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The Long View
Pat Dorsey: Economic Moats and More
00:43:05
Morningstar’s former head of equity research on what investors get wrong with moats, what to look for in company management, why quantitative screens are less useful than they were, and the process he uses to filter out signal versus noise.
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- [00:00]
Pomona Investment Fund Announcer
In private equity secondaries, relationships aren't just an edge, they're everything. Trust and reputation open doors long after deals close. For 10 years, the Pomona Investment Fund has brought institutional private equity exposure to individual investors, delivering opportunities others can't. Think private equity is just for large institutions, think again. All investments carry risk, including possible loss of principal. For details on the Pomona Investment Fund and its risks, Visit Pomona Investment Fund.com investors.
- [00:30]
Disclosure Announcer
Please stay tuned for important disclosure information at the conclusion of this episode.
- [00:36]
Ben Johnson
Hi, and welcome to the Longview. I'm Ben Johnson, head of Client solutions with Morningstar.
- [00:41]
Amy Arnott
And I'm Amy Arnott, portfolio strategist for Morningstar.
- [00:45]
Ben Johnson
Today's guest on the Longview is Pat Dorsey. Pat is the founder of Dorsey Asset Management, a boutique asset manager serving institutional clients. From 2000 to 2011, Pat was the director of equity research for Morningstar, where he led the growth of Morningstar's equity research group from 20 to 90 analysts. Pat was instrumental in the development of Morningstar's economic moat ratings, as well as the methodology behind Morningstar's framework for analyzing competitive advantage. Pat is also the author of two books, the Five Rules for Successful Stock Investing and the Little Book that Builds Wealth. Pat holds a master's degree in political science from Northwestern University and a bachelor's degree in government from Wesleyan University. Pat is a CFA charter holder. Well, Pat, welcome to the Longview. Thank you so much for joining us today.
- [01:42]
Pat Dorsey
Yeah, you bet. Happy to be here.
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Ben Johnson
So, Pat, I want to start with, I guess, maybe a question of identity. Specifically, you've developed a reputation as sort of the quote, unquote, moat guy. So if we can start by firstly defining what is a moat in your mind, your interpretation. And how did you wind up becoming the moat guy?
- [02:05]
Pat Dorsey
I mean, look, a moat is just a structural competitive advantage, something that's an attribute of a business that makes it difficult to compete with them and generally lends them some pricing power. Could be scale, could be switching costs, could be a brand, a few different things. I think the origin of it is simply my time at Morningstar. When we launched coverage of individual stocks in 2001 or so, we were a new entrant to the industry. Obviously, Morningstar had been well known for mutual funds, but was not known for equity research. And frankly, equity research is a commodity. You take the logo off of a Goldman Sachs or a Bernstein Report, you don't really know who wrote it. And so the goal was to differentiate ourselves and then also try to offer something, a perspective that was useful for investors and Competitive advantage had never really been categorized or codified anyway. And so that was the moat framework that I helped develop. And there's obviously been lots written about it since, a lot of it that's vastly more intelligent than anything I ever came up with. Probably because we were some of the first ones to take that Warren Buffett phrase of economic moat and, you know, codify it, categorize it, probably why the label stuck.
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Amy Arnott
So you mentioned a couple of types of moats. What would you say are the most common moat sources?
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Pat Dorsey
I mean, I think it really just depends on the industry. I mean, obviously in consumer products you're going to have brands and scale in luxury goods are going to have really brands. You know, in B2B software, switching costs tends to be the most common. You know, people don't use SAP because they have a huge affinity for the brand. They use it because the switching costs are really high. So I think it really does depend on the type of business, the industry that you're analyzing.
- [04:10]
Ben Johnson
I'm curious because moats I think really involve in both sort of my lived experience and all my reading. And I think, you know, you see this in your work, you're part sort of science, part art. So when you see other investors trying to identify companies with moats, what are some of the common mistakes, sort of even head fakes that they experience when trying to identify different sources of moat? And even to say, you know, XYZ company has a moat for ABC reasons.
