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FCCB chickens come home to roost
Only six months ago, the mood was one of great confidence and celebration. George Soros was investing heavily into India, putting money into both sides of the Ambani divide and then some more. The Arabs were supposed to pour money into India to diversify their asset base. The Indian corporate sector was borrowing, taking over companies globally (there were...
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Like the four earlier books in the series, this one too is slim, lucidly written and persuasively argued. But this one is the most difficult for individual investors to follow. It is also the only book written by someone who is not actually managing money. Pat Dorsey is a director of research at Morningstar which is best known for its star ratings of mutual funds, not its prowess for stock research. Dorsey may be a careful and successful investor in his own right but that is different from a successful record of professional investing involving large amounts of money of outside investors like say, Joel Greenblatt, author of Little Book that Beats the Market, can boast of.
The reason it is impossible to follow this book in real life is that economic moat is a concept, not a formula. It is simply not practical for a lay investor to look at thousands of stocks and figure out which company has an economic moat around it. The bigger issue is: that a company enjoys an economic moat is usually proven by hindsight by which time it may be too late – the stock would have run up. Anyway, for what it’s worth, here are Dorsey’s ideas of moats, how to find them and how to avoid being trapped in companies whose moats are eroding. There are four factors that can create moats. One of them is intangible assets, those that cannot be quantified easily but do generate additional value. It is commonly assumed that brands are intangible assets but there is a difference between a brand like Sony and one like Tiffany’s. Sony is well known but it can’t easily charge a significant premium over, say, Samsung. But Tiffany’s is able to do exactly that for its pretty little blue box. According to Dorsey, patents and regulatory protection are also great moats, but the most valuable companies are those that have lots of small patents, not a few big ones.
Another kind of moat is switching cost. Many providers of financial services enjoy this. How many times do we change our banks? Or even a fund company we have invested with, despite average performance (witness the continuing popularity of UTI)? Then there is the moat arising from network effect. Microsoft does not sell great software products, according to the techies (they derisively label these products ‘bloatware’). But can you abandon MS Office and Windows and move to something else, as long as the whole world uses them? A distribution company enjoys a moat because the cost and effort of creating a distribution network is huge. This is why it is almost impossible for another Coca-Cola or Pepsi to come up. They cannot afford the costs of distribution.
There are two other kinds of moats – cost and size. The cost edge can come from better locations, better access to resources and better processes. The steel industry is a very good example of all these. Indian steel companies have access to iron ore and so have the advantage of access to resources. Korean steel giant Posco does not have access to resources but has the advantage of location (Korean and now Chinese manufacturing) while Nucor of the US has pioneered thin-slab casting and has the advantage of process. Of these, the process moat may be eroded the fastest. Other steel companies have adopted thin-slab casting and ArcelorMittal, with plants in resource-rich areas and near steel-consuming markets, has all three advantages.
The size advantage is obvious. Just witness what a Wal-Mart can do or what Reliance Industries can do – bring in efficiencies in processes, drive a hard bargain with suppliers and ride economic downturns better than their rivals.
Having described the four moats, Dorsey rounds up his thesis by describing several crucial aspects of the moat strategy – how to choose companies with moats, how to value them, how to monitor them and when to sell.
Finding moats by researching companies directly is impossible for lay investors. Where do you even start? Probably professional investors can. But mutual fund portfolios are stuffed with plain vanilla companies from cement, auto, steel, construction and other mundane sectors, where companies have no moats. According to Dorsey, there is one way of finding companies that might potentially have a moat: look at the long-term return on capital. Unfortunately, this is of no use. Any ranking of long-term return on capital will throw up Hindustan Unilever (HUL) as a buy. But it has no moat and is being beaten by companies a fraction of its size – from Emami to Marico.
That takes us to the biggest weakness of the book. It is like the books on new management concepts that come out every year. Choose a few success stories that fall into a pattern and hold up the pattern as the new success formula. They advocate something that cannot be tested and falsified. Dorsey necessarily chooses companies known to have wide moats and a strong record of value creation to support the thesis that the idea of moats works.
This is inductive logic and retrofitting, and, hence, flawed. It does not take into account many stocks which may have had moats at some point (all companies do) but failed to retain them, or companies which have no moats but have delivered great value to shareholders or even companies like HUL which have recorded high return on capital (Dorsey’s touchstone) but failed to create any value for a decade. Still, an interesting book to have. – Debashis Basu