This is the fifth book in the Little Books series from Wiley, each of which
focuses on describing a specific investing strategy. The four previous ones
(all reviewed in MoneyLIFE) dealt with value, growth, a combination of the two
and the superiority of index funds. This one deals with finding stocks that
earn superior returns over long periods because they enjoy some peculiar
competitive advantage. To use Warren Buffett’s term, they have economic
moats around them that keep out competitors.
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
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. –