- [04:46]
Pat Dorsey
Yeah, it's a great question because I mean, the historical touchstone for a moat, which is return on capital sustainably above cost of capital, has kind of gone out the window as accounting has not kept pace with economic reality. You know, it used to be that all of a company's assets sat on a balance sheet and were part of a capital base. But with the advent of, you know, Internet based businesses and software companies, a lot of expenses that create competitive advantage code or a network of users never show up on the balance sheet. And so return on those quantitative metrics like return on capital are frankly not that useful for many types of businesses in determining whether they have a mode or not. To your second question, in terms of what people get wrong, I think the most common trap is just kind of mischaracterizing a great product or service as a moat. You know, people use a product, they experience a service, they say, wow, that's awesome, this must be a great business. And you have to think through, you know, how sustainable is that demand, how much pricing power is it going to have over Time, how easy would it be to replicate it? Those are really kind of the key questions in determining whether it's a sustainable advantage or just kind of a flash in the pan.
- [06:05]
Ben Johnson
Pat, I wanted to ask a follow up specifically on the shifting landscape with respect to the scientific part of moat identification that you called out around just returns on invested capital. And I think in particular some of the trouble we have sizing the denominator in that equation is things have shifted along the lines that you described and maybe even grounding it on a company that you're familiar with in Facebook, which among others recently done some things to, you know, maybe shift sizable investments that they're making off their balance sheet. Like how does that come to be in the case of companies like Facebook and elsewhere? And what sorts of adjustments are you trying to make as you're sussing out moats?
- [06:55]
Pat Dorsey
Yeah, so to level set, you know, Facebook and Google are both becoming more capital intensive businesses than they were a few years ago. So that's an important thing to recognize when thinking about them. But to your other point, your much more subtle one, some of these investments are being shifted off balance sheet. So there's capex occurring that is not showing up in the financials as part of a capital base. So that makes the quantitative analysis frankly pretty complicated. But I think in the case of a business like Facebook or Google, which is sort of a hybrid capital heavy becoming more capital heavy business return on invested capital was never all that useful as a metric. It was much more about the qualitative attributes of, you know, user captivity driving incremental, you know, value from each user via, you know, advertising or other means. I think the only cases where a strict return on capital metric is still useful is a business where the bulk of the value creation is coming from capitalized assets, you know, in industrial businesses, for example. So I think, you know, for those types of businesses or businesses that do heavy m. And a return on invested capital is still a super useful metric. But I think any time that you have a fairly capital light business, you're much better leaning on the qualitative side than the quantitative side.
- [08:24]
Amy Arnott
You've also written about the difference between companies that have what you call an inevitable moat versus a non inevitable moat. Can you kind of walk us through the difference there? And is one type more compelling than the other?
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Pat Dorsey
Yeah, I mean Buffett used this originally, I think back in the 80s to refer to kind of the consumer brands, companies like Coca Cola that he owned, that they were inevitable, it would always be just fine. And I think a Mistake many people make is they assume that to have a moat, a business has to be inevitable, sort of slowly changing, one you can put in a safety deposit box and come back to in a decade. And the issue for me is that that's actually a subset of moats. It's not the entirety of the moat universe because there are lots of businesses, you know, in dynamic industries like semiconductors or software or Aerosp, where things can change more rapidly but moats can be created all the same. And these are not businesses you'd want to put in a box and come back to in 10 years. But there are certainly businesses with moats that you can own, hope and hypothesize that they stay on top for a decade, but evaluate them, reevaluate them over time. And it's a facts change, change your mind. And the nice thing about kind of these less inevitable boats that operate in dynamic industries is that they typically have greater scope for reinvestment because their end markets are growing faster than the, you know, 2, 3, 4% that non changeable, non dynamic industries like, you know, waste management or soft drinks are typically growing at.
- [10:07]
Ben Johnson
Pat, I'm curious about sort of moat surprises that you've experienced, you know, in your years applying this framework to analyzing companies, specifically examples of companies whose moats may have dried up more quickly than you might have expected or conversely, any examples of moats that have proved more durable than you've ever imagined.
