Speaker 1Switching costs can cut both ways because if you have high customer switching costs, then probably your competitors do too. It's hard to get people to switch. You have trouble growing in the high switching cost industries a lot of times. Network effects are often held up as the end-all be-all of modes, but network effects can degrade. People leave the network, the value of the community diminishes, the distinction between radial networks like Western Union or nodal networks. It's complicated. And that's honestly one of the fun things about it is that over time, you start to, like everything in investing, develop pattern recognition. The great traders that you read about in Money Masters, they develop pattern recognition. I've seen this macro story before, and here's how it usually plays out. So I'm going to make this bet. Analyzing competitive advantage is the same thing. The more companies you look at, the more likely you are to say, okay, I think there's something here. Then you try to think through why. Is it a government approval? Is it a switching cost? Is it scale economies? There's some foundational attribute. That enables the company to withstand competition, defy the laws of economic gravity, sustain high returns on capital in a competitive world where, both in theory and empirically, most companies don't do that. Most companies do revert over time to cost capital.
Speaker 2I'm Ted Seides, and this is Capital Allocators. My guest on today's show is Pat Dorsey, the founder of Dorsey Asset Management, a $1.7 billion global public equity manager focused on companies with competitive advantages and long investment runways. Pat created Morningstar's Moat Research Framework and led its equity research efforts for a dozen years before launching his firm in 2014. Our conversation covers the nuances of investing in businesses with wide moats. Across quantitative analysis, switching costs, network effects, brands, management, alignment, capital allocation, and reinvestment runways. We then turn to Pat's application of moat analysis to his investing, including concentration, global scope, position sizing, decision making, and lessons learned. Before we get going, long-time listeners might remember my discussion of the lived experience of Joseph Campbell's business. We then turn to Pat's application of moat analysis to his investing, including concentration, global scope, position sizing, and reinvestment runways.
Speaker 1that had done that could be sourced to some kind of an intangible asset, like a brand or a patent or a government approval, high customer switching costs, like you see with databases, network effects, or scale advantages, cost advantages. Most of them fit in one of those buckets. And it was like, well, that's what the data says. Let's use that framework going forward.
Speaker 2Once you had those ideas, how did you then distill it into an analytical tool?
Speaker 1Boats were the lens through which we looked at every business at Morningstar. It was partially because we felt like it was a useful framing for individual investors who are most of our clients. It was partially also because, frankly, we had a business problem, which was differentiating our research to be totally blunt. Equity research is a commodity. You take the logo off the top and you don't know who wrote it. Morningstar was known for mutual funds. What, you guys cover stocks? What is this? I was scratching the intellectual itch, but also solving a problem. How do you differentiate the research that you're producing so people know that it's from you and not from somebody else? We decided that instead of trying to be all things to all people, I would argue most sell-side research is, that we would just have a point of view, the same way any buy-side manager does. And the point of view was that moats matter. Not that you have to invest in a business with a moat, but knowing whether a company does or doesn't have one is probably useful in some way, shape, or form. We looked through every company through that lens and tried to help the customers, which were mainly early investors. We looked through every company through that lens and tried to help the customers, investment advisors, RAs, and individuals understand whether this was a business that had durable competitive advantage or not. Doesn't mean it's better, doesn't mean it's worse, but it probably means you want to think about it differently as an investor.
Speaker 2When you went through the quantitative part of the analysis, what were the most important metrics that you used?
Speaker 1The data we were looking at from the 60s through the late 90s, software companies were not yet a big part of the investment universe. We had Microsoft, we had Oracle, and that was it. We had a simple return on invested capital metric. Today, I would argue return on capital is less useful as a touchstone for does a company have competitive advantage? Because if you don't have any capital and your denominator is nothing, it's pretty easy to generate a high ratio. It's just math. There's lots of cruddy software companies with high returns on capital. It's not as useful a metric because value creation in society has trended away from capitalized assets and is often created from expensed assets. Building a brand, you expense that. Hiring a bunch of developers and writing code, that's expensed. It's not capitalized, which is silly when you think about it because it's not as if every bit of code that, say, Amazon writes is useless after December 31st, which is the definition of what you expense. That's just patently absurd. But if you gave companies all this leeway on what to capitalize whatnot in their code base, all hell breaks.
Speaker 2Are there other important quantitative metrics beyond the original ROIC that you look at when you're trying to figure out if a company has a good moat?
Speaker 1No. I find it's best to stay away from that because you go down the route of, oh, it should have high margins. What about a distributor? Distributors are often beautiful businesses. They have relatively low margins, but they don't have a lot of capital employed. But they're great companies. So, okay, we can't use profit margins. It really comes down to free cash flow. Okay, fine. But what if they're reinvesting? What if they're putting capital back into high return projects that have a high NPV? Free cash flow may not be the best metric. Obviously, if a company has gone a decade with cruddy financial metrics, there's probably nothing much there. But the point is that the bulk of it is qualitative. Understanding what kind of price the company can take, if it has pricing power, or whether, in some examples, there's what the nomad guys called scale economies shared, where benefit is not taking price, but passing scale benefits along to customers. Costco is one of the canonical examples. Medline, which recently came public, is another great example of passing on scale benefits to customers. They're even saying, oh, gee, moats are all about pricing power. Well, no, they often are. It's squishy. And that's why the qualitative angle is more useful than a quantitative metric.
Speaker 2What are some of the other important qualitative angles that you look at?
