Invest Like the Best with Patrick O'Shaughnessy - Pat Dorsey - Buying Companies With Economic Moats - [Invest Like the Best, EP.51]

Episode Date: August 22, 2017

My guest this week is Pat Dorsey, who was the longtime director of equity research at Morningstar, where he specialized in economic moats: sources of sustained competitive advantage that allow a few companies to deliver huge returns over time. Several years ago he left Morningstar to form his own asset management firm, Dorsey asset management, and build a portfolio of companies with wide moats like those he studied at Morningstar. And while moats are critical, equally important is how companies allocate the capital generated--or made possible--by the existence of the moat.   A special thank you to Brian Bares who introduced me to Pat, and to Will Thorndike--an earlier guest on the show. In the vast majority of conversations you hear on this show, I'm meeting the guest for the first time. I mention this to encourage you to connect me with anyone whose story or way of looking at the world might resonate. Always feel free to contact me with ideas.   Pat and I begin our discussion with the key differences between the sell side and the buy side, and then discuss all aspects of moats and capital allocation.    For comprehensive show notes on this episode go to http://investorfieldguide.com/dorsey For more episodes go to InvestorFieldGuide.com/podcast. To get involved with Project Frontier, head to InvestorFieldGuide.com/frontier. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag   Show Notes 2:23 – (First question) – Transition from the sell side to the buy side and the biggest surprise  3:40 – What is a moat  5:16 – What part of the stock market universe has a moat  6:57 – Pat’s framework for identifying moat, starting with intangibles  8:32 – The power of brands  9:44 – what chance does an upstart have to come in and usurp a well-established brand    12:24 – Switching costs as part of the framework for identifying a moat  14:55 – The third component of identifying a moat, network effects, and what businesses should do to effectively build one  17:29 – Last component, cost advantages/economies of scale  19:29 – How do you analyze these four components into an investing framework that can be built into an actual strategy  21:13 – How does Pat think about this from a mis-pricing standpoint  23:37  – How does Pat incorporate current price of a company in consideration for future returns when pricing a moat  25:39 – How should a company with a moat operate to protect that characteristic, especially when it comes to their capital allocation  26:51 – Which characteristic of a moat does Pat find most intriguing  30:35 – What makes for good and smart capital allocation  35:58 – What is Pat’s process for identifying the best investment opportunities  38:38 – What are good economics when looking at a company  41:03 – If Pat could take any business, but have to swap leadership, what would he choose.  44:13 – Back to his process of finding investment opportunities  46:05 – Kindest thing anyone has ever done for Pat   Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

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The views expressed in this podcast do not necessarily represent the views of CFA Institute. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is a principal and portfolio manager at O'Shaunacy Asset Management. opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect

the opinion of Oshamously Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Oshonof the asset management may maintain positions in the securities discussed in this podcast. My guest this week is Pat Dorsey, who is the longtime director of research at Morningstar, where he's specialized in what we call economic moats, sources of sustained competitive advantage that allow a few companies to deliver huge returns over time. Several years ago, he left Morningstar to form his own asset management firm, Dorsey asset management, and build a portfolio of companies with wide modes like those he studied at Morningstar.

And while modes are critical, equally important is how companies allocate the capital generated or made possible by the existence of the moat. A special thank you to Brian Bears, who introduced me to Pat and also to Will Thorndyke, an earlier guest on the show. In the vast majority of the conversations you hear, I'm meeting the guest for the first time. I mention this to encourage you to connect me with anyone whose story or way of looking at the world might resonate. Always feel free to contact me with ideas. Pat and I begin our discussion with the key differences between the sell side and the by side and then discuss all aspects of moats and capital allocation.

Please enjoy our conversation. Pat, well, I thought a fun place to start would be the transition from the sell side to the by side. I'm always intrigued by people that cross that threshold. And so I'd love to hear what was the most surprising and or difficult thing during that transition phase. So there's two big differences in going from the sell side, which I promised not to take umbrage at, given that we were an independent firm and not commission based on what you start, but that's all right. I mean, we're selling equity research. On that side of

the street, you're paid to say yes. On the by side, you're paid to say no. That's the simplest answer I can give because if you're selling research, everybody wants an idea. Everybody wants an idea, what you got, what you got, what you got, what you got. And on the buy side, you're paid to not lose money. You're paid to do a small number of smart things, which means you have to say no to a lot of stuff. And I think the second big difference is that on the cell side, there is no sizing.

Everything is binary. I like it, I don't like it. It's a buy, it's a sell. But it's much harder on the buy side because it's a, is it a 5% position buy? It's a 10% position buy. Is it a buy all 5% now? is it by half and wait? It's a much more nuanced process than just do I like it or not.

We're going to spend most of our time talking about your process for evaluating businesses, which was rooted in your research on the sell side. So you developed Morning Stars or led the development of Morning Stars moat ranking or I don't know if there's a specific name, but effectively a look at how defensible an economic moat is for stocks around the world. And so the framework that we'll follow today is first to talk. talk about what the hell a moat is. Everyone talks about moats, but it's kind of hard to dimensionalize or understand what that means. And then two, capital allocation and sort of how the market mispriced moats. So we'll begin with moats themselves, a term popularized,

I think, by Buffett. I'll let you begin by just describing what that might mean, and then we'll get into how to identify different kinds of moats and what they might mean. I mean, the simplest way thinking about it is it's a structural characteristic of a business in structural meaning inherent to the business. You cannot separate this characteristic from the business itself that insulates the business from competition. That's the simplest way of thinking about it. You can't think of Tiffany without the Tiffany brand. The two are one and the same. You know, you can't think of SAP without thinking about switching costs. It's really hard to rip the stuff out once you have it. And so that structural attribute is what gives the business leeway to reinvest capital at high rates of return.

