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The Little Book that Builds Wealth, Pat Dorsey

May 19, 20215 min read

Pat Dorsey

Capitalism Works
  • Capital seeks the highest returns possible: High profits attract competition.
  • So…most businesses with high returns on capital will see returns decrease over time.
Moat Basics

  • Economic moats are structural & sustainable qualities that are inherent to the business.

    • Not hot products. (Heelys? Krispy Kreme?Sugar is a moat)
    • Not just a cool piece of tech (lomega?In tech there will be a newer with more advanced product)
    • Not the biggest market share (GM? Compaq?)

  • Moats generally manifest themselves in pricing power: A company that can’t raise prices is unlikely to have a strong moat.

INFO: We looked at companies that maintained Return on Capital above Cost of Capital for 15+ years.

  • What are the common characteristics of these business
  • Whats the similarities in these business
Intangible Assets

  • Brands

    • Increase willingness to pay / lower search costs
      • Sony(Tech product:who buys VCD Players) vs. Tiffany(Diamonds, its worth it)
      • Amazon, Groupe Richemont, Coca Cola İçecek

  • Patents

  • Legal monopoly vs. expiry/challenge/piracy

    • If one drug is driving all the economic value, if that patent is getting challenged, you are dead. So, you have to be very careful.
    • Novo Nordisk, Qualcomm, Chr. Hansen

  • Licenses/ Approvals

    • Legal oligopoly vs. regulatory fiat
    • Casinos(limited licenses), landfills(nobody likes to live there, less number licenses), aircraft parts(Most of the parts are made by one company, good business)
Widening the Moat: Brands

  • Brands are valuable if they deliver a consistent or aspirational experience.

    • Consistency lowers search costs & drives loyalty. Don’t change & give people a reason to switch!
      • Mistake: New Coke, The Schlitz

  • Aspiration increases willingness to pay. So, create scarcity & exclusivity. +Tiffany’s store layout(40% revenue comes from stuff that costs less than $200 and shop layout is like costly items in front and cheap at last) +“You don’t own a Patek Philippe, you merely take care of it for the next generation.”

Confidence is how other people see you.

Switching Costs
  • Does the cost of switching to a competing product or service outweigh the benefits?

    • Integrate with customer’s business: Upfront costs of implementation payback from renewals

      • Silverlake Axis, Oracle, SimCorp
      • Migrating to Oracle to another database is a expensive thing for a multi-national company, they will not go for it. So, lock-in is a good thing.

    • Sell ongoing service relationships

      • Rolls Royce, Otis, Kone, Schindler
      • Kone is a elevator company, once a elevator is setup, its not coming out. Rolls Royce, sells JetEngine they change you by the hour. You pay is related to how much you use it.

    • Provide a product with a high benefit/cost ratio

      • Fastenal(Makes bolts, product doesn’t cost much, but brings huge economic cost to the company), Ecolab, Novozymes, Fuchs Petrolub
      • Lubricant which improves performance of a mining machine, that lubricant costs less when compared to the actual machine or production, so even if they increase 20%, they will pay for it.
The Network Effect

  • Provide a service that increases in value as the number of users expands.

    • Aggregate demand b/t fragmented parties.

      • Edenred, Henry Schein(used by dentists), XPO Logistics

    • Non-linearity of nodes vs. connections.

      • Visa, Mastercard, Facebook

  • Western Union is Radial, they have lots of branches but nobody is sending money from Bangladesh to Chicago or Mexico

Network Effects

Cost Advantages

  • Process: Invent a cheaper way to deliver a product that can’t be replicated quickly.

    • Inditex, RyanAir, GEICO, Dell

  • Scale: Spread fixed costs over a large base. Relative size matters more than absolute size.

    • UPS, Aggreko, Stericycle

  • Niche: Establish minimum efficient scale

What About Management?
  • “Good jockeys will do well on good horses, but not on broken-down nags.” (Buffett)
Moats, Management & Mistakes
  • Moats can buffer management mistakes
    • Microsoft minted money despite Steve Ballmer
    • New Coke didn’t kill Coca-Cola
    • Moodys put profits before integrity, and still cranked out a 40% operating margin
    • But even a genius like David Neeleman couldn’t change that fact that JetBlue is an airline - the worst industry known to mankind.
The Good & the Bad

  • Good managers are constantly looking for ways to widen a company’s moat

    • Amazon’s focus on the customer experience(There is a lots of trust involved)
    • Costco’s focus on using scale to lower costs

  • Bad managers invest capital outside a company’s moat, lowering overall ROIC

    • This process is called “deworsification,” or “setting fire to large piles of cash.”
    • Example Cisco — Starting a consumer business, Garmin — Starting a GPS Handset business(Every phone has GPS)
An Exception to Every Rule

  • A tiny minority of managers can create enormous value via astute capital allocation - even if they don’t start with great horses.

    • Warren Buffett (Berkshire), Brian Joffe (Bidvest), Dick Kovacevich (Wells Fargo), Steve & Mitch Rales (Danaher)

  • They are hard to find, and false positives abound…but they can create enormous wealth over time. Keep an eye out!

Valuing Moats

  • The value of an economic moat is largely dependent on reinvestment opportunities

  • The ability to reinveset tons of cash at a high incremenetal ROIC = a very valuable moat.

    • Fastenal, XPO, Curro

  • If a firm has limited ability to reinvest, the moat adds little to intrinsic value. +McCormick, Microsoft, Oracle

Isn’t Moat Already Priced In ?
  • Moats usually matter in the long run than in short
  • Most investors assume the current state of the world persists longer than it usually does.
Finding Moats = Finding Inefficiency
  • Quantitative data is efficiently priced in
  • Qualitative insight is less efficiently priced
Moats in a Global Context

  • Local differences create moats

    • Canadian banks, Edenred, German car washes

  • Minimum efficient scale is more common South African retailers, Globo, BEC World

  • Cultural preferences create barriers to entry Beer travels. Candy & snacks generally don’t.

# References

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