Speaker 1It's going to depend on the business. Switching costs can cut both ways, because if you have high customer switching costs, then probably your competitors do too. Network effects are often held up as the end-all, be-all of moats, but network effects can degrade. People leave the network, the value of the community diminishes, the distinction between radial networks like Western Union or nodal networks, it's complicated. There's some foundational attribute that enables the company to withstand competition, defy the laws of economic gravity, sustain high returns on capital in a competitive world where both in theory and empirically, most companies don't do that.
Speaker 2As you looked at those businesses and that historical analysis that sustained that advantage, those high returns compared to those who had it for a while and then lost it. What are the distinguishing features that you saw in those two groups?
Speaker 1One commonality is what the lean community calls voice of the customer, always paying attention to the customer and adapting to their needs. That's where pricing power can become abusive. What they do is they enlarge the profit pool. That then says, oh, gee, this might be more attractive for somebody to come in and try and take part of those profits because by overpricing, you've said there's more money here to be garnered. You're seeing this right now with Adobe. There's an AI problem here. Had they not been so aggressive in pricing over time, would the customers be as willing to switch to new AI tools? It's an interesting counterfactual to think about. Those companies that have done well in riding through changes in their industries, in ecosystems, have generally listened to the customer, attempted to not add more than they've taken, but at least if they're taking five in price, adding three in value. If you're taking five in price and adding zero in value, over time, that catches up with you, I think.
Speaker 2How do you think about the power of brands when it comes to moats?
Speaker 1That's a lot of early investors, certainly mine, initial introduction to what is a moat from Buffett's letters a long time ago. I'm talking about the inevitable. I've historically invested less in consumer-facing businesses because I don't have a good feel for what a good brand is, but it's useful to kind of distinguish brands in terms of the classic Coke or Gillette, lowering your search costs. You go to the shelf and you see the label, it's what you want, and you don't have to spend a whole bunch of time thinking, what do I want? You just grab it. The consumer can decide to defect with no cost to you. If you say, I would rather try President's Choice Cola than Coke, you can do that, and if you don't like it, you go back. Big deal. If you think about a luxury brand, that's more consensual. I'm not wearing a Rolex because it tells time better. It's because I want people to know I have money. I'm signaling something, but that signal value is only useful if everybody else agrees that a Rolex has signal value. If I decide one day to say I'm going to wear some no-name watch that nobody's ever heard of that costs $200,000 because I want to signal my wealth, if nobody's ever heard of it, I don't know what to do. I'm going to wear it. We all have to agree. If I defect, there's a cost to me. If I defect out of that luxury positioning ecosystem, the cost is nobody gets the signal value because they've never seen or heard of the watch. That tends to make the luxury modes durable. Luxury hasn't done well recently, but I think a lot of that's because you've had a demand source in China drying up and alternative luxury brands being developed in China. The value of RMA is the same as it was two decades ago, wealth and signaling, I suppose, taste as well, of which I have little. So I've never understood brands that well.
Speaker 2Are there other applications of brands beyond that easier for choice and then this network signaling effect?
Speaker 1There's the stamp of approval. If I went up and started out Pat's bond rating agency tomorrow, I'm not sure anybody would care. Whereas, of course, Moody's and S&P, there's a value to that that's been developed over time. If people see that Moody's has rated the bond, S&P has rated the bond, they'll pay a lower interest rate than if the bond is rated by Pat's rating service or Ted's rating service. If you want to start up that as a capital allocator's adjunct, that signaling value is high. And that's another interesting, it's a little bit more like a luxury brand where if I defect out of that ecosystem and say, I would rather use somebody else's stamp of approval, I'd rather use Pat's bond rating. Nobody cares. You're not going to get the benefit of the rating.
Speaker 2I'd love to ask you about the impact of management. You start with the Warren Buffett line that. You want a business so great that any idiot could run it because eventually someone will. How do you think about the importance of management with moats?
Speaker 1That's been the biggest evolution in me as an investor over the past decade. When Dorsey Asset launched in 2014, I was probably 60, 70 moat and 30 management. So you want to weight things. And I'm probably the reverse today. That's largely because I've seen just how poorly people can behave and how much damage they can do to even a great business. We only need 12 stocks. So why suffer with the people who don't know what they're doing when you can partner with people who do know what they're doing? Management is hugely important. That phrase from Buffett has probably done more harm than good over time to a lot of investors in not interrogating the quality of management or underweighting signals that maybe capital allocation is poor, that management's incentives aren't aligned because they're so hyper-focused on the business. My attitude is why not have both good management and the great business? How do you go about assessing management? Gosh, talk about moats being squishy. This is even squishier. My biggest goal is to look for humility because it's easier to find management teams who are unlikely to blow up than who are likely to do amazing things. I'm mainly focused on avoiding that left tail. If you go back and read Theranos or Wirecard or a lot of the great corporate frauds, frauds or corporate hubris, like in the case of Enron, one of the common attributes is people who aren't willing to listen. When the company begins to head down a non-value creating path and there are voices in the room saying this is not a good idea, they don't listen. When I meet with management, I ask a lot of questions about what's a do-over. I used to use mistake, but then people get their hackles up. What's a do-over? What's something that you might have done differently in the past? Which board member gives you the best advice? Which of your immediate? Reports is the one you least hate to lose. And you can see how do people talk about their team? How do they talk about the people around them? How do they self-reflect on what might have gone differently? Or do they just think they're amazing and the business couldn't survive without them? Which is probably not true. It is probably a bad signal. That's one huge thing. Another one, which is less common in the U.S., but more common outside the U.S., is conflating the business and the person. There's an amazing Australian. It's a business I looked at many years ago where the CEO owned the headquarters and leased it back to the company. That was an artifact of how the company had started when it was a startup. Once you grow up, you don't need to do that anymore. It's economically immaterial, given the size that the company had become, but it indicates that someone is at the margin not making choices that benefit outsiders over themselves. If they're willing to let things slide in that way, what else is happening underneath the hood? What other choices? What other choices are being made inside the organization that you don't know about and you will never know about that could be leading the company down a path with left-tail results?