not without competition, but with competition, we've been making it more difficult for competition to do what economic theory says it should, and which generally does happen for the vast majority of businesses, which is drive down above average returns of capital. So the return on invested capital is an interesting way of thinking about moat, right? And, but the reinvestment potential is a key attribute of this as well. Michael Mobus and others have done really interesting research on the mean reverting nature of returns on invested capital, that they do mean, revert, but not necessarily instantly or it could take up to 10 years. Could you give a sense for kind of what part of the stock market universe might have in

percentage terms or something like that, might have one of these kind of moats that we talk about? Oh, sure. And that's a great question because I think it's something that's utterly undiscussed in classical finance textbooks, which is that not all businesses are created equal. And it's also not something you really get from the sell side because the sell side is full specialists who are paid to say, of the really awful companies I cover, this is the least awful. And that was, in fact, actually, my personal frustration with the Michael Porter 5 Forces work that led me to develop the moat work at Morningstar, which is that Porter's role was writing

for business owners, and he was a consultant. And you don't gain business as a consultant by narrowing your market and saying, if you run an auto parts company, you're host, just do something different. You want auto parts customers, right? And so the idea there was maximize, even if you have something in an awful business. Whereas as an investor, well, you can just skip the business. You don't have to invest. And so it's a critical, I think, thing to remember that business quality, economic modes are not normally distributed across the market.

There are some parts of the business, consumer package goods, enterprise software, that just have competitive advantage all over the place. And there's plenty of others, life insurance, commodity chemicals, pick your area, that just stink. They're just really hard businesses. So let's talk about your framework for identifying and measuring moats, kind of four key categories. And maybe we can start with intangibles. So what intangibles might represent a moat? And throughout all these questions, I'm also curious to hear your opinion on things that might signal or look like it might mean a moat, but in fact it's sort of like fools gold. Yeah, so we'll start with intangibles.

How might companies, and this is relevant for business owners too, I think. How might companies build or as an investor identify a moat in intangibles? Yeah. And so, you know, the intangible asset is just what it sounds like. It's not on the balance sheet, but it gives pricing power. So you can think of a brand, you can think of a patent. You can think of a license, to have a landfill or a gravel pit or to make a particular type of aircraft part, all of which are intangibles, but which give the owner of that

intangible pricing power. And I think the key thing to be wary of to address your fool's hold question is companies love to talk about their brand. They love to say how well-known they are. But if that brand doesn't translate into pricing power, it's frankly not worth what the company spends to maintain it. And so you always have to be thinking, you know, what advantage does this brand give you? Does it allow you to raise prices? Does it allow you to price ahead of the competition? If it's a license, you need to think about the regulatory regime, because what a regulatory gives, he can take away as well. And so you've seen people write up really beautiful theses on companies because they have this license to do X, Y,

Z without ignoring the fact that it's perhaps in a country that doesn't have the best rule of law, and there's six more licenses that are about to get handed out to the boss's friends. Let's talk about brand specifically and the different types of brand and what might be more or less durable. So we'll come from the positive angle. When you're looking for a company whose mode is dependent on its brand, what are the markers that you're looking for? So I think the thing to ask yourself is always, what does this brand do for the consumer?

Does it create positional value for me? When I wear a Rolex watch, which I don't. But if I did, it tells the time, just the same is a time X, but it says, hi, I have a lot of money. And that gives positional value to people, right? And so that's the value of that brand. There are other brands that confer trust, a Morningstar Mutual Fund rating, the opinion of a Gartner IT analyst, a Moody's Bond rating. These are all things that confer trust because there are enough people have used that rating, that it has value greater than its actual what it costs to produce it, right?

It doesn't cost Moody's any more to produce a bond rating than it would you or high to go look at a bond and rate the damn thing. But yet they can price a lot higher than we can because there's social proof involved. Nobody will accept the patent-pat bond rating, but they'll accept them Moody's bond rating and enable to access capital markets with it. It's a really interesting idea where in all those examples, I think a key part of that is history and ubiquity, So even beyond Rolex, other watch Agiles show like intergenerational pictures. Oh, that Petek-Philippe had.

Yeah, that's great. And these brands have, for the most part, I think everyone you listed, been around a long time and been doing something very consistently. So that trust is sort of trust or even the positional value is based on everyone knowing about it and having it having been around for a long time. How often do you see upstarts in those kind of well-established spaces? Like obviously Moody's and others may have. been the first rating agencies. So there's a first mover advantage that can grow into the brand we're

talking about. But what about the capacity or from your investor's seat, the potential for a new upstart to come in and take part of Rola? This is a fabulous question because it is so unbelievably relevant right now, especially to anyone who has historically invested in consumer product, consumer packaged goods, right? Where the brand does not really confer positional value. Nobody thinks you're a better person because you tied. But what it does is it reduces your search cost. You see the orange box and you grab it. Those brands, I would argue, are that type of brand, rather, is much more subject to disruption now than it has been at any point in the past 30 or 40 years because those brands were built by control of mass media. If you were Procter and Gamble, if you were Unilever, you could afford to advertise on broadcast TV.

Nobody else could. And so you had a privileged position right there. Now you look at what's had with Dollar Shave, with Chabani, because you can reach millions, if not, hundreds of millions of consumers with YouTube, with Google AdWords, with viral videos, with tons and tons of digital media, the barrier to creating mass recognition is vastly lower. And so I think those brands, I would argue, are much less durable today. Much is maybe a little overstating it.