- [10:31]
Pat Dorsey
Yeah, I mean certainly we got Wrong footed on PayPal and it was a great example of where frankly common sense would have led us to a different answer than company disclosures. You know, the company like to talk about its large network of 400 million users and higher levels of conversion from merchants use PayPal, all of which were true. The issue is simply that PayPal can't access NFC on your smartphone. And so as payment modalities shifted from not simply used online to also, you know, using tap to pay in a physical environment for the consumer, it's much more logical to use the service that allows you to do both. Like Google Pay or Apple Pay, where you can buy a candy bar at Walgreens and you know, go to Amazon and buy something. You know, PayPal is cut out of one of those sides of transactions and it really lost share because of that. And so that's one where the emergence of new competitors and payments and sort of their inability to access those new entrants, Google and Apple's platforms caused them to lose a lot of share in their most profitable business, which was the branded consumer. But on the flip side, you know, I'll say point blank that I think Visa and MasterCard have proved far more immune to regulatory pressure than I would have ever imagined. I would have expected some type of regulatory pushback on the frankly, egregiously high fees that they charge in the US relative to what they are able to charge in other countries a long time ago. I still find it rather staggering that credit card fees for merchants are so much higher in the US than in analogous developed countries. And there's a number of reasons why that's the case, but it is not an outcome that I would have expected 10, 15 years ago.
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Amy Arnott
So following up on PayPal, would you say that the network effect is something that people tend to overestimate as a moat source in terms of how durable that is?
- [12:49]
Pat Dorsey
Yeah, I mean, I think people can kind of put it on a pedestal and say, oh, this company has a network effect and assume that if they make that statement, they have eliminated all questions around competitive advantage. And that's, you know, frankly, false. You know, you have to consider both the type of the network, you know, is it interstitial or radial, which you know, the latter being easier to disrupt, but also what value that network is delivering to people. And while PayPal's network remains very large, the value it is delivering to each member of that network is lower today than it was 10 years ago because there are competing advantages there. And for quite a long time, PayPal recorded a very key metric which was transactions per account in a very obfuscatory way. That led one to think that the network was remaining very strong because transactions per user was going up. But there are numerator which was transactions was being driven by their braintree back end processing business, which has nothing to do with the utility of the branded button. So the network effect there was mischaracterized, frankly by the company in terms of the financial metrics it disclosed and, you know, was not nearly as strong as many people, ourselves included, had assumed.
- [14:18]
Amy Arnott
We also wanted to spend some time talking about management quality and the management behind the moat. What are some of the key traits that you look for in company management?
- [14:31]
Pat Dorsey
Probably the biggest thing is just humility and a willingness to listen to alternative viewpoints. You know, most people get to the top of organizations by having aggressive personalities and large egos. And those can be very dangerous when you're in charge of strategic decisions and capital allocation. If you're not listening to other viewpoints and if you're only listening to yourself because you think, you know, you're a genius because you got to the top of the business. And so one thing when we meet with management or listen to interviews with them that we always look for is, you know, whether management, do they attribute the company's success to themselves or do they share that credit with members of their management team? Are they willing to admit mistakes? Do they talk about others who have influenced them or who provide valuable alternative viewpoints? The dangerous ones, frankly, are the ones who think they're always right and are unwilling to listen to alternative viewpoints because some of the worst disasters in corporate history have occurred when, you know, the contrary information was available, but the people at the top were either unaware of it or unwilling to listen to it.
- [15:49]
Ben Johnson
So Pat, I'm curious, not having had the privilege of being a fly on the wall for internal strategy sessions or board meetings or what have you, you were able to get a good read on management from the outside looking in. That gives you a level of confidence that they meet a lot of those criteria that you've just described.
- [16:11]
Pat Dorsey
Yeah, well, certainly, I mean, as institutional investors, we are able to meet with management, at least some management teams. I mean, Mark Zuckerberg is not on my speed dial, so we have not met with them. But. And you know, I'm able to ask questions around culture, around the stakes and kind of get a read from that standpoint. But I would say from the outside, it's much easier today than it was 20 years ago. You can pull up transcripts of how management talks about the business at conferences, and I think it's probably less so on earnings calls than when they go to a sell side conference and they kind of have to describe the business or answer questions for maybe a audience that's less familiar with the company. Just think about how do they describe it? Do they really overemphasize the positive or they present a more balanced viewpoint? Do they answer questions in a straightforward way or do they kind of dodge the meaning of more critical questions? YouTube videos, YouTube interviews are fantastic. Again, not a resource really available 15, 20 years ago. You know, members of management will often get interviewed, you know, in a wide variety of forums that you can find on YouTube and then, you know, get a real life view on again, how do they talk about the business? Do they agglomerate all credit to themselves? Do they share it amongst members of their team? Are they willing to listen to critical questions and respond to them thoughtfully or do they just brush them off? So I think that it's not easy today, but it's certainly the resources available to the investor are far greater than they were even a decade ago.