Speaker 2You mentioned alignment, and that's a great example of misalignment. Curious how you assess alignment at a deep level.
Speaker 1I versus we is one thing. If managers talk about the company as if it's them, as if they own the company, instead of owning a half a percent of it via options, which is usually the case, that's usually a bad sign, because that means they're more aligned with themselves than with external shareholders. Looking at incentive plans and corporate actions, are they aligning themselves with creating value for customers and shareholders or creating value for themselves? I've seen companies where they're domiciled somewhere, there's a large corporate headquarters, and new management comes in and they decide to move it to somewhere sunny and warm. You're prioritizing yourself over all those people who work for you who are going to have to either uproot, their lives, or find a new job. It's a tough one. It at least co-varies with humility. Even if they're not exactly the same thing, the Venn diagrams do overlap. By looking for a willingness to listen, a willingness to take outside counsel from either their management team, the board, a willing to reflect on their decisions and the path not taken, those generally take you down the path of alignment versus not. It's important because look at the example of CoStar. They killed it in commercial real estate data, then they killed it again in apartments. The pattern recognition as well, when they go into competing with Zillow, they're going to kill it again. We spent a bunch of time analyzing the business and management. Our guess was that they wouldn't shut down spend even if it wasn't working because they'd never experienced failure. They'd never had to pull back. The CEO in that case was successful, but for a founder, he'd largely had sold stock along the way. So he didn't retain a large ownership stake, in the company. If all that spend and competing with Zillow didn't work out, shareholders were probably going to suffer more than him because he'd been cashing out along the way. That fact pattern said, well, I'm not sure that the alignment is there. That's probably not somewhere we want to play.
Speaker 2There are a couple of dynamics you touched on with a founder CEO. That's one in CoStar, the I versus we. You can imagine getting conflated. How have you thought about founder run businesses?
Speaker 1I don't think they're any better than non-founder run businesses. It's an outgrowth of the degree to which Silicon Valley likes to self-promote on venture capitalists who are at heart promoters. We put founders on a pedestal. You remember when the Chesky founder mode talk or whatever it was went viral? I hate that. It's terrible. The skill set of a founder is very different than the skill set of a manager. A founder comes up with an idea and then needs to inspire people to give them capital and inspire early employees to work for them for profit. I think that's a very important part of the business. of a Danaher or a Transnet. dime or a constellation. It's a learned skill. You iterate, you go back and say, okay, what were our deal assumptions and how did they work out? What did we learn from that? What do we lean into? What do we change? Most companies don't approach acquisitions that way. For most companies, it's a large deal that's often defensive in nature, is something that's done infrequently, often because some investment banker shows up and says, this company is for sale. Are you interested? Generally approach it with skepticism and the evidence is usually in buybacks, deals that have not gone well and how do they talk about them and do they write them down? The evidence is there, you just got to look for it.
Speaker 2With a base rate that doesn't sound like it's all that good for the leaders of these businesses, how do you protect against moving towards the left tail in your assessment of one of these companies?
Speaker 1One is you look at the M&A history, what's worked, what hasn't. Did the deal make sense strategically and would they pay for it? Then what are the hurdle rates? I encountered companies where the goal of our acquisitions is to beat cost of capital by year three. Ooh, wow, that sounds great. Sign me up. But no, that is not an uncommon target. If that's the bar that management is measuring themselves against, they may think they're being successful in these deals. That's their prerogative. My prerogative is to walk away and look for a different business. What bar they're setting in terms of, I think that's a super important question for companies that are acquisitive, like what's your hurdle rate? How do you measure that hurdle rate? How often do you not meet the hurdle rate and what have you learned from that? Those are important questions. Simple things like when companies issue stock or buy back stock, there are also big tells looking at companies where when times are less successful for them, they build cash. And they sit on it. Then times are great. Of course, when times are great, the stock's probably up a lot. But now we have excess cash, let's buy back some stock. Probably not exactly the right behavior you want to see. But I would argue pretty common behavior too. Being thoughtful in terms of how they buy back stock and how they allocate capital. We buy back just to sop up our SPC dilution. Great. That's exciting. You're giving with one hand and taking with the other. It's not going to get me out of bed in the morning. That's where meeting with management and asking them some of these simple questions like, how do you think about buybacks? How do you think about dilution? What's your hurdle rate in M&A? That kind of stuff is not in quarterly calls. But the answers can be revealing in terms of, A, what the answer is, and B, have they even thought about it? I would argue there's more than a few companies where all this capital allocation stuff, purchasing stock or issuing equity, it's this afterthought. The CFO says, well, we should probably do this. And then managers go, oh, okay. And then the CFO says, well, we should probably do this. And then the But is it core to how they think about it, how they run the business? That's a tiny minority of companies, I would argue.
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Speaker 1One is privileging some moats above others. You often see network effects put on a pedestal. I see write-ups, this company has a network effect, as if you've just said this company will be a 30-bagger. Maybe. Let's unpack that network effect, see whether it has anywhere to grow. Marketplaces have great network effects. The trouble is, and you've seen this with eBay, you see this with some of the European online listings companies, once you get that market, you're going to see that it's going to be a 30-bagger. Now what? It's a great moat, but if you don't have anywhere to put the cash, maybe something with less of a durable moat, but more places to expand, is going to be the better investment. You can't say, I want the widest moat possible. Then the company may not grow. That may not be great for your portfolio. That's one misconception. Another one is, I see this a lot in write-ups where they say this brand is strong, clothing or restaurants, where the switching cost is low. Early in my career, Abercrombie & Fitch was the stock. I never understood, why is it? I have no fashion sense. Why would you go there versus somewhere else? Abercrombie & Fitch had a great run, and then eventually the brand faded. Non-luxury brands require care and feeding. They require constant maintenance. Just say, this company has a brand. Okay, let's unpack that. Those are a couple that come to mind.