But I think you need to be very cognizant of that if you own one of the Buffettist inevitables. How inevitable is it truly? And conversely, the ability of things to go viral. and scale quickly, I think it's fair to say Amazon is one of the more trusted consumer brands right now. It didn't exist 20 years ago. I mean, this is not Rolex. This is not Cartier.

It's not been around 200 years. But because from day one, Amazon realized that offline is actually a better business model than online because it has the ability to confer trust, right? Offline, I give you a dollar, you give me a good, and we're finished. We have no relationship anymore. Online is all this trust involved in terms of the user experience being what I think it's going to be. or what I've been promised that it will be, Amazon figure that out from day one. Let's move to switching costs, which is the second of kind of four key categories. Tell us a bit about what you look for there or look to avoid when thinking about moat and durability of a moat.

Yeah, so the durability really is the key question here, right? Because if a business has high switching costs or captive consumers is another way to think about it, it has the incentive sometimes to abuse its position. Those of us in the financial community generally load the word bloom, when it is mentioned, given the pricing power that it tends to exercise in often very rude ways. I think it's the best way to put it. And I would think that's the, I would argue that's an example of perhaps close to abusive pricing power, where perhaps you're not maximizing your market, you're maximizing price. And so what you want when you have a high switching cost business

is one that is reinvesting and improving the product and delivering value so that the consumer feels like, yeah, I'd just pay 3% more, but I'm getting 4% more in terms of the value of the product. The ones, the switching cost businesses that treat the product as a cash cow and don't reinvest and just milk it, advent, to use another financial example, would be a perfect example of this of a product that looks like it was made in about 1960, but we have no choice but to use it. What is a good example or a favorite example of a firm that's done managed switching costs the right way, so in the way you just described? Oh boy. So I think a good place to look for this is on vertical market software. So software that's speaking.

become the language of an industry, the plumbing of an industry, you could argue that Microsoft has managed it pretty well. Although the usability of Windows and of Office has often been exceeded by other products, the G Suite, for example, a lot of people actually like G Suite better, the ability of Office to link in and hook in to lots of other things that people use has kept it much stronger than you might have thought. I mean, the demise of office has been called, I mean, I don't know how many times. You know, it would be another good example. Aviva, which is a company that we own.

This is a company that makes essentially very high-end AutoCAD software for designing process plants. Think a chemical plant. Think of an offshore all rig, a lot of pipes in it, very, very complex processes. And their customers are in a highly cyclical business. If you're in a construction contractor, your KBR, for example, you're project-based. And when CAPEX is high, you're loving life. And when CAPX is low, you're hurting. And what they've done is made it so that those businesses can flex down their spend, but not too much.

So Viva doesn't have to watch all of its business go away, but the business is able to flex down a little bit because it is a sick little business. The third, which is one of my favorites is this notion of network effects. This is kind of the talk of the town, right, that a lot of, and I know you own quite a bit of Facebook, so maybe a prime example of a network effect. But that's obvious, right? So network effect being kind of the more people that come involved, the more valuable the network becomes. But dig into that in a little more detail. What outside of the obvious examples are some good things to think about when looking for network effects? and kind of how businesses themselves should be thinking about developing them.

Well, and I think that the key thing there is to always think, as my users grow, does the fact that there are more users on the network add value to users number 10, 20, and 30, the folks who are early on, for example. You know, restaurants are the canonical opposite example. The more people who go to a restaurant, it actually becomes less valuable to you, right? Because more crowded, the food may get worse. But, of course, the more places I can use my Visa and MasterCard, the more valuable that network becomes to anybody who uses it.

I think one place people often get confused with networks is what are called sort of radial versus interactive networks. You know, an interactive network is Facebook, right? I mean, basically tons and tons of nodes connecting with each other. A radial network, you know, has basically sort of lanes. There's more hub and spoke. Western Union would be a good example. So, you know, Western Union likes to tout having the most locations globally to send money back and forth. But most of the money is sent along specific lanes. It's sent from Chicago to Mexico City, or it's sent from Chicago to Bangladesh. It is not sent from Bangladesh to Mexico City. Okay. And so those individual lanes are vulnerable to a lower cost competitor. You know, the fact that it's just, it's a, it's a red herring saying that, oh, we have the most locations of it because it just, that's not a relevant number to the moat. So the

moat is much less durable than say a Visa or MasterCard where you, it's more like a web than than a radio network or hub and spoke. Really interesting. Yeah. I never thought about the distinction between those two, but I guess you want it to be as dispersed as possible. Like, a Facebook, right, where you remove any one of those, like, vertices in the network, and it doesn't really matter. Whereas if you pull, I guess if you pull Chicago, Bangladesh out of Western Union, they've got a big issue. Yeah, exactly, exactly. It's more from a competitive standpoint than anything else. Like, if you wanted to attack Facebook, you have to get all these users on one place for another. But if I wanted to basically just attract Mexican immigrants into, in Chicago who want

to send money back home to small towns in Mexico, I can attack question. You. You can attack question with that without touching its Asia franchise, without touching any of each other franchises, right? So I don't have to go after the whole thing. I can just go after a piece of it. And so you can see fine focus competitors doing that. The last one is cost advantages, economies of scale, et cetera, maybe sum up kind of the key in today's environment. Obviously scale economies is pretty straightforward. But in terms of change, like what new ways are cost advantages being? Yeah, no, that's a great question.