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Amy Arnott
You've invested in a lot of founder led firms which can turn out to be great investment opportunities. But you've also written about the danger of the cult of the founder. How do you differentiate between a founder who can scale well with their companies as they grow versus a founder who might become a liability as the company matures?
- [18:16]
Pat Dorsey
Yeah, this is a super important point because I think a lot of folks put founders on a pedestal. Especially because in Silicon Valley and in the venture capital world there's sort of a tendency to, you know, look, when you're investing in a business that has almost no revenue at this point, or lots of revenue, no profits, you really are just betting on the founder. And so that's as a venture capitalist, that's a very sensible thing to do. But as as an investor in larger organizations, you need to differentiate between the fact that, you know, a founder's job is to rally troops, have an idea and then execute on that idea. Whereas a manager has to sit on top of a very large and complex organization, balance competing priorities, think about addressable markets and what to do when they don't pan out as expected. It's a different set of skills. And so I think that just because someone is a founder and may still own a big chunk of the equity in no way, shape or form means they're going to be a good manager of a business. It's super important, I think, to put founders on a level playing field with non founders when evaluating management. And I think maybe one of the key things to look out for is, you know, as a founder, being a micromanager is probably a benefit. Right? You need to be on top of everything that's happening at any point in time. What's your burn rate, how are you acquiring new customers, you know, and it's a smaller organization, so you're able to have your hands in every pie in the business. But when you become a larger organization, micromanaging becomes a liability. Having every decision run through you slows things down and can really prevent you from listening to alternative viewpoints if you think that you're the one who has to make every decision. You know, the Steve Jobs model worked for Apple. It doesn't mean it's going to work in every business. So the key thing is simply to evaluate founders of large organizations the exact same way you would non founders and don't give them the benefit of the doubt.
- [20:22]
Amy Arnott
And I would imagine that to be a successful founder you have to have kind of a builder mindset where you're creating something from the ground up and nurturing it over many years. But there may come a point where the industry changes or technology changes, the competitive landscape changes, where you may actually have to pivot and destroy what you built, which could be probably difficult for a lot of founders.
- [20:54]
Pat Dorsey
Yeah, for sure. And I would nuance what you said in that I think some founders, the ones who mature into good managers, are builders. But frankly, given the way venture capital works and the huge payoffs that are available for exits, I think some founders are in it to create and sell. Right. Or create something that can then get monetized via an IPO at a very high level. I would hesitate to characterize those types as builders. They're certainly creators, but they may be optimizing for a 6 to 7 year payout as opposed to a 20 year value creation story.
- [21:34]
Amy Arnott
Yeah, that's a helpful distinction.
- [21:36]
Pat Dorsey
But to your point, certainly, I think that not many founders become good capital allocators. You know, I mean, you look at frankly Airbnb right now, and certainly Brian Chesky created a wonderful business, but they're having real troubles. Growing supply, they have a wonderful moat, they get most of their traffic organically, they have great margins, but you know, it's simply not going to grow at the rate it did when alternative accommodations were going from non existent to a meaningful competitor to hotels. All accommodations are now a scaled business with competitors like booking. And you know, Airbnb generates way more cash than it can profitably reinvest back in the business. But the odds that, you know, he says, okay, the rational thing for us to do is, you know, buy back stock as opposed to continue to pursue the growth that we once had. I would say those odds are pretty low. And that's, that's a common flaw that you see in founder led businesses.
- [22:42]
Ben Johnson
I wanted to ask you about management discretion over one of the larger levers that teams can pull, which is pricing. And we've seen that, we've lived through that in recent years with this spike in inflation that we've lived through. I'm curious how you think about management teams that pull that lever utilize their ability to get price in a way that is sensible and focused on both sort of preserving and maximizing maybe the value of their moats. And when maybe that sort of crosses the line into potentially abusive territory where short term rents become the priority.