Speaker 2I'd love to turn this back to your path. You're doing all this work for a long time at Morningstar. At some point in time, you decide to start Dorsey. Take me through that trajectory.
Speaker 1We became a victim of our own success at Morningstar, or at least I did, in that our original clients, because it was Morningstar's core audience, were fee-only RIAs and individuals. As we were covering more companies, we began getting inbounds from mutual funds and institutional investors saying, hey, I like this longer-term mindset you guys take relative to the sell side. I like this moat framework because it's interesting. I'd like to subscribe to your research. We were writing 500-word tear. They wanted more, which is reasonable. They wanted analyst access and access to our valuation models, just like you would to the sell side. You had to build out a whole product for that. I was sowing the seeds of my own destruction, but it was also immensely gratifying because the people I'd grown up learning from as investors were now getting some value out of a service that I'd helped create, which was cool. But those folks are much higher touch, and I was the one doing the touching. I was the one on the road with the salespeople. I was the one visiting clients. I was the one giving talks. I wasn't in the office very much. The last 15 people we hired while I was at Morningstar, I never even interviewed. They literally couldn't get me on the schedule. I began to feel like a talking head, like a pundit, where I was repeating what other people were saying without having any hand in the creation of it. Being put out to intellectual pasture at age 40 is not a good thing. I was like, look, I need to be in the office more. I can't be on the road as much. I said, this is not the best path for me over the next 15, 20 years. I left Morningstar in 2012. A couple of our clients, we'd talked about me going to work for a big 40 act somewhere and starting up my own fund. I didn't know the rest of the investing world. Morningstar is this one little corner of investing that deals with mutual funds. There's an entire world of types of vehicles and types of investing, and types of clients that I had never spent any time thinking about or interacting with. I figured if I'm going to make a decision over the next 15, 20 years, I should learn a little bit before I do that. I spent a couple of years working for a small high net worth firm while I figured out what the next 30 years was going to look like. That's when I became more aware of the endowment and foundation community as one that not only doesn't fear concentration, but also is generally more willing to take a bet on people early in their careers because they realize often when you're smaller, that's when the best returns show up. A mutual fund world, you need to have a 15-year track record. I said, it might be the best route to go down because I might get a client in the first 10 years, which would be good. That was the journey to launching Dorsey as a concentrated firm focused on the ENF community in 2014. When you took
Speaker 2these years of research into moats and how to think about them as great investments into an investment fund, what did you decide you wanted to do? Concentrated because that was
Speaker 1something I hadn't had the opportunity to do at Morningstar because we covered 1,700, 1,800 companies. You can't get that in depth on any of them. Because moats are qualitative, you can have more confidence in the non-obvious ones when you are able to have the time to do the work, to talk to customers, to talk to former employees, to go to the trade shows, all the usual true leather stuff that we know about. You can't do that in a 50-star company. Stock portfolio without some gigantic team, which I didn't want. Concentrated was the only way to go in terms of the structure. We were long only because I'd never shorted a stock in my life. I would be dangerous shorting. That was never on the table.
Speaker 2What did you decide were your favorite moats to identify?
Speaker 1We've certainly leaned away from consumer-oriented moats, consumer brands, CPG, luxury, because I don't know that I have as good of a pattern recognition there. And I don't know that I'm going to have the confidence in those moats to stick with the business when the chips are down. B2B businesses, you can talk to a dozen customers, and if you get a similar story about the value of the product or service, you can reach out to them. confident that you're going down the right track. Consumers, you would need to do larger surveys, larger sample sets, and that's technically complicated. Big picture, it's when the company has the ability to reinvest back into the moat that we find most interesting because then that whole capital allocation conundrum that we discussed earlier becomes moot. You don't have to worry what will they do with the money they're generating because there's an obvious thing to do, which is put it back into the business. And it's often at a higher rate of return. How many money managers have done 20% returns on capital over a decade? Not a lot, but there are tons of businesses with 20% returns on capital. If I've got a choice between company A that is constantly giving me back the money and then I need to go reinvest it in a super competitive public equity market, or company B, which can plow it back into a 20% return on capital internal project, the math is obvious which one I ought to be choosing. Not only am I getting better returns with B, I'm also taking risk off the table because they're less likely to go out and do a dumb acquisition or buy back stock at the wrong time because they have an obvious place to put the money. That reinvestment runway is something we look at a lot. It helps A, keep us out of trouble, and B, it leads you more down the path of the companies that are in growing markets where there's often less competition because if the pie is growing, you're not fighting as much for every scrap that's available and where you've got that ability to reinvest.
Speaker 2When you had a universe of 1,700 companies you're following to get to 12, what filters have you used to narrow that lens?