I think we're used to, we are trained to think about cost advantages in terms of manufacturing in B-School 101, like, you know, reduce the marginal unit cost because, you know, you can produce at a lower marginal cost. But what's becoming more and more common with value being produced by intangible assets, value being produced by R&D, value being produced by scope, is the value of scale to lend durability to a business. So think about Google and Facebook's investments in artificial intelligence right now. It's a hot buzzword, but it is a good example.

because machine learning benefits from scale. The more data you feed through it, the better it gets. And the more data you feed through what you got that's now better, the better that gets. And so that is, it's not a scale advantage in terms of it reduces cost. It doesn't reduce cost at all, but it improves the product. It improves the output for the consumer. So I would argue that's a scale advantage in the same way that having the biggest factory to produce widgets is. Another thing I think people often miss is sort of, I think my scope advantages,

that you've just been doing something longer than anybody else. You know, if you've been focused on a very small part of the market for 30 years and you've nailed all these small little nuances to running dollar stores. I mean, look, in the U.S., the dollar store has come down to basically doopoly at this point. And retail is a tough business. And so it's certainly not as durable as a moat as having the kind of the AI scale that Google and Facebook do. But I think, and I'll admit to this, I think it's easy to undervalue experience. the ability to serve a niche profitably for a very long period of time

and to have developed just lots and lots of little trade secrets that make it hard for the competition and replicate. These four dimensions are all interesting, especially when they start to interact to create maybe very defensible modes. But now we need to move to the investor side of the equation. So first question will be, how do you take those four components and as objectively as possible,

come up with some ranking or system, you know, I'm a quant, so I can't help to think about it this way. But is there a method by which we could take these four? And I realize that the determination of the four might be very subjective. But let's say you've got some opinion of the four for company XYZ. How do you start to build this into an investing framework that can be used in an actual strategy? Yep. Well, I think the thing is, the first thing is, four is not better than one. to realize that, I mean, if you've got one incredible brand, Tiffany's brand, you know, one incredible moat, Tiffany's brand or Facebook's network effect, whether you had the others or not, it doesn't really matter that much.

You don't need to have, like four is not better than one. Four moats is not better than one moat. What matters is your ability to maximize that moat, to reinvest back in that moat. And that's why, you know, we have gravitated towards businesses that are less mature and can reinvest because I think where moats become Hungarian Lollapaloozes, is when each dollar of cash flow can be reinvested in incrementally higher rate of return. And that doesn't happen if you have a static moat that's great. Coca-Cola, right?

The mode is the moat, but it's not really getting bigger. And the reinvestment potential isn't very high, right? All the cash needs to get paid out to shareholders via dividends or repurchases. But if you have a business where each year, the moat gets a little bit better, and so returns on capital get a little bit higher each year, and there's reinvestment potential. So the dollar that's reinvested at 18% this year gets reinvested at 20, percent next year. It gets reinvested at 22 the year after that.

How do you think about this from a mispricing standpoint? So there's only alpha if you've done a better job of evaluating the value of, say, a moat than the market has. And some of this comes in timing. So I think it's hard to argue markets haven't focused more and more on the shorter and shorter term. It's where a lot of the brain power and machine power is being focused is next quarter's earnings. So tying into this idea of a longer time horizon, as an advantage. How do you think about, okay, let's say, so Facebook, let's stick with Facebook since you own it and it's obviously well known. So it has an enormous network effect, but I don't think anyone doesn't think that. So then the alpha becomes, well, its network effect is actually

more powerful than the market has discounted. So how do you think about identifying those gaps specifically? Yeah, that's actually a perfect example is on Facebook's Q217 earnings call that was just last week, probably half the analyst's questions were on Messenger, which is not monetized now and will probably not contribute materially to earnings for several years. No one asked a whole lot of questions about the core platform that's growing 50% per year and cranking out a 47% operating margin

and how long that can continue. That's what you need to be focused on, is what's the return on ad spend for an advertiser right now? So in the case of Facebook, the alpha comes not from saying, oh, there's a network effect here. The alpha comes from looking at it from the advertiser side, not the consumer side, and getting icky, advertising is icky.

Google doesn't like to admit it's an advertising company. Facebook doesn't like to admit it's an advertising company. You're a big ad company. But once you sit in the advertiser's seat and say, what does this platform do for you that other platforms cannot do? How does it enable you to reach people in ways that other platforms do not enable you to reach people?

What does the return on spend on the dollars you give to it? And the answers that come back are incredible. well, that's when things get interesting. And that's where, so network effects are great, but if they're not monetized, they don't mean doodly to an investor. And so I think focusing on not kind of the ethereal kind of, ooh, there's a network effect, but how do you make money off of that? How do you monetize it?

I mean, Yelp is a great example. So Yelp has undermonetized. A TripAdvisor has arguably under monetized their own moats in the review databases that they have. And so the network effect, it's just. it's not as valuable if you can't monetize. How do you think about price, traditional statistical cheapness? So Google and Facebook, two examples we've talked about, by traditional measures, pick your fundamental price to whatever, look very expensive relative to maybe not Google as much,

but certainly Facebook looks statistically very expensive. So how do you square kind of that multiple? How do you come to a market consensus multiple and kind of incorporate current price or valuation in your view for potential future? return. Yeah, it's a great question. And I think the first thing is to take one of the first words in your question statistically and eliminate it from your jargon, eliminate it from your analysis, because the businesses with moats that compound best over time have futures that are vastly different than their past. And statistical, quote, unquote, valuation does not, just can't see that.

