Hi Pat Thank you for your time.
What is your current new role, and can you tell us more about your firm?
Sanibel Captiva Trust is an independent trust company – basically, an asset manager that can administer trusts – based in southwest Florida, serving high-net-worth clients. I’m Director of Research and Strategy, so in some ways, my role is similar to what I did at Morningstar – overseeing SanCap’s research team. The difference is that we take a highly personalized approach to investment management, so we have to consider each client’s individual financial situation in addition to the merits of the specific securities that might go into their portfolios. It’s a challenge, but a lot of fun. It’s also a privilege when a client trusts you to be the steward of their financial assets, which is personally very rewarding.
I wanted to start off with your background. Can you give us a little information on your background
Before joining Sanibel Captiva Trust a couple of months ago, I was at Morningstar for about 12 years. I started in late ’98 as a senior equity analyst, and took over the equity research team in about 2000 or so, so I was there kind of since the start of Morningstar’s foray into equity research. My role was developing our equity research methodology and focusing on intrinsic value and economic moats, all while overseeing the 90 plus analysts Morningstar has today.
I came to this industry in a sideways fashion which I do not think is the case with a lot of investors. I do not have a degree in finance, I do not have an MBA and I’ve never taken an accounting course in my life!
I am studying for the CFA, and I know you are a charter-holder so that is impressive enough.
Let me tell you the best level is level IV!
But most of my academic background is in liberal arts and I came to the profession almost by chance. In a way equity investing combines a lot of different fields in that it is a set of ever shifting problems to be solved. It’s not electrical engineering where there’s a right answer to everything. There is never a right answer to what the company is worth, or what is the competitive advantage to a business, or how much cash will they generate in five years. These are all forecasts that involve uncertainty and an ever shifting set of variables and that is what makes it so much fun.
So that is what attracted you to the profession?
Sort of; actually, my very first job out of college in the early 90’s was as a receptionist in a Merrill Lynch office in Boulder Colorado, and that was just as a temporary position. I got the job just to pay rent! Basically, answering phones was not a lot of fun, so I figured that if I learned what these guys did every day, maybe I would not have to answer the phones anymore. And I had bought mutual funds in college with my lawn mowing money, but didn’t know much about the stock market. I eventually studied for my series 7, became a broker’s assistant, and learned about the market. I quickly figured out that I couldn’t sell snow to Eskimos, which meant that I was in the wrong place at a brokerage firm. I left and wrote for an investment newsletter for a little while and then ended up at Morningstar just a few years later.
What was your exact role as director of equity research at Morningstar?
Morningstar has about 90 equity analysts and I was responsible for their overall output. I was what you might call the Chief Quality Officer, and a lot of what I did was reading as much of our own research as I could to offer feedback and make sure that we were being consistent on our views across the staff. I wanted to be sure that we were thinking properly about outside data points, because with any quality investment operation, whether a research group or a buy-side firm, you have to have a point of view about the world and you have to have an investment process. Without that you are doomed to fail. The danger, however, of having a well-defined process is that you become insular. You tend to have group think and you don’t accept outside information as a result. If you have a view of the world and don’t have things that fit neatly into that view, then they get rejected. It is confirmation bias. So, a lot of what I did was try and read a lot of outside research and feed those ideas to Morningstar’s analysts analysts so that I could say “well, have you thought about this,” or “have you seen what so and so is saying?” Sometimes it is things you haven’t thought of and you need to incorporate that into our analysis, and frequently it is a point of view that the analyst has thought about and says, “Well actually, I just view the world a different way.” And that’s a fine answer, as long as the discordant information has been taken into account. Essentially, a lot of what I did was taking outside viewpoints and trying to make sure that we were factoring them into our analysis when necessary.
You actually answered one of my questions. I was going to ask about focusing on the process over the outcome, and you seemed to already state your views on that.
