Interview: Pat Dorsey, Guarding the Moat


Pat Dorsey is one of the most highly visible equity analysts on the market today. He rose to prominence as the director of equity research at Morningstar. He was one of the key figures who developed the fund management company's strong emphasis on "moats," or structural advantages enjoyed by companies that defend against competition. Today he's a TV pundit, an author of several books on investment, and serves as the vice chairman and director of research and strategy at Sanibel Captiva Investment Advisers.

In this interview, he expands and expounds on the moat concept and why it's critical for investors.

Eric Volkman: What's a capsule definition of moats, and why are they important?

Pat Dorsey: So, intuitively and empirically we know that competition drives down returns on capital. But, again intuitively and empirically, we know that there are many businesses that beat the odds, like only a dozen -- Oracle, Cisco [ (NAS: CSCO) ], Coca-Cola [ (NYS: KO) ], Pepsi, Tootsie Roll [ (NYS: TR) ], name whatever you want. Companies that have managed to maintain high returns on capital over a long time. The question just becomes: how, why? The answer is pretty simple; these [companies] have erected structural barriers, or moats, around their businesses that make it difficult if not impossible for the competition to eat away at their profits.

Volkman: Which other [publicly traded] companies these days have that sort of advantage?

Dorsey: Well, certainly Google has a very wide moat. It's a relatively young company, as economic history goes, and I think the core search business is incredibly strong in terms of competitive advantage. Part of that is the network effect of AdWords, and part of it is because Google does what's called "status slicing" -- they give you a good enough result. And that's really all a user asks of a technological tool. And so because of that, I think the odds that the core search franchise will erode are very low.

Volkman: Aren't you concerned that there are kind of low barriers to entry in a way? After all, I just need to make a website and I have a search engine.

Dorsey: True, but you could make a website and sell books. Would you be Amazon [ (NAS: AMZN) ]? This is a common mistake made by people who don't invest in technology or who think moats can only occur in businesses that sell sugary soft drinks. They confuse barriers to entry with barriers to success. Anyone can launch a website. Can they make it profitable? Can they entrench the individual's behavior? Anyone can start a mutual fund. Can anyone become BlackRock? Probably not.

Volkman: In your writings on competitive advantage you make a very strong statement that management in itself does not constitute a moat. This kind of flies in the face of a lot of "management first" philosophies.

Dorsey: Management by itself is not a moat. But management can build moats, as well as destroy them. So it's not that management is irrelevant, because remember a moat is structural.

Management does matter. It's just not a structural advantage. I think what's valuable as an investor is to understand when that's relevant and when it's less important. Management introduced New Coke to Coca-Cola and they didn't blow up the business. Steve Ballmer has been setting giant piles of capital on fire for a decade at Microsoft; they're still insanely profitable.

Volkman: So that would be one of the greatest values in having a wide moat -- that you can actually withstand periods like that and return to success.

Dorsey: Exactly. Your business is less vulnerable to stupid mistakes. It's that simple. And again, that doesn't mean that management is irrelevant. We can all point to businesses that have great moats that are not as good investment-wise as businesses with poor moats but genius management. Look at Whole Foods.

Volkman: Moat building is not an easy or quick activity. As such, isn't it antithetical to equity culture? Because investors are always looking at publicly traded companies to make their estimates this and next quarter.

Dorsey: Yeah, it can be. And that's why you need a company where [moats are] the focus of the business. Where management gets up every day and says, "What can we do to build our moat?" Not "What can we do to hit our numbers?"

Amazon's a fabulous example of [the former]. Every time they start making a decent operating margin, Jeff Bezos says, "OK, time to reinvest back in the business." You can see this in the cycle; every time they start ramping up capex, Wall Street hates them and the stock takes a hit. It happened just earlier this year. It's like clockwork.

Volkman: You touched on a few companies that are not as effective at building these advantages -- one of your more memorable phrases is they "shovel dirt into a moat." Do you see this happening with any known or prominent companies today?

Dorsey:Walgreen [ (NYS: WAG) ]. For years they had highest scripts per store, they drove high sales per square foot with the script traffic, and it was a great business. But what they missed is a change in the way consumers get prescription drugs. It's much more common now for people to get drugs by mail order than to walk into the store, and for people either to get advice, or be required to get advice, on their medication from an HMO or a PPO as opposed to their local pharmacist. The local pharmacist was essentially being dis-intermediated and I think Walgreen, their entire history and corporate culture, was based around the primacy of that pharmacist relationship. They just missed it, you know? Basically, a secular shift in the way drugs are delivered, consumed, and recommended is eroding their moat. And instead of fighting that secular change, they're basically fighting a rear guard action. Which is never a happy thing.

Walgreen's moat is quickly drying up, whereas Amazon's seems to be getting wider. Find out much more about the company in our premium report on its stock. This in-depth analysis also includes a FULL YEAR of quarterly updates. For more on the report or to download it, click here.

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