It can say, what has it, where is it today relative to where it has been? So when MasterCard came public. It was the first of the payment networks to go public. It was printing like a 13, 15% operating margin. Okay, it's pretty good, right? And so, you know, it just doesn't look that good as a business. But if you then think about the qualitative characteristics that it was owned by a whole bunch of banks before it came public, which means it was probably not managed optimally, and then if you just run through the very simple mental exercise of, okay, MasterCard gets $1 of incremental revenue, what is the cost it needs to put in to generate that dollar? Uh, not much.

You know, the operating leverage thesis is just not rocket science to come up with. But statistical analysis isn't going to show you that, right? Facebook, same thing. I mean, two years ago, they printed a 31%, mid-30s operating margin, low 30s, because they just bought WhatsApp, and a lot of that got allocated to R&D. But that has nothing to do with the incremental economics of the business, the fact that they pay nothing to generate their content, and the advertiser pays them a whole bunch to get access to the users.

So what it involves, I think, is carefully, and creatively thinking through the core economics of the business. Let's say there's a moat. What should Amazon do? For example, what should it be its future strategy? Well, I mean, basically, strategy and capital allocation should both serve the moat. So they both serve to strengthen the moat. And I think as you point out, Amazon is the canonical example of this because everything has been focused on making the customer's life easier. So if the customer's life is easier, they'll use it more. To go back to Facebook, you know, it's how do I keep users engaged?

Because if users aren't engaged, if they don't come back to the platform every day, there's less reason for the other users to come back to the platform every day. And so you have to keep that flywheel going. In their case, it's adding things like live video and whatever else it might be. You know, if your moat is a brand, then you have to ask yourself, again, break it down into is it a positional brand? Is it low search cost? Is it one that garners trust? And so if it's one, just take the example of one that garners trust, you have to ensure that a trust is based on social proof. And so that's why you see Gartner analysts, always out there.

in the media saying, oh, we think the market share for this thing will be this or that. And why? Because that gets the name recognition of Gartner out there. And it says that if I'm a CTO and I go to my boss and say, we should spend on this software product versus that one, why will Gartner thinks are the better one? That has some resonance to him or her. Before we get deeper into capital allocation, I forgot a fun question, which is, so we established the four types of, or four dimensions of a moat. If you, and we'll go submoat, so a brand could be, could be the answer here versus intangible. If you were starting a business, and we don't know what the business is, but I bestowed you ahead of time with the knowledge that you're going to get one of these aspects of brand is going to be fantastic.

What would you pick? So what would be the most intriguing dimension of moat if you could guarantee you had it ahead of time? Well, if you can guarantee that you have it, then it's a network effect, right? Because it feeds on itself. It grows. A network effect business grows itself with very little marketing dollars. So just the fact that you said guarantee takes me straight to that position. What about the guarantee?

Without the guarantee, I think it's high customer switching costs. You know, when you have a product that becomes integral to a customer's life, they literally cannot do their job or function without whatever product you might have. That is an insanely powerful place to be. And it just gives you enormous pricing power over time. Sometimes those businesses do have challenges growing because you basically, you become integral to the lives of all the customers you're going to get,

and then it becomes a return of capital story. I mean, you see this is the vertical market software companies. They sometimes have a hard time growing. And so that's where, to your question, capital allocation becomes a bigger and bigger question, because what you don't want is the VMS company that spits off cash going out and buying another VMS company. I mean, if you're Mark Leonard, consolation,

and that's part of your strategy, well, it's great. But if you're just dominant in one business, you've got and buy another one, I mean, 2 plus 2 does not equal 4. two probably equals two and a half. My guess, I was going through the list before our conversation. And I would have guessed that you would have said positional value brand, something like a Rolex, because of how I'm always interested in things that don't change, right?

So things that reliably in 10 years will be the same, sort of like the opposite of like a technology company or something like that. And it seems like there's such low turnover in the big positional brands. You're totally right about that. And I think those are ones where, as an investor, you know, if you can essentially, you know, look at those brands. And I would say those are the brands that lend themselves best to your statistical valuation analysis, which you're just saying, right?

You know, when Tiffany gets statistically cheap, when Richemont, you know, which owns Cartier and a whole bunch of other big brands, you know, gets statistically cheap, you should take a hard look. And if the moat has not been impaired, you should take an even harder look. I mean, the only caveat there is you do have occasional spurts in demand. So, right, you know, there was about, you know, eight, ten years ago a huge spurt in demand for luxury products coming out of China, partially because people are getting more money, but partially as bribes.

And with the big corruption crackdown a few years ago, you saw sort of a structural slowdown in growth. And so you would want to make sure that your statistical analysis sort of incorporated the longer view of growth, you know, which is probably like four to six percent volume growth, and not the one that was bumped up for a few years by the China experience. Because if you use that as your arbiter of statistical cheapness, you'd be able to, you probably would be misled into paying too high a price. I love your line that capital allocation is effectively the link between business value and

shareholder value. So we've spent the conversation thus far, really talking about business value, things that create good operating companies. But it's a really important point that two things can screw that up, the price you pay, so you can overpay for a great business and then it's not a good investment. But maybe more interesting is that if you have a terrible capital allocation plan or managers that are awful at allocating capital once it's been generated, that can also destroy from an investor's seat the value of a fantastic operating business. So talk about your view on what makes for a good