Yes, Morningstar is very, very process focused because processes can be honed and changed over time, but outcomes are really just outcomes. If you don’t know whether they’re due to skill or luck, then you don’t really know very much. Morningstar is very process focused and very unique in that all 90 analysts use the same process. That is quite unusual for a large research group. If you look at Morgan Stanley, or Goldman Sachs, they are full of very smart people, but there is no Morgan Stanley way of doing equity research nor is there a Goldman Sachs way of doing equity research. Each analyst is just kind of doing research in their own way because it is kind of a star driven field. Whereas, Morningstar has a very consistent way of approaching investing which all of the analysts share. That gives them a little bit of an advantage sometimes because there’s a common internal language. They don’t have to spend meetings debating on how to view the world; they’ve already done that. They’ve already agreed on what matters and what doesn’t. That means they can get down very quickly to the real issues at hand in terms of competitive advantages, the amount of cash something will generate, or whatever the issue might be. I can say with a great deal of confidence that if you took the research output of six well known sell-side firms and stripped off the logos, you would have no idea who wrote which one. If you took Morningstar’s equity research and stripped off the logo, you would know who wrote it.
Can you elaborate on how Morningstar’s approach is different? Is it a company secret?
There are three pillars to Morningstar’s process. First there is a focus on intrinsic values; business values as opposed to stock prices. The second is a focus on competitive advantage and economic moats. Third is always having a margin of safety. When you buy a security and buy a piece of the business you are a part owner of that business. That means focusing more on the long term cash generating power of the business as opposed to the short term price fluctuations, which is what everybody else seems to focus on. The market for long term returns is less competitive and therefore less efficient than the market for short term returns. Most marginal investors want to make money over the short run. The average turnover of a US equity mutual fund is over 100% now. Because of that, there are literally armies of people focused on figuring out whether a company will beat or meet earnings next quarter, what stock prices will do over the next few months, and so that’s a very efficient market. So, why not avoid that market and play in the less-efficient market for long term returns? Long term returns are driven by the amount of cash a business generates. So that’s the intrinsic value part of the equation.
In terms of economic moats, it is tied into the long term viewpoint because if you are focused on making money over the next two weeks and next two months, then you probably aren’t thinking about the long term competitive advantage, and I’ve also found that moats tend to get mispriced by the market because companies with durable competitive advantages tend to generate higher returns on capital much longer than the market expects. Most businesses face competition that drives down returns on capital, but you and I can name rather quickly a dozen businesses off the tops of our heads -- Microsoft, Oracle, Proctor and Gamble, Nestle, McDonalds etc. -- that have generated returns on capital well in excess of costs of capital for decades at a stretch. And so Morningstar works very hard at identifying those types of businesses and thinking carefully about what kinds of businesses are likely to have returns on capital in excess of costs of capital due to structural advantage for some years into the future, and that’s a very big part of the analysis. I think that competitive advantage is under-analyzed by most investors. Most of the work on competitive advantage is from a managerial viewpoint – think about Michael Porter, for example.
A business manager has a very different challenge than an investment manager. If you manage the division of a company, you have one set of assets (people, plants, products) that you have to maximize the value of. But, you are kind of stuck with just that set of assets. However, as investors we need to choose amongst hundreds of thousands of groups of assets called companies. In which case, we can say, “That’s a bad business and I don’t want to invest there,” or, “That’s a great business, so I want to own lots of those.” The manager of a company can’t do that, so we have a challenge with a somewhat different perspective.
You talk a lot about moats in your books what do you define as moats? Would you say you differ from Michael Porter or how someone like Warren Buffett defines moats?