Speaker 1To be clear, we had to cover the waterfront at Morningstar. That 1,700 included utilities and oil and gas and life insurance and auto parts and auto OEMs, which are all not good. Those are easy ones to just throw out. Step A is, is the industry structurally attractive or not? This is one of the hard truths that early investors have to learn is that some industries are tough. You got to respect the managers who are in them and got to respect the CEOs who try to make money there. Making money as an airline is hard. Making money as an auto parts company or a life insurance company or an oil and gas, you're a price taker. Huge parts of your future are not under your control. You can invest in these businesses and do well with them if you don't have the money. You develop pattern recognition and understand that world. They're not conducive to creating modes. Those are areas that we largely ignore. The second is, can we understand it? We are global. Historically, about 30, 40% of our portfolio has been outside the U.S., but we're a bunch of folks raised in the U.S. and in Chicago. There's smart investors in Sao Paulo who are going to understand a local drugstore chain a lot better than we are. You have to not get over your skis in thinking you can understand it. You have to understand it. Better than somebody who's lived in that culture all their lives. We definitely avoid stories where the moat is based on local tastes or local regulation, where we're likely to be the patsy at the table, which is not a fun place to be. That shrinks the universe down pretty quick. Liquidity matters too. We're about a billion and a half, and with 12 stocks, you can do the math on what kind of liquidity we need. That shrinks the world quick. There's probably 300, 400 companies in our universe. We're about a billion and a half, and with 12 stocks, you can do the math on what some companies that are investable for us.
Speaker 2How do you think about the relative merits of a company inside the U.S. where you understand the structure, understand the culture and businesses outside the
Speaker 1U.S.? There are two benefits that U.S. companies enjoy that non-U.S. companies do not. One is called the SEC, which is the nastiest securities regulator on the planet, which is great for us as investors. If you see a company that had a choice to invest, anytime you look at a software and it's listed in London, and maybe it's not a super U.K.-centric company, you've got to ask, why didn't you choose to list in the U.S.? Why would you not list here and get the higher valuation and access to talent? You saw this with BaFin and Wirecard. Good Lord. Unbelievable oversight by the regulators. If something's listed in the U.S., you're probably going to get better disclosure. You've got a higher level of confidence that there's not related party transactions or hooey going on. That's a great thing for us as investors. The second is, on balance, as overpaid as they are, and 99.9% of American CEOs are overpaid relative to the value they create, they're generally better managers and they're generally better at capital allocation than you see outside the U.S. You don't tend to see a U.S. company buying back stock and paying a dividend. That's weird. I see that all the time outside the U.S. because dividends are sacrosanct in other investing cultures. You see buybacks happening as well. It doesn't make any sense. Some of that also is, generally speaking, corporate talent comes to the U.S. because they get paid a hell of a lot more. If you're a good manager in any industry, running a U.S. company, you're probably going to make 5x what you would make even running a sizable European company. That doesn't mean that we don't have idiot managers in the U.S. We do. That doesn't mean that there aren't talented executives in the U.S. I've had fewer head-scratching meetings with management in the U.S. than I have outside the U.S.
Speaker 2As you walk through this, it sure sounds like non-U.S. could be in the Buffett too hard pile. What does it take for a non-U.S. business to get you excited?
Speaker 1It's got to be a phenomenal business, and they do exist. Our largest position right now is ASML, a monopoly and a key part of the semiconductor value chain. That's hard to overlook. They're managed, in fairness. It's not like they have this great monopoly. They've been good capital allocators in the U.S. and they've been good capital allocators in the U.S. and they've been disciplined over time. We've done a lot of work on the aerospace ecosystem with Safran and Rolls. You can argue about management at Safran to some extent. The disclosure is not so good. But at the end of the day, they've got one half of the CFM56 franchise that is on a lot of 737s and it ain't going away. I don't want to say that the bar is higher. It's more that these tend to be global businesses that we're looking at that happen in the U.S. and they're not going to not be listed in the U.S. It's important to keep an open aperture because I do see mispricings a lot where the U.S. listed analog might be trading four or five turns higher than the European analog because there's large pools of capital in the U.S. that don't invest in non-ADR securities. Building the operational infrastructure to enable you to own local common, even if that's only two out of 10 opportunities, you participate in, that's two you wouldn't have had if you hadn't bothered to do that. It's about keeping an open aperture but not lowering the bar.
Speaker 2I'd love you to take me through your research process. There's so many nuances you describe in how you like thinking about these businesses and management teams. How does that play out within the organization?
Speaker 1Everything starts with the creatively named quick idea. It could be a few sentences. It could be a page. What's interesting about this business? What does it look like the moat is and what could the opportunity be? Super easy. Maybe a third of those, a green light for a first pass memo, another creative naming, which is about a week's worth of work where we try to look at critically the vector of the moat. Is the competitive advantage widening or shrinking? What are the key debates? What are the areas where we might have a variant perception on this business? What's the runway for growth? Because that thing we prioritize and what we look at, any red flags on management and kind of a scratch valuation. That gets posted to our internal research system. People ask offline Q&A and then we meet on it. We tend to do a lot of offline Q&A on memos because I find that it makes the meeting more robust and more discursive and more of a back and forth because you're not asking, oh, I didn't see what segment margins are for that thing. What was that write-off in 2014? We take care of that offline. It makes for a more robust conversation. And it's about, is this the droid we're looking for? If it is, we try to figure out what the correct research vectors are. Is it talking to formers? Is it interrogating clients? Is it understanding their supplier base? It's different for every company. You have to not approach every company with a template, but say, okay, now that we've understood what is likely to be important for the thesis, how do we answer the key questions? Then go out and do that.
Speaker 2You've had next to no mention of valuation, just a little scratch here and there. How do you think about valuation of these businesses?