capital allocator and what you look for in investments. Thoughtfulness, I think is probably, if I had to summarize it in one word. We frequently talk to companies and say, okay, so let's talk about, you know, buybacks, do it. And like, oh, well, our goal is to do about a third buybacks and a third dividends and then the third, you know, accretive M&A. I mean, that's the dumbest-ass answer I've ever heard. I mean, that's not a thoughtful answer. That's a pull-it-out-of-your-ass answer. You know, you know, if you have tons and tons of opportunity in a given year, cut the dividend and buy a company. I mean, great. I mean, market will probably kill your stock, but you generate a lot of value. And so it's thoughtfulness, right? It's about thinking through

what makes the most sense for generating future returns for your business, whether that's buying back stock or reinvesting in projects, projects. I think you see this in the UK, Australia, some other parts of Europe. You have this is what we call the dividend fetish. We're basically, you know, paying out dividends is the sine qua non of a great business, which is just asinine. And, of course, in the U.S., you have this, you know, buyback fetish, which is, of course, equally moronic,

because when your buybacks are just sopping up options dilution, it doesn't add a damn bit of value to me. So I think it's that capital allocation needs to be thought through just as carefully as business strategy, right? Just in the same way that you would want a competent, CEO to say, okay, how are we building the moat? And lay that out very clearly. Say, okay, how does your capital allocation strategy help me as a shareholder make money?

You want a thoughtful answer to that. And I know that's loosey-goosey, but there is, because there is no good answer, right? For some businesses, it could be payout the dividend. Or some businesses it could be just buy-back shares like a Banshee over five years' time. You know, for some businesses, it could be acquire like Matt. But the key is, don't have it be a stock off-the-shelf answer. Have it be an answer that's specific to that business. business and that does not do things just because other people do them.

One of the things we've studied quantitatively, which obviously is, you know, this is a very qualitative area, but... But it can be steady qualitatively. Quantatively, one of the interesting findings is looking at lumpiness. So you mentioned that idea of a third, a third, a third. And what you find is that companies that do that kind of thing to sort of have a steady state capital allocation, it doesn't mean they're going to be terrible underperformers. But the best performing stocks tend to have a little bit more lumpy type result.

So take buybacks as the example. Companies that do, you know, 1% every year or 2% every year don't really outperform, but ones that randomly gobble up 10% of their shares in a very short window tend to outperform by quite a wide margin. Yeah, that's cool. So you kind of run sort of a high level of variance in repurchases. Yeah, exactly. Or variance of capital allocation policy. If there's a pie, right, that you can do these five or six things. if that moves around a little bit more, and I guess you'd have to have success at moving it around, so it's not easy. But that that might make more sense than that just like it's fixed, just kind of do this same thing. Totally agree. Totally agree.

I mean, that makes intuitive sense, right? Because acquisitions don't come along every day and your stock's not cheap every day. I think maybe one rule of thumb would be you said thoughtfulness. I would think about it in terms of what's the highest return, right? Like it sounds obvious, right? Just as investors look for companies that are going to deliver the highest return, CEOs should be doing the same thing. And sometimes that might mean buy a company.

Sometimes it might be send everything back because you're mature. Highest return and setting a high and reasonable hurdle rate. We see this especially with the European companies we look at, given how low interest rates are in Europe, is that companies think that beating their whack, you know, in like year three when whack is seven, is like a good outcome. Like that's our hurdle.

I mean, God, oh my God, this is a few months ago. I sat down with a company in London. And they were one of these, yeah, our goal is to beat our whack. in year three kind of things. And I was just like, what? You know, why is that your hurdle rate? And I just got this blank look from the woman I was talking to. Like, well, what other hurdle rate would we use?

An absolute number, something higher. As an investor, I can buy anything in the world. I can allocate capital anywhere. Why would I allocate my capital to you, sir, when in this case I was ma'am, to then reallocate my capital with a 7% hurdle rate? That makes no sense whatsoever. And so that's another.

one I would say is that in addition to thoughtfulness, absolute hurdles. Like relative hurdles, like beating our whack is just, it's, it's squishy, right? What you, because of the goal in investing is make money, compound capital, whether you're a CFO or a portfolio manager. And so if you don't have an absolute bar that we think 10% is good, we think 12% is good, we think 20% is achievable, whatever. And things need to clear that hurdle for us to allocate capital. You can talk yourself in it some pretty dumb stuff. You really do need kind of independent thinking, not just buying back shares because other people are independent thought. Seems like another key attribute of a thoughtful capital allocator. Yeah. Yeah. The willingness to do stuff that looks optically

stupid. But then later on turns out to be the smartest thing going. I mean, just to go back to Amazon. I mean, do you remember when they locked Amazon Prime? And people thought that was the free shipping? What? People went crazy, right? It's a good example. I mean, it's actually, I, I, I, I, I, You know, Patrick, I never thought about this. That's actually probably a good one, a good, not a bad test, that when you have a decision by a company, where there's a giant hue and cry, and everyone just kind of says, oh, that's the dumbest thing ever. And it's probably worth the hard look. I'd love to try to codify your process a little bit.

So we've talked a lot about the key things you look at. But like anyone, you, I think it's all equities, right, your portfolio. And fairly concentrated, so 10 to 15 stocks. So certainly no closet index. from start to finish, what are the stages? So you've got some investable universe, you've got LP dollars, and you need to start winnowing that universe down. So what are the stages of that? How do you think about it? And as many stages as we can draw, I'm fascinated by this for more discretionary traditional asset managers relative to quants where it's, obviously, it's exactly codified.

So how does that, starting at 3,000 companies or 5,000 companies you can buy, what happens next? I mean, so I think the thing, the first thing for us is throw out all the stuff that we're not interested in. And so these would be, you know, commodity chemicals, life insurance, businesses that just have structurally awful economics. And those tend to comprise a higher proportion of the equity universe outside the U.S. than in. So it actually kind of narrows the world pretty fast. And then, you know, you start fishing in the pond. So that's step one, right? Fish where the fish are.