As far as moats are defined by the Morningstar framework versus someone else, I don’t know if it’s different … we are all playing the same sport. We might be on ten different teams, but we are all playing baseball. What I in coming up with Morningstar’s moat framework is basically take a look at all of the businesses that have generated high returns on capital for decades at a stretch and said, “what are the common characteristics,” and, “What are the commonalities that can be distilled down from these companies?” And four of the commonalities were:
1. Intangible assets that give a company pricing power.
2. Switching Costs. Ones that make it difficult for a customer to move from one product to another. For example, if you are an engineer and you are very familiar with AutoCAD, then you are probably trained on it in high school and college. Switch to a different computer aided design (CAD) software application would be very, very time consuming. That’s the same thing with data processors like Fiserv or Jack Henry as well.
3. The network effect is the third kind of competitive advantage in the framework. That’s when the product or service increases with the number or users. You see that with financial markets and credit card networks. About 85% of U.S. credit card traffic goes through Visa, MasterCard, Amex and Discover. We all carry those cards because they are accepted everywhere, and they are all accepted everywhere because we all carry them. So if someone would like to start up a brand new credit card network, they would need to start up and amass a very large number of merchants and users very quickly because no merchant will accept the card before people carried it, and no one would want to carry it if they couldn’t use it anywhere. So it is a very difficult market to break into and I’ve found that network advantages tend to be some of the most powerful and one of the most difficult to overcome.
4. Risking a low cost producer in a commodity market. In a way that is sort of B-School 101, but it’s very important to think of where a cost advantage comes from. The process based cost advantage is inventing a better process for delivering a good or a service. You might think about a Dell or Southwest or Nucor for example. They tend to get copied over time. They do have great runs and certainly Dell and Southwest have made people plenty of money for a while, but if something can be copied it will be. At the end of the day, capitalism works. You can contrast those to a scale based advantage where a company’s advantage comes from running a larger revenue base over a relatively fixed cost structure; that is very hard to copy. You might think of a FedEx or a UPS with their ground delivery networks. DHL lost almost a billion dollars trying to compete in the U.S. in the ground delivery market and they lost. The pulled out after losing a ton of money. It’s not because they are a poor company, they are very well run and they are strong in Europe and Asia, but they didn’t have the dense delivery network that UPS does here in the states. So when they tried to have lots of yellow vans going through lots of places, they didn’t have the volume going through the network to save them from losing a lot of money. They couldn’t compete with all of the brown vans already going everywhere which were carrying lots and lots of packages.
Which is the most important if any in your opinion; network effects?
Network effect is the one that seems hardest to overcome, but I think it’s less valuable to think about which kind of moat is most durable and it’s more valuable to think if a company has the opportunity to reinvest inside the moat. Microsoft, for example, may have a pretty good moat, but that moat doesn’t add a ton of value to the company since the cash is tied up in the balance sheet. The business isn’t growing, so they have nowhere to plow the money back into the business. And that means the moat is not all that valuable. You contrast that with a MasterCard, or a CH Robinson or a Fastenal, which also have wide moats but also have the opportunity to take the cash they generate and plow it back into the business at pretty high incrementally rates of return. That is where a moat really builds value over time because a company can reinvest cash flow at a 20% or 30% return on capital and that really compounds intrinsic value in a way that Microsoft simply can’t compound value because its core business isn’t growing. So all the excess cash just sits on the balance sheet in treasuries earning very little.
What is important for investors to know is not a moat?
The biggest misconception that most people have is that they think bigger is better, and also that managers are supermen. A lot of people confuse size, whether being a larger business or having a large market share, with having a strong competitive position, and I would like to point out the strong counterexamples of General Motors and Compaq. It’s a good example of businesses that were bigger but not necessarily better. And also people often think that managers can do anything. That if you have a great manager, that matters a lot more than a business’ competitive advantage.
It’s like the old saying of betting on the jockey and not on the horse. And, while betting on the jockey makes a lot of sense, it only works if all the horses are thoroughbreds. Not all businesses are thoroughbreds. Some businesses are structurally built to generate higher returns on capital in a better way than others. The manager of an airline will never generate high returns on capital, no matter what a genius the person is, it simply won’t happen due to the structure of the business. And I think that sometimes investors get starry eyed over great CEOs to their peril.