Speaker 1Coming out of Morningstar, which is a little bit more of an academic flavor to it. I was canonically focused on demotor and style DCF. That wasn't good because people have used multiples for a long time to great success. There's a reason for that. Today, we tend to use multiples as our primary touchstone and do a three-stage DCF as a backup to see where there are differences. The thing that a DCF is quite poor at, even though people think it's long-term oriented, is that mathematically a DCF assumes that returns on capital fade to cost capital. But if we're looking for moaty businesses and we're trying to only own businesses that are likely to, quote unquote, beat the fade and sustainably have high returns on capital, the DCF may not be the best tool because it might undervalue the business. And so you wind up suffering an opportunity cost because you don't invest in things you should have. It's important to be Catholic can mean not just the church, but Catholic in terms of open-minded in valuation. Commercially, how has the market historically looked at this company? Is it EV-event? it to? Is it EV-EVIT? Is it free cash flow? Empirically, that's what people seem to care about. Let's not fight city hall. Look at that and make sure that we understand where the multiple is on that in that framing, but then back that up with a very thorough three-stage DCF. So we understand that those two are far apart. If they are far apart, you probably got a problem. They should be in the same neighborhood.
Speaker 2When you bring this work together, what goes on in your head when you're deciding to bring a new name into your portfolio?
Speaker 1The first thing is opportunity cost. You've got a set of things that you own where the theses have, hopefully in many cases, progressed along the way you thought, and probably in some cases, not progressed the way you thought they were going to. You've got expected returns for all of them. You're expecting to make Z per year out of companies A, B, C, and D in your portfolio. The hardest thing is to be careful about endowment bias. There's a lot of empirical, legally demonstrated behavioral finance evidence that we overvalue what we own. The famous coffee mug study. It's easy to do with your portfolio as well. We're familiar with this company. We've owned it for a while. You don't put it in a level playing field with the thing that you don't own, but that you have done a lot of work on. Low turnover sometimes gets put on a pedestal. The platonic ideal of the investor is you buy a few stocks that are wonderful and compound, and then you sit around reading annual reports for 10 years and watch the money roll in. The reality is, of course, very different. It's hard to admit to clients, well, we were wrong about this, or we found a better opportunity over here because you might look indecisive. Your turnover numbers might go up. If you have taxable clients, they don't like that. For us, it's does the thing that we don't own offer better returns or portfolio diversification characteristics that improves the portfolio? You shouldn't change the portfolio unless you make it better. Making it better could mean a higher return. That's a good thing. Could mean introducing factor diversification. That's a good thing too. Swapping out something that has a slightly lower expected return, but offers good factor diversification or is acyclical so that will be available as a funding source when everyone decides the world's going to pot. That's valuable. You've made the portfolio better. How have you thought about position sizing? Our max size is 15. There's no magic to that number. That means that maxed out, we'd be about eight stocks. We've historically owned between, 10 and 15. 15 is a hard number. One in, one out. Being a little bit concentrated is being a little bit pregnant. You either are or you aren't. You see a lot of people as more capital comes in, they become less concentrated over time. And we've made a promise to our investors, we won't do that. Max is 15. And that would be a business where we think management's an A plus. We think the mode is phenomenal and there's a runway for reinvestment. And the expected return is exciting, well above our 15% hurdle rate. Otherwise you shouldn't, own a very large position. Even if management's great, the mode's great, and the runway's great, if it's priced appropriately, we either shouldn't own it or it should be a smaller position. That's pretty simple. We've started some things more closer to the nine or 10 level. Most things will start closer to six or seven, just to give us dry powder. If, as does happen, things don't go the way you expect, you need to average down.
Speaker 2You mentioned earlier on that the most important aspect of a CEO of a portfolio company, is humility. I'm curious about the lens of balancing the confidence and conviction you need to have concentrated positions with the humility that you might be wrong.
Speaker 1The line between confidence and stubbornness in our industry is thin. You have to have confidence to own equities at all. It's a residual security. We're the lowest guy on the capital stack. Everybody gets paid before the equity holder. There's a wonderful book by Elroy Dimson called Triumph of the Optimists about the history of equity returns. That title is telling because it's Triumph of the Optimists. It was- The optimists who believe the future would be better than the past and owned equities, as opposed to owning bonds or something with more security. You have to be an optimist. You also have to be willing to listen to disconfirming information and be humble enough to say, okay, I was wrong. That original hypothesis I had, the weight of the evidence says, no, that's not the way the world's going to play out. That is a decision better made sooner than later, in most cases. One thing that helps with that for us is that we've a team-based environment. You're less likely to miss a valuable perspective if you invite debate. If you listen to the people around you, if you actively solicit their opinion, if they know that opinion is valued, if you ask them and then never act on that, then it's an empty ask. Framing conversations as truth-seeking helps as well in staying humble. A lot of times debates can be about who's right and who's wrong. That's a dangerous way to approach a conversation in investing because the goal is not to be right or wrong. It's to iterate closer to the truth, which is probably unknowable. Framing it as every debate being truth-seeking in the service of making a better decision for the client, as opposed to proving somebody right or wrong so that you score political points or they get more of the P&L structurally enables a bit more self-reflection and humility.
Speaker 2What ends up being the difference between something that's in your portfolio and something that is really close, doesn't quite make
Speaker 1it in? Sometimes it's the personal comfort level because at the end of the day, when the numbers are flashing red and the news is bad, I've got to make a decision. That's my job. If I don't have a good feeling about the business, if there's something nagging at me about it, whether it's management or the business model, the analyst can do all the work. They can be confident. They can line up correctly. But if I'm likely to make the wrong decision when making the right decision is valuable, we should know. It's almost a personality aspect. The PM's got to be comfortable with everything in the portfolio. That often can be a little bit of an edge case. Another one can be confidence in the runway, things where the business is unlikely to grow a lot, but might have a great moat and a great valuation because then I'm going to have to do something with the capital. Once it we've made our nut, now I've got to put the money somewhere else. That relative to a business that has reinvestment opportunities and is more likely to be able to find incremental things to do with its capital, that's probably a better place to put our capital because we're likely to own it for longer. And we're likely to not have to replace it in X amount of time once it re-rates, which then frees up research resources to find more businesses like that, as opposed to having to continually buy things at 10X and sell them at 15.