Don't, don't fish with there, no fish. And then the next step is really thinking about businesses, just sitting down and thinking about business. about businesses that have structural tailwinds behind them in the case of Facebook digital advertising you know advertising going from offline to online e-commerce in the case of Amazon what you know because things when companies have the wind at their back

and their market end market is growing quickly can cope not I don't want to say cover up a lot of sins but just really sure makes their life easier but so thing one find businesses with go to track structural economics which tend to as we said earlier cluster in specific industries could you list maybe I don't know five examples of industries like that.

Oh, yeah. Okay. I mean, so the payment networks, right? Obviously, it's an easy one. You know, MasterCard Visa. The processors, that's, I wouldn't say, a commodity industry, but there's not a lot that differentiates one merchant acquirer from another merchant acquirer, aside from scale to some extent. But they all kind of do the same thing. They have similar tech stacks, I would argue.

So the vertical market software, you know, software that becomes kind of the language, the plumbing, you might say, of an industry. Exchanges. Exchanges tend to be beautiful businesses, futures exchanges. tend to have much better margins than cash equity exchanges because futures are non-fundable. You have to open and close the position in the same exchange as opposed to, you know, can buy something in NYSC, sell it on ARCA. Those tend to have very good structural economics.

You know, obviously, as we've talked about, the positional goods, luxury brands, consumer products, those tend to have very good economics, but have challenges when it comes to reinvestment. And that's where you want, you know, really, I think capital allocation becomes more of a challenge. You use the term good economics. Can you be a little more specific on what that means? Is it margins? Is it?

Well, yeah, the end result, good economics at the end of the day means good high returns on capital, right? Which you can achieve with low margins in high asset velocity or low asset velocity in high margins. But I guess when I think about good economics, it's not just RIC,

it's the ability to grow the pie over time, right? Because a high RRIC that can't grow, I then have high capital allocation risk. If you have a business that's a high return on capital and just spits off cash, well, either they're going to pay it to me, me as a dividend, which case I've got a favorite what I have to do with it. So why do I study this business? Or they're going to do something with it, in which case now I have capital allocation

risk, which maybe, if the business gets a great capital allocator, well, fine, that's good. That's a whole separate set of questions that you need to answer. Whereas if the business has higher returns on capital, the ability to reinvest capital. And the ability to reinvest capital usually comes from either having small market share and being able to take market share in a market that's not growing or the ability to just keep your market share but grow along with the market that's growing very quickly. E-commerce grows at 15%.

So even if you're not Amazon, you can do pretty well in e-commerce just because there's a structural shift in dollars from A to B. And I don't want to say it doesn't take the capital allocation question out of the table, but it means that you can just stay focused as an analyst on what are they doing internally? How are they reinvesting those dollars? because there are plenty of companies

are, like, would Jeff Bezos be a great acquirer? I don't know. Like, if you put Jeff Bezos in charge of a company that did not grow and said, you now need to, like, here's a great example. What have you exchanged Jeff Bezos and Mark Leonard? Could Jeff Bezos run Constellation?

It's a, because it's a very different business. I mean, capital allocation is capital allocation. Capital allocation of buying businesses, nurturing independent teams that then kind of send cash back up to the headquarters, which is what Constellation does, versus, I would say, a more ruthless culture in Amazon that is just laser focused on one thing, delight the consumer, damn the torpedoes.

I'm not sure those are interchanged, but that's all internal reinvestment, right? And deciding between Project A, Project B internally, and some don't work like, you know, the Kindle fire, and some work beautifully like Amazon Prime. I guess I would argue that's a different skill set. This reminds me of a fun question, kind of a version of which I asked Will. The question is, if you could take any one business, so you get to choose your business today, but you have to swap out its current leadership, its current CEO, and put someone else in, what company would you choose and who would you swap in?

Oh, man. That's really fun. See, and it would be, it's more fun if you to go kind of off the run. Yeah, no rules other than that. No, no, no, I know. I know. It's why you want to go through the road and go, go, go. go off the run.

I mean, so I'm trying to think of, like, mismanaged businesses. I mean, there was Yahoo, but honestly, it was so horrible by the time Meyer, she took over that I'm not sure you could have, you could have plunked anybody else there, and they would have done much of a better job, honestly. Man, it's just, it's just funny, because we tend to throw these things out very quickly in our process, ones where, you know, you just, you know, you can't change management, we don't do activism, and so we just kind of keep on going. Ooh, BlackBaud.

There's a good one for you. So BlackBaud dominates the market for fundraising software. So if you're a YMCA or you're the city opera or whatever. And current management, A, is vastly overpaid, and B has made some absolutely stupendously bad capital allocation decisions, we think, in terms of getting outside their moat. So I think if you just, because it's a very sticky product, right? I mean, you think about most nonprofits, right?

They don't have a giant AT department. So once the software comes in, you're just going to keep. using. It's called Razors Edge, you know, R-A-I-C-I-C-R. And the customer work we did indicated that the platforms, it was almost MS-DOS-like for a long time, very low reinvestment. But the customers, this is kind of all they had, right? The sales force didn't really work for them. I mean, boy, you could have maximized that. So who would you, who would you pick to do it? Oh, boy, who would I pick to do it? I'm not sure Mark Leonard would take the job. He's got too good of a job. He's got too good. He's got too good. He's got too good.