My favorite example is David Neeleman, of Jet Blue. Phenomenal entrepreneur, created the only business to ever get bought by Southwest, which made him sign a ten year non-compete. He went to Canada, started West Jet, the non-compete expired and he comes back to the U.S. and starts Jet Blue. Amazing story. But Jet Blue’s cost structure was never going to be lower than the day that they went public because planes don’t get newer -- they get older. Baggage handlers and pilots don’t get less seniority they get more, and they want more money. At the end of the day it’s a commodity industry. So betting on the jockey rather than the horse makes sense if all the horses are the same, but at the end of the day, Pat Dorsey on a thoroughbred can probably beat a professional jockey on a goat. Some businesses are goats and some are thoroughbreds.
So you follow Warren Buffet’s motto “when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Yes and tellingly he made that quote right after selling his one and only investment in an airline. It was US Air – preferred shares, I think. So it’s interesting to know that’s when he made that. If I remember correctly it was because he thought very highly of Stephen Wolf who ran U.S. Air at the time. But, no matter what a genius Stephen Wolf was, he was still running an airline.
You talked about Cisco’s moat in a recent Morningstar video; do you think this moat is being eroded due to cloud computing?
It’s interesting because people often think of “tech” as a very difficult area to build a moat in, because the pace of technological change is so fast, and Bruce Greenwald has said there is always a better toaster with more blinking lights coming down the pipeline. I think that’s true in hardware areas that can get commoditized. And I would never view a superior technology as being in an economic moat. There are a lot of smart engineers in the world, and what one can invent another can improve upon. There is absolutely no question about that. But when you have a technology company that becomes an industry standard, and we can say maybe that AutoCAD has for the computer aided design industry, or in the way that Photoshop has for the digital design industry, at that point switching costs going from product A to product B become very high, even if product B is much better. So that lock in effect is quite strong, and I think that a great way to think about it is a phrase that a friend of mine came up with once: “Disruption and commoditization are the long story arc of tech.”
I love this phrase because it makes you remember that over time, many parts of tech get commoditized. You saw this with Sun Microsystems where ten years ago during the dotcom bubble, Sun was a dotcom. They supplied hardware, supplied software, chips were phenomenal... At the end of the day, Intel gets a little better every cycle and Window’s server system gets a little better every cycle. Eventually that performance just kind of eats away at the proprietary systems that Sun was selling. That’s the commoditization part of what I was just talking about. Disruption is the other part of this in that every once in a while technology paradigms get disrupted. That’s what we are seeing with cloud computing right now. The cloud could become Microsoft’s best business ever, or it could seriously diminish their competitive advantage. Microsoft’s cloud platform, if you model it out, has some pretty attractive economics if they can get the user base going and really scale the data centers. But, what it does do is open a wedge for other companies to potentially compete with them, because the desktop simply becomes less essential to your computing experience. Computing power then moves off the desktop and you are into centralized data centers and people become more and more comfortable accessing their computing experience via browsers and remote data as compared to on their desktop. So, the cloud is a threat and an opportunity for Microsoft. It’s hard to say which way things will go right now, but it certainly puts their competitive position more in question today than at any point in the past decade.
A recent article in the WSJ talked about how Best Buy was getting hit by technology so it even seems non tech companies are having their moats eroded. What impact do you think technology will have on non-tech companies?
Best Buy used to have a moat, but Best Buy always made a pretty decent margin on the DVDs that they sold and CDs as well, but as that became a smaller percentage of the floor space, you suddenly had a lot of floor space that was being used for pretty much nothing.
Another quick example is Nokia. Nokia missed the fact that the hardware part of cell phones, which is where they had an advantage, was becoming commoditized, and the value was moving to the software, which they had never done a very good job of innovating in. That in a nutshell is why they are in so much trouble right now. They are a hardware company and over time hardware tends to become commoditized, whereas with software it’s a lot harder to do that.