Speaker 2If you look back over your history, what have been the drivers of your sell decisions? Being wrong, probably the biggest.
Speaker 1The sell decisions when the stock gets wildly overvalued, you've probably made money along the way. That's not a bad thing. We haven't had a lot of those. The longest standing position in our portfolio is Meta, which we first bought in 2015. It's never gotten wildly overvalued. It certainly got wildly undervalued at one point in late '22 when it was 10X EBIT. I don't think it's ever traded above low 20s EBIT. There's some reasons for that. It's a less predictable business than some because it has to follow different trends in social media and how people like to consume their social content. So it's had to evolve over time. And so it's not inevitable in that sense. We've never had to sell that on valuation. Most of our sales have come because we got it wrong. The thesis was wrong, management did something we didn't expect, or we thought they were better capital allocators than they turned out to be. The bulk of our sales have been driven by errors that we needed to correct.
Speaker 2In this dozen or so years you've been managing money under your own umbrella, what have been the biggest lessons that you've learned from what you knew when you started?
Speaker 1The biggest one is you can never set the bar too high in terms of the quality of the business or the quality of the management team. Most of our errors have come from compromising on one of those two. That either we thought this was an A business and it turned out to be a B minus business, or that we thought this was a phenomenal management team. And I would say early on, I definitely fell into that founder mindset of giving founders a pass. That's resulted in some errors. You can never set the bar too high because, especially in a concentrated portfolio, you don't need that many ideas. Why compromise? Definitely have in the past, and that's resulted in some errors over time. You can't set the bar too high. That's the biggest one. How about any others? Weird is definitely not wonderful. I learned that early on. When the good ideas staring you right in the face. You should take that. Selling sooner than later is another biggie. It's hard to admit an error. As humans, we don't like to do that. You have to write about it. You have to talk about it with clients. What that means is that people often wind up hanging on to positions where the thesis is not going the way they expected for too long because it's psychologically hard. You have to admit you're wrong. You have to talk about the error. History shows, certainly our history does, the history of most portfolio shows that when you think the thesis isn't going right, when the weight of the evidence says this is not going to work out the way you expected, as opposed to hoping it changes or hoping an activist shows up and saves your bacon, admit the error and move on because there's other ideas. There's lots of other things you can do. Why not iterate towards something you're more confident in than something that has probably gotten cheaper because the thesis is not going the way you expected, but where the likely vector is negative. Admit the error. Take your 12, 15, 20% law and find something else. It's hard to do because you've probably written about the stock and you've expressed confidence in it with clients when you're you first bought it. Now you're saying, whoops, screwed up. But you have to. That's another big lesson. Recognizing errors, underwriting errors sooner than later, staying on the right side of that confidence and stubbornness line.
Speaker 2Can you talk more about that weird isn't wonderful?
Speaker 1That's a lesson from our early years where we launched with a whopping 3 million in assets under management. It wasn't much. We got a couple of institutional investors relatively early, but we were still pretty small. My thinking is, hey, we're really small. We can buy smaller businesses that are not well-known and undervalued. Power can generate great returns. The risk with that way of thinking is that sometimes businesses are small because they've never succeeded. There's a reason why they're small. There's a psychological aspect of you're a newer manager and you're trying to sound different. You're trying to add value for the client and say, oh, I own all these things nobody else owns. Isn't that neat? I'm going to be a diversifier in your portfolio, or I'm not going to own a lot of NVIDIA or whatever it might be. All that matters over the long run is returns. That's all that matters. If you've got the weird off-the-run business that's going to require some leaps of faith and maybe not offer you great liquidity, and you've got an amazing mega cap staring you straight in the face at some screamingly cheap valuation, it doesn't matter if everybody's heard of it. That's where you're going to generate the returns. Put the money there. That was a wake-up call I had. So the first couple of years were okay, but not great. In early 16, I wrote an internal memo called Better. It was just basically, we can be better. We are unconstrained. We have a couple of wonderful clients who trust us. We don't need to be doing weird things just because they're weird. If the best way to generate returns for our clients is obvious, we don't sound cool talking about it because we didn't have to get on a plane for eight hours and go talk to a company in some weird domicile. So what? The goal is to make money. Unusual ideas often get privileged in our industry. If it's unusual, if it's hard to understand, if you had to do all this detective work on the balance sheet to find out the value of this hidden asset, that is a sexier pitch for the client than mega cap X at 12 times earnings. That might be the better route to making money.
Speaker 2So both with those unusual ideas and the idea of selling, or selling earlier, have this impact on what you communicate with clients and what they understand your methodology and story to be. What have you learned about the business of investing and relating to your clients so that they can be with you for the long term?