- [23:28]
Pat Dorsey
I think the key to look at is, you know, what value are they delivering in exchange for the price they're extracting. And most consumers won't complain too much. If you're raising my price by 6, but the value you're giving me went up by 4, I mean, optimally, the value went up by 8, you're charging for 6, like that's even more sustainable. But it's when companies don't reinvest back in the product and they just kind of milk it and raise price because the consumer or user has little other choice. That's a business that is often less sustainable. So I think that the key there is simply, you know, whether management is reinvesting back into the product or service and improving it to some degree. Even if they are perhaps charging more than the value they're delivering, are they at least delivering some incremental value as opposed to just leaving the product relatively static and, you know, milking what will eventually become a melting ice cube.
- [24:32]
Pomona Investment Fund Announcer
In private equity secondaries, relationships aren't just an edge, they're everything. Trust and reputation open doors long after deals close. For 10 years, the Pomona Investment Fund has brought institutional private equity exposure to individual investors, delivering opportunities others can't. Think private equity is just for large institutions, think again. All investments carry risk, including possible loss of principal. For details on the Pomona Investment Fund and its risks, visit pomonainvestmentfund.com investors.
- [25:03]
Amy Arnott
We also wanted to spend a little time talking about your investment process. And in one of your letters to shareholders, you shared an anecdote from a time when you had a group of students visit your office and one of the students asked what kind of stock screens you apply to find high quality businesses, and you admitted that you found that question kind of hard to answer. So we wanted to sort of put you on the spot again and ask, how does that process work? How do you winnow down your investment universe from 4 or 5,000 publicly traded stocks to a very small list of companies that you actually invest in?
- [25:50]
Pat Dorsey
Sure, yeah. I mean, I think that the first thing is, and I discussed this earlier in the conversation, I think quantitative screens are much less useful than they were 20, 30 years ago simply because returns on capital are a flawed metric. Given that the prevalence of capital, light value creating businesses, and they can mislead you too, right? I mean, the worst software company in the world is going to have high returns on capital because it has no capital. So a screen isn't going to help you a lot there. You know, I think gross margins generally are a better tell though. The flip side there is you can have distributors which are low margin but very high return on capital because they're flowing the inventory through the system so quickly. I think for us, one important thing is to realize you don't need to invest in everything and that you can ignore gigantic swaths of the investment universe. We spend almost no time on auto parts or insurance companies or banks in the U.S. or chemical companies or energy companies or commodity oriented companies, because those are businesses where you can build a moat. But it's really, really, really hard and we might as well fish in ponds where there's just frankly more fish. And so I think we win our downer universe by spending more time and areas like aerospace or semiconductors or enterprise software or Internet advertising that, you know, have good market structures in terms of being, you know, oligopolistic, you know, tend to have good pricing power and then also have good secular growth prospects. So it's really just a matter of kind of thinking about where the moats are, where the fish are, and, and fishing in those ponds.
- [27:43]
Ben Johnson
Pat, on that note, and you know, I think oftentimes what you've just described gets sort of termed as being your two heart pile. You shared in your most recent letter to investors a timely example whereby we've seen significant price pressure on the stocks of any number of different enterprise software companies in response to the evolution of all things AI. And for the time being, it seems as though sort of you're setting those aside irrespective of how compelling the valuations may or may not be. Could you speak a little bit more to sort of your decision process there? Why things that many might say, you know, hey, these look relatively cheap and their prospects might not be as dim as the market might think are kind of being pushed off to the side for your purposes today?
- [28:41]
Pat Dorsey
Yeah, I mean, I think for us there are sort of two categories of too hard bucket. You know, one is where we think will be the proverbial patsy at the table and that others are likely to something be structurally more able to understand the business than we are. So this would be the case for say, a non US business. You know, if it's a retailer that depends on local tastes or depends on local regulations, somebody on the ground in that country is going to understand that setup way better than we can. So we tend to put those in the too hard bucket closer to home. And the example that you brought up, when the range of outcomes widens to a very large degree and it's very hard to kind of put a confident assessment on the lower bound of that range, that's when we also tend to put things into a hard bucket. I think that for some enterprise software companies Figuring out the pace at which frontier models advance, the degree to which users are willing to substitute the service with something homegrown gets very, very difficult. There are others where the mission criticality or the risk reverse nature of the user base, I think makes the cone of potential outcomes much tighter. And the market is pricing. And those are some businesses that we're doing a lot of work on right now. But I think that the larger point is, you know, when the cone of uncertainty widens a ton and you have to figure out way too many uncertain variables to create a good investment hypothesis or a viable investment hypothesis, it's probably better to realize that there are lots of potential opportunities out there and you're better off moving on to another.