So back to non-technology companies, do you think their moats are being eroded due to technology?
It really does vary. You do have the digitization of media which is driving some companies out of business. This is just like the recent bankruptcy filing of Borders. On the other hand, Wal-Mart is in a lot of ways a technology company. They have been very good and very innovative at using technology to be more efficient, to run leaner, and to squeeze a few extra basis points out of the margin line whenever possible. And so, the efficient deployment of technology has strengthened Wal-Mart’s competitive advantage in the same way that the advance of technology in the digital media has driven Borders out of business. It’s a very hard thing to generalize about and the only generalization you can make is that if a management team doesn’t have a set opinion about whether a certain technological trend is strengthening, weakening, or not affecting their competitive advantage, then they should find an opinion on that real quick.
But, I really haven’t thought about that that much yet. So it’s probably a bad answer.
Your second book "The Little Book That Builds Wealth" basically focuses on moats, is there anything you would like to add about the book?
It’s basically an outline of the framework that I developed at Morningstar, which is sort of evaluating competitive advantage as an investor because as an investor you only have access to publicly available information, whereas a manager studying Michael Porter you have private information because you run a company or a division. So, the critical thing for an investor is to say what are the external attributes that I can look for that might help me think about whether this business has a structural competitive advantage or moat or whether it doesn’t.
In your first book; The Five Rules for Successful Stock Investing, you discuss five main themes: 1) Do your homework. 2) Find economic moats. 3) Have a margin of safety. 4) Hold for the long haul. 5) Know when to sell? Can you elaborate on these principles?
The first book is a primer on fundamental investing – it’s the book I wish I’d had 15 or 20 years ago. There are a lot of books out there written for people who don’t know what a price to earnings ratio is and there are a lot of books written for people at the CFA level, and in my view, there just isn’t a whole lot in between for the investor very early in their career or for the very serious amateur. That’s kind of what I set out to write, because when I started out, I knew what a price to earnings ratio is, but I didn’t have the luxury of getting accounting in college, so I need to know how to read an income statement. How do I read a cash flow statement? What do I want to look for in a business? How do I do basic valuation work? So that’s kind of what I was trying to walk people through.
What are your favorite books?
Joel Greenblatt’s “You Can Be a Stock Market Genius” is a phenomenal book, and I think it has gotten probably more publicity in the past few years since the book originally came out. I liked that one a lot because like the Peter Lynch’s books, it provides us with examples and I think that’s how you learn rather than by saying, “Hey, I have some grand theory on investing.” You kind of take it from a bottom up approach and say, “Here’s a lot of things that worked, what can we learn from that?” which is a much better way of learning about investing.
The Halo Effect is a great book that came out a few years ago that really deconstructs why people often think managers have more of an impact on companies than they actually do. And, I would say for anyone who is a giant fan of Jim Collins’ “Good to Great” school of thought, where any business can go to from good to great through eight steps, you should read the Halo Effect. It’s the contrary opinion I will say.
I would agree with Seth Klarman, that anything Roger Lowenstein writes is almost always worth the reading.
There are a bunch of others obviously, but those are a few good places to start.
There is no one good book on behavioral finance, unfortunately, not that there’s nothing good as there is plenty of decent stuff out there but there’s no one great one.
You discussed some recent alternatives to TIPs as an inflation protection; everyone nowadays is looking for some type of inflation protection. Could you elaborate?
I kind of fell back to the comment about the best protection against inflation is a business with pricing power; a business with a moat. A business that can raise prices ahead of inflation, at the end of the day equities tend to do better when you’re hedging against inflation. And, we are seeing companies like Nestle and also Colgate get hurt by input costs. But they are certainly performing much better than their peers that don’t have any brand equity at all. You have some companies where if you do get higher rates along with inflation which is frequently the case, you’ll benefit basically 100% gross margin incremental income as rates rise. The distributors are an interesting place to look, too. Because they are businesses that don’t really carry a lot of inventory and just act as the middlemen, they are taking in goods and then passing them along, and acting sort of as demand aggregators between buyers and sellers, they tend to do well because they get that nominal boost on the top line without incurring any real additional cost.