Look, I think for any VMS company that's under managed, he just dropped Mark Leonard in. I mean, he's got a more nuanced understanding of what drives a good VMS business than anyone I've ever met. I had the great good fortune to meet him one-on-one at their offices one time, and then I saw him speak to a class of Columbia students

about a year and a half ago, and those were both master classes. And there's some people you meet with in any industry. I mean, for Mark Leonard's VMS software, who you're getting chapter inverse, right? So there's one CEO of one company we own currently. I still remember he visited us not long ago, and he talked about it as a salesperson at a company,

and in this case it was software, could be anything. He said, your goal as a salesperson is to get the hall pass. Your goal is to show up and be able to walk around that building and talk to anybody you want. You want to be so familiar with the security guard, with the secretary of everybody, you want the hall pass. And I was like, that's a great way to think about a sales culture. I mean, it's a great way to think about when you're talking to companies and assessing whether they can sell well or not, you know, how are people getting out on the street? How well are they don't going to? Do they have the hall pass? It was just kind of a cool way of framing it.

Very cool. So coming back to your process. Yeah, anyway, so fish and ponds where the fish are. And so, you know, mechanically, what we'll typically do is we'll do a quick idea, which is just sort of a paragraph or so and kind of what's the moat, what's the opportunity, what's the idea here. And then I'll decide what to do what's called a first pass memo on, which is basically a two-thirds to a day's worth of work, which is not answering the question of should we invest? It's answering could we invest. It's does this business have the characteristics we want in terms of reinvestment potential,

infrastructural advantages, management that does not misallocate capital. And that's honestly, I think, one of the hardest jobs of any portfolio manager is to allocate the 100 or 200 or whatever hours of research time you have per week, because that's a finite asset, right? And so we try to, we do probably seven to eight, no, seven, seven or so six to seven, first pass memos per month. Maybe one or two of those will kind of get approved for further work. And the approval process for us is very team-based.

We're not a top-down shop. I have a very diverse team. They come from different backgrounds, which I think is a topic for another day, which I think is very valuable in our profession, because we all know that any successful investment shop has a process, as a philosophy, a way of looking at the world. But that can lead you into group thick, right? That can lead you into, you know, our way is the best way.

We don't really, you can kind of reject outside input. And I think one way to mitigate the risk of that is building diversity. I mean, Mopasson talks about this a lot, building diversity into your organization, diverse viewpoints. And so there's decisions on kind of what to move forward with are very, very much team-based. I mean, you have to, somebody makes the final say, obviously, you can't invest by committee. But then if we just so, I consider it, I get the input from everybody, and then we go to what's called a, you know, sort of an in-depth stage, or we're going to do customer calls, we're going to go to trade shows, gets into the industry backward and forward.

And then the key we've found that really adds value to our process and everyone can cook the pie differently is to, give ourselves multiple opportunities to say no. Because I think if you just send an analyst off and say, you know, go get to know this industry and this company and give me a 20-page in-depth memo in X amount of weeks, if in three days they find out something that kills the idea, that they're going to waste the next month. But if the boss said, go write that memo, they're not going to come back and say, boss, this is kind of a really bad idea because I just found out X, Y, and Z.

But you have to give people that opportunity. In your process, you have to have those windows where you say, what do we know now, That's different than what we knew week ago, and should we keep going or not? Because the most finite asset is not capital. It's time. And so you always want to be maximizing the ROI on the research time. Unfortunately, the flight schedules at LaGuardia conspired to shorten our window a bit today, so we're a bit short on time.

But for our last question, one of my favorites that I ask everybody is for the kindest thing that anyone's ever done for you. The kindest thing. That's a really cool one. The kindest thing anyone's ever done for me. There's a professor named Scott Hendricks at Kansas State University, and he's used one of my books in their kind of undergrad investing classes for a while. And when I host the K-State students when they come to Chicago every year or so, he was actually one of the very first undergrad programs to go see Buffett,

those sort of Sunday things, that he actually kind of was one of the progenitors of that. And to this day, I think pretty sure that K-State goes every year, and even like the top MBA programs are on every two-year rotation. but I got a call on Wednesday, and he said, we're going Saturday. You want to be an adjunct professor for a day? Because technically only professors get to, you know, you have to be faculty to go. And he figured he'd kind of shoehorned me in because I've kind of, you know, written the books or whatever. I was like, you know, do you want my right leg or my left leg?

Yeah, of course. And, you know, he didn't have to do that. He got no benefit out of doing that. And I couldn't ask any questions. I had to kind of, you know, the students could ask him. But, you know, he was like, here's a chance to kind of hang out with a man. for two hours. He got no benefit of it. But I think, I'm glad you asked that question, because I think it's actually really important in our profession, because the goal, I think,

for all investors should be that the next generation is smarter than you are. And so I think that the importance of making time for the ones who are coming up. And I think about that a lot, actually, because I came into this profession a weird way up through Morningstar, and I never really had a mentor, you know, and I actually didn't have the moxie to kind of reach out to people I really respected. And so I respect the hell out. these 25-year-olds who just email me blindly. You know, I mean, some of them that emails are misspelled. That's a problem.

But I think kindness matters and the importance of making time for the ones who are going to be hopefully replacing you and better than you in 20 years, 30 years times is important. Great place to end. This has been really fun. I hope we get to do a round two with a little bit more time next time. Yep. Thank you very much. No, thank you.

Hey, everyone. Patrick here again. To find more episodes of Invest like the Best, go to investorfieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com forward slash book club. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also follow me on Twitter at Patrick underscore Oshag, Oshag. If you enjoy the show, please leave a quick review for us on iTunes, which will help

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