didn't hesitate to scrutinize R&D expenses after the WhatsApp acquisition, leading to the insight that the core user-generated content business remained highly profitable (as WhatsApp's R&D expenses were absorbed into the consolidated profit and loss statement). Facebook's willingness to sacrifice short-term gains for long-term benefits also impressed Dorsey.
Smaller businesses can extract valuable lessons from giants like Facebook and Google. One of the most crucial takeaways is the emphasis on taking care of customers and ignoring Wall Street's short-term pressures. These tech titans understand that it's the customers who ultimately pay the bills and are essential for the long-term success of a business. Prioritizing customer satisfaction and loyalty can lead to sustainable growth.
When questioned about his decision not to invest in Amazon, which seems to check all the right boxes, Dorsey admits to lacking a definitive answer. I suspect his reluctance may stem from Amazon's high valuation.
Dorsey encourages aspiring analysts to get off their chairs and conduct fieldwork. The best way to gain insights is by engaging with customers directly at industry conferences or other gatherings where they congregate. For instance, when evaluating Chegg, he polled 800 students across the country online to gauge the platform's name recognition.
Dorsey's philosophy is clear: you have to put in the effort, sometimes picking up the phone, to truly understand the businesses you're investing in.
Why He Believes in Wide Moat Investing
Dorsey believes that the scarcest resource in the future will be human talent, rather than financial or physical capital. This perspective is grounded in the idea that the output of human capital is often inadequately reflected in financial statements.
Building a moat around a business involves leveraging human capital, establishing and maintaining a strong brand, fostering increased engagement through network effects, and creating switching costs through product quality. And opportunities arise when the financial results lag the moat-building groundwork.
Dorsey invests behind tailwinds. Aside from industry trends, he pays attention to where in the world capital is flowing into. He appears to have located India and Japan as two international areas of focus.
While he's bullish on India's growing economy and improved corporate governance, he acknowledges the limitations of his circle of competence. He avoids businesses that require a deep understanding of local tastes and preferences, focusing instead on Indian export businesses with a global reach.
Similarly, in Japan, where corporate governance is improving, in-person visits are often necessary to build relationships and initiate meaningful conversations.
However, investing in non-U.S. markets entails currency risk. Given that his clients transact in dollars, he demands a higher hurdle rate in countries such as Brazil and South Africa, where he anticipates currency depreciation over time.
More Examples of Moats
Distributors - relative market share
Dorsey challenges the notion that market share alone equates to a sustainable competitive advantage. From his experience, businesses tend to have superior economics when they hold a 6% market share, with the next largest competitor trailing far behind at 2%.
The relative scale of market share becomes crucial in fragmented industries, allowing the leading player to consolidate the market and benefit from the flywheel effect.
For example, companies like Watsco WSO 0.00%↑ and Pool Corp POOL 0.00%↑exemplify a successful business model. These companies operate in markets with fragmented supplier and customer bases, enabling them to aggregate demand. Some of their inventories are bought frequently, while others are less so.
The advantage of scale becomes evident here, as larger distributors can turn over their inventory more rapidly, making it more cost-efficient than for smaller competitors with less aggregate demand.
Netflix's ability to invest heavily in original content is also a testament to the power of aggregated demand. With a massive subscriber base, they can allocate substantial resources to create compelling content that keeps customers engaged and attracts new ones.
This illustrates how aggregation can be a significant driver of success in the modern business landscape.
Software-as-a-Service
In the realm of Software as a Service (SaaS), Dorsey emphasizes the importance of customer lifetime value (LTV). Companies that successfully transition to a subscription model often witness a 1.5-2.0x lift in customer LTV.
For Dorsey, the critical metric is the LTV-to-Customer Acquisition Cost (CAC) ratio. If this ratio is too high, the SaaS vendor should invest more aggressively in customer acquisition. In such cases, generating free cash should not be the priority, as long as the market opportunity remains substantial.
Lessons Learned as a Founder
Dorsey acknowledges the enormous leap of faith was required to start Dorsey Asset Management. He is grateful for the support of those close to him who encouraged him to take the plunge. He recognized that the odds of success may be low, but he believes that taking action is far better than those who merely estimate the odds of a venture without making a move.
In the firm's early days, Dorsey made mistakes - he was heavily influenced by other investors he was close to, often buying stocks that his peers would have bought instead of establishing his own unique style.
An investment firm's performance is a product of both people and processes, necessitating a thoughtful approach and a willingness to adapt when necessary. Dorsey also stresses the importance of hiring diverse individuals and being open to different perspectives within the firm.
In an asset management firm, analysts can sometimes employ jargon and leverage their access to privileged information to win debates. However, Dorsey highlights that the best insights can often come from those with the least information and advises humility among junior analysts. He has seen sector specialists at larger firms game the system to get names in their covered into the portfolio for personal gain, which ultimately hurts the client's best interests.
Finally, the importance of aligning with limited partners (LPs) is crucial in Dorsey's investment approach. Dorsey Asset Management only offers one product. He warns against creating new products to chase trending demand, potentially selling to the wrong audience. Ensuring alignment with LPs, especially those with a five-year-plus time horizon, is key to a successful partnership and outperformance.
Thanks for reading. I will talk to you next time.
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