So what would you recommend as an inflation hedge?
As an inflation hedge, I am a stock guy. I look at great businesses and certainly people who owned gold over the past several years have done very well and more power to them but, to me, gold is something with a lot of extrinsic value in that it gets its value from the value that other people place on it. But, it’s also very hard to figure out what intrinsic value it has. Personally, I have always done better at figuring out what a business can do in terms of compounding value and generating cash than forecasting the behavior of others. Some investors are quite good at forecasting the madness of crowds. And, if they are good at that then more power to them, but if you are buying gold as an inflation hedge or another reason, then you are depending on the opinions of others to put the price of gold even over the long run. It isn’t bad or good; it’s the truth. It’s the reason I have never recommended it myself, and that has been the wrong decision the past few years. But, we will also see where gold is five years from now.
You Recommended Ford Recently I believe?
Operating leverage tends to get mispriced by the market. If an analyst goes to their boss or writes a report that shows that profit margins are going from 20% to 5% or 5% to 20%, people kind of laugh at them. People tend to think linearly and it’s hard to think in terms of big step changes. And so, you saw that with the newspapers, where margins had been ticking down slowly, and then suddenly they couldn’t cut costs further and margins just collapsed. That was operating deleverage that caught many people by surprise.
By contrast, when the Chicago Mercantile Exchange, MasterCard became public, they had good margins, but structurally both businesses should have been able to support much higher margins, so if you forecast significant improvement in operating margins for a few years, you had the stock right; if you didn’t, you didn’t buy them. And I think that something similar is probably going to happen with Ford, in that the operating leverage of this business is probably going to surprise people to the upside. One of the caveats will be oil -- if oil stays up where it is now, that could definitely be an impact on consumer demand that throws a wrench in the operating leverage story because you need that higher sales volume to drive operating leverage. It seems like there is pent up demand in the auto market because cars do break, get old, and auto sales has been at a very low level for a number of years but there is a lot of unsatisfied demand out there but consumer balance sheets are not at their strongest, so very high oil prices for a while could push that off for a while.
The case for Ford seems reasonable, but I would say the one stock that I like the most now is probably Advanced Micro Devices, which has been a second banana to Intel for a many years. They have fixed up the business nicely over the last few years, spinning off their foundry business into a joint venture called Global Foundries. Getting that capital intensive business largely off the balance sheet, they got about a billion and a quarter settlement from Intel a few years ago which was basically a judgment against Intel for some sales tactics back in the day. And that’s helped the balance sheet out nicely. The near term catalyst is that they have some new chips that are coming out later this year which have the potential to take meaningful market share from Intel. AMD doesn’t need to take that much share to have a very meaningful impact on its bottom line. And, since the market is basically pricing AMD as if it will get no incremental share, if they get just a bit, you get the double whammy of improving profits an improving expectations.
Do you think Ford still has pension liabilities, which could be an issue for the company?
This will probably be a larger issue for Ford than for GM because Ford wasn’t able to restructure the same way that GM was during bankruptcy. So it will be a little more of an issue for them, but I’m not sure I can really say much more beyond that. The thesis on Ford and has to do with auto sales volumes rebounding higher than the market forecasts over the next couple of years and that’s what should get the stock closer to intrinsic value, but Ford is not what I would call a buy and hold company. I would not want to be hanging around owning Ford shares until all the evidence comes to roost on those pensions. This is not a company that you would want to buy then walk away from for five years.
Thank you again for your time.
It was a pleasure speaking to you, and looking forward to seeing the interview
Pat Dorsey’s books can be purchased from Amazon.com from the following links- The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market, and The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments
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