- [30:30]
Amy Arnott
You've also written about something that you call a pre mortem, which is a way of thinking through potential problems, I guess, with portfolio companies. Is that a discipline that you've codified with your research team? And what types of things have you learned from that?
- [30:50]
Pat Dorsey
Yeah, the way we tend to frame it is, okay, so let's imagine that we invest in X and five years from now it's flat, or five years from now we're down 30 on the investment. What has probably transpired in the interim, Right. And then you're kind of imagining, okay, is it because multiple hasn't rerated the way we thought? Is it because, you know, they have not been able to exercise price the way we thought they would? Is it because, you know, the addressable market is smaller than we'd anticipated? That exercise, I think, really focuses your mind on what variables to not just pay attention to, but to attach high signal to. So, you know, obviously for any business, there's tons of information coming through at a constant pace. And one of the hardest things for any investor, any investment, is when information begins to flow that is contrary to your original thesis. Do you categorize that as a short term blip or a buying opportunity or thesis violation? Because if you just reacted to every bit of negative contrary information, you probably own every business for about 20 minutes. What the pre mortem does is sort of says, okay, if we've identified these are the vectors or areas where our thesis could go wrong, and then information comes in that is pertinent to one of those areas that's pertinent to the addressable market or pricing or whatever it might be, you can attach higher signal to it, right? You can weight it more heavily in your decision process and help to kind of create signal out of noise.
- [32:39]
Ben Johnson
Pat, I'm curious to get your take on Kind of widely held notions of market efficiency, specifically as it pertains to opportunities that as you've described them in the past, might be hiding in plain sight. And examples in your portfolio include Meta, which I'm realizing earlier I referred to as Facebook because I'm that guy that
- [33:09]
Pat Dorsey
I still call it. That's fine by me.
- [33:11]
Ben Johnson
The Willis Tower will forever be the Sears Tower to me, Pat. I'll die calling it the Sears Tower.
- [33:16]
Pat Dorsey
Exactly, exactly. Something, something, something.
- [33:20]
Ben Johnson
But examples like Meta and asml, where the amount of information that's out there, the amount of analyst coverage, just the sheer amount of information that's being priced into those stocks on a day in, day out basis from all corners of the globe is like insane. So how do you think about approaching those and whether or not you can truly have an edge or a differentiated point of view on these firms that are just so widely known, so widely held, so widely followed?
- [33:53]
Pat Dorsey
Yeah, it's a super duper question and I think it's frankly an error that many investors make and that I've once made thinking that, you know, weirder is better. The key I think is going back to an old paper by Russell Fuller called Three Sources of Alpha that sort of thinks about different types of quote unquote edge, you know, and sort of disaggregating that glop of edge into informational, analytical and behavioral. And what you're referring to and what I think many investors think of as quote edge is knowing more or having information about the company that is, you know, superior to others in the marketplace. And I think that that's really, really, I mean, it's hard even for smaller companies in the land of Rec fd, but for a company like an ASNL or Meta, it's virtually impossible. And so when something's really hard, don't try. It's much easier to have a behavioral advantage. And so I think that that is something that any investor, regardless of information, can have. And it's actually become easier, I would argue, over the past 10, 20 years, partially because of the rise of the pod shops which control large amounts of capital but are very short term oriented. And so they just have a different time horizon than longer term focused investors like us. And also the very large amount of what I would call non price seeking capital out there. So you know, you think about passive funds, you think about shadow indexers who are active but might own 4% of Nvidia even though it's a 7% weight in the index, because they don't want to get left behind, right that individual is not expressing a value descriptive view on Nvidia. They're just owning it because they don't want to get left behind by the index because the stock has a high weight, the index, and because there's more and more capital like that out there, which you can think of moving shares one way or the other for reasons that are not oriented around, you know, converging long term value and price. You know, it opens up inefficiencies. I mean, ASML is a great example. All last year, all through 25, the hyperscalers were cranking up their capex budgets to the sky and ASML was going down most of the year. And it's because most people were waiting for a short term signal that quote, unquote, the cycle had turned. But you know, eventually if you buy more chips, you need more lithography machines. And so we kind of owned it and just sat on it for a while and it wound up working out okay, largely because we could look at a few years versus looking at a few quarