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Pat Dorsey Digs in on Digging Moats

May 04, 2012
Pat Dorsey, one of the best thinkers out there on competitive advantage, just delivered a great talk here at the Value
Investing Conference on valuation. Here are the highlights:
Foundations of Moats: Most businesses with high returns on capital see those returns drop over time. Big profits attract big
competition. It is intuitive and shakes out empirically. But a small minority of businesses those with moats -- do enjoy high
returns for long periods. An economic moat is a structural business characteristic.
Moat Types: The four kinds of moats Dorsey recognizes are intangible assets (brands, patents, approvals and licenses),
switching costs, network effects, and cost advantages (processes, sales).
Why Moats Matter: They add intrinsic value. A wide moat allows companies to generate economic profits returns on
capital in excess of their cost for a long period of time.
What's a Moat Worth? It depends almost entirely on the reinvestment opportunities that are available. If a firm can
potentially reinvest large amounts fo cash flow in high-ROIC projects, the moat is worth quite a lot (think Fastenal,
Expeditors, CME, MasterCard). If a firm has limited (or no) reinvestment opportunities, the moat affects intrinsic value very
On Microsoft: We could spend 40 minutes on Microsoft's moat.
What About Management? As Buffett said, good jockeys do well on good horses, but not on broken-down nags. Good
managers may create or destroy a moat, but great management is not a moat by itself.
The Commoditization Spectrum: The more commoditized an industry, the more impact that management is likely to have
for better and for worse. On the no-moat end, you've got banks, energy, insurance, mining, and retail. Management
matters a lot here. On the "Moaty" side, though, management has less of an impact. That's the end with brands with pricing
power, network businesses, demand aggregators, scale businesses, and niche businesses. The takeaway: Weight more
time towards evaluating management of no-moat businesses and less time on wide-moat businesses.
Diggers Can Help Widen Moats: Management teams with a fanatical focus can drive value: Wal-Mart's focus on prices,
Amazon's focus on the customer experience, etc.
Amazon Poll: Dorsey asked the room to raise their hands if they've bought something on Amazon without checking a price
elsewhere. Practically everyone, including me, raised their hand. Moral: Amazon has developed a powerful brand and trust
Shoveling Dirty in the Moat: Companies that aggressively invest outside of their moat are essentially blowtorching large
piles of money. For example, Cintas' move into fire safety and document management, Pitney Bowes' move into mail-room
outsourcing, Cisco's move into consumer markets, Garmin expanding into phones, eBay buying Skype, etc.
Digging a Moat with Intangible Assets: Brands are valuable if they change consumer behavior by delivering a consistent
or aspiration experience. Consistency lowers search costs and encourages loyalty, aspiration increases willingness to pay.
Consumer brands: Don't give a reason to switch!

Digging a Moat with Switching Costs: Integrate with customer business processes upfront costs of implementation yield
payback from renewals. Sell a solution that includes an ongoing service relationship, not just a one-time product purchase
elevators, jet engines, deepwater rig parts, etc. Customer stickiness is higher with products/services that address pain points
rather than revenue opportunities: Ecolab, Stericycle, Aon, A.J. Gallagher, etc. Or, provide a product/service with a high
benefit/cost ratio: Fasteners, compressors, etc.
Digging a Network Effect: This is one of the few areas where "first-mover advantage" can be truly worthwhile. Otherwise,
the phrase is often code for "We got into this market first, which means we can make a lot of mistakes that others can learn
from and subsequently crush us." Scaling quickly is key, as CoStar and eBay highlighted. Position yourself between
fragmented groups of suppliers and users (C.H. Robinson, Edenred, Fastenal, etc.). Watch for large groups of users who
can establish critical mass with a competing network think BATS disrupting Network.
Digging a Cost Advantage-Based Moat: You can build a process-centric moat, but the advantage is temporary and
complacency will kill you. Scale means winning through attrition fight the war, not the battle. Or look at niches, but size can
bring competition. Grow via expansion into complementary markets, overall scale, and be comfortable with not growing at
Digging a Technological Moat: Be willing to kill your own business. Disruption and commodization are the long story arc of
tech. Have or acquire the moral authority to do case in point, Intel. And don't ignore the inevitable looking at you,
Digging a Moat in Industrials: Industrial markets are often mature and cyclical, so moat are frequently built or destroyed
via acquisitions. Look for small and complementary deals. Big deals in new areas can be deadly. Big fish in small ponds are
successful and rich. Thinks Scott Miracle-Gro in lawn care, Middleby in commercial kitchens, Graco in pumps and
Digging a Moat in Banking: This is a commodity business, so keep operating, deposit, and credit costs low. Controlling
operating and deposit costs means management doesn't have to "reach" on credit decisions: M&T, Wells Fargo, US
Bancorp, etc.
Digging a Moat in Consumer Brands: Look for longer product cycles to reduce fashion risks: watches vs. handbags vs.
shirts. The Holy Grail is maintaining exclusivity and generate volume: Polo, Tiffany, Coach, etc. Switching costs are low, so
never give consumers a reason to switch.
Management Acid Test: What are you doing to build the company's moat, or to widen the moat you already have?