Speaker 1You can never be too transparent. That's the biggest lesson. I've met investors who won't write about positions. You'd have to pry information out of them about the companies that they own. It's not like that. Somebody investing with you as a manager, they have a harder job than you do investing in equities. When I invest in a company, I have years of audited financials. I can talk to customers. I can talk to suppliers. I can talk to performers. When someone invests with us or with any other manager, they're betting on the person as much as anything else. There's a lot that goes on in that person's head they don't know. The more you can be transparent about why you're making decisions, what decisions that you're making, it engenders a huge amount of trust. Because it's rarer than it needs to be in our industry. We don't play in long, short world, but most of our clients have SMAs. They can see everything we're doing on a daily basis. Great. Fine. It doesn't bother me. I've talked to investors who are like, I would never allow an SMA. Now the clients can see what I'm trading. Why does that matter? Transparency goes a long way to creating trust. The other one is, and this goes back to our pricing power conversation earlier, not pricing in an abusive manner. We started with SMAs and then we launched a fund. We were writing up the fund docs and the lawyer was like, so yeah, what expenses are you going to run through? And I was like, what? You couldn't have the clients pay for your blueberry? Really? That's ridiculous. That's what the management fee is for. You see that all the time. What that communicates is we're together rowing in a boat to generate returns for you, my client. We're sharing in the rewards in an equitable fashion. When you do it in a less than equitable fashion, like running too many expenses through the P&L or whatever it might be, again, it doesn't engender trust and
Speaker 2alignment. When you've given all that transparency, where have you seen disconnects in how you're thinking and what the expectations of your investors have been?
Speaker 1Certainly because I'm more prone to talk about my mistakes in a meeting and I'm more prone to help people understand where things have gone wrong and then how we've tried to improve our process or my thinking as a result. I've had at least one client say, we have to always calibrate when you come to talk to us because you leave and then everyone says, why are we invested with this guy? And he has to remind the team that, hang on, everyone's making the same number of mistakes that he is. They just don't talk about it. So there is some calibration that has to happen on that front. I've tried to get better about this. You're helping clients realize that we're making the same number of mistakes. Sometimes there's an incentive to overweight patients because great investors are supposed to be patient. My favorite holding period is forever. Famous quote from Mr. Buffett. In a changing world, especially if you're investing in growing industries, because growth usually is accompanied by change, I'm not sure your favorite holding period should be forever. Your favorite holding period should be as long as the thesis holds up. If that's forever, great, you're a genius. Good for you. But it may not be. Your favorite holding period should stop as soon as your underwriting assumptions cease being valid. Your holding period should stop right then. We canonize this ideal of the guy sitting around reading annual reports, watching the companies compound and not changing the portfolio at all. Some people can do that. I can think of investors who've had low turnover and have generated great numbers. They made some great choices on building a great portfolio. So it's a valid way to invest. But there are biases around the starting point. What was the market environment at the time you started your investing? And that can lead to lower turnover because you just had a great opportunity set then. Could also just be maybe those folks are in the half of 1% and I'm in the top 20%. You don't want to damage the client by trying to be someone you're not. By striving to be that canonical super low turnover investor, if that means you ignore data or underweight data, and don't sell when you should, you're not doing anyone any favors.
Speaker 2After having done this for a dozen years, what are you hoping to achieve in the next dozen?
Speaker 1I'd like us to be a slightly bigger, only slightly, and better version of what we are right now. It's that simple. Some of the things I've learned since our big drawdown in '22 give me some confidence that the next decade might look even better than the past, because I'm a better investor today than I was in 2014. We've got a good starting point, we've got a good start, we've got a good structure. Investing is a craft. It's not a profession. It's like woodworking or glass blowing. There is no perfection. You're always getting a little bit better at what you're doing every time you make a decision. Every year, try and get a little bit better at who we are and what we're doing. Hopefully 12 years from now, I'm 12 units better than I am right now.
Speaker 2Pat, I want to make sure I ask you a couple of closing questions. What was your first paid job and what'd you learn from it?
Speaker 1Slinging pizza at a Sbarro in the mall. I remember vividly wearing my boat shoes. They had these white soles. Those are the nicest shoes I owned. I remember going for the interview in the food court of the mall and being nervous. I wound up slinging pizza for a couple of years there. If you're going to work fast food, pizza's pretty good because there's no grease. I had friends who worked at McDonald's. It just got into their pores. It's just awful.
Speaker 2What's the best advice you ever received?
Speaker 1I was sitting down with another investor in 2013 in Omaha, at Mr. Toad's. I remember exactly where it was. He said, "Pat, why haven't you launched yet?" That was the best advice I ever received was, "Get off your tail and launch." What's your biggest pet peeve? In general, rudeness. People who are so self-involved or self-centered that they don't think about the people around them and are rude. Life is too short. Don't let the door slam into my face. Hold it open for me. Or do the same for the person behind you. Those tiny things make life more pleasant and enjoyable. What's your biggest pet peeve? Investing. It's probably some of the parts' valuations. They're absurd. If it's a company that's clearly articulated, "Hey, we're going to break up or we're going to sell off this division or whatever," but if it's a company that has given no evidence that these disparate parts will be separated, you can howl at the moon all you want. But it's never going to get realized by the market. I've just never understood those. If you're an activist, sure, and you can fight to get on the board and break up the company, great. But if it's got passive minority investors, who might own one-tenth of one percent of the company, why does the world care that you think some of the parts is X and the stock's trading at Y?
Speaker 2All right, Pat, last one. How's your life turned out differently from how you expected it to?
Speaker 1Completely and utterly. I didn't grow up in a family of entrepreneurs. I didn't grow up in a family of investors. I didn't know this profession existed until I was out of college. There was absolutely no way I would have predicted where I am today 20 years ago. No way at all. There are people who grow up around entrepreneurs. They grow up around investors, or they go to college and everyone's going into iBanking or private equity or whatever. and to have a feel for what this looks like, I had no idea. It's all been unexpected and learning on the fly in a lot of ways.
Speaker 2Pat, thanks so much for taking the time to share all your wisdom about moats. Thanks, Ted. Thanks for having me. Appreciate it. Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com where you can access past shows, join our mailing list, and sign up for premium content. Have a good one and see you next time.
Speaker 3All opinions expressed by Ted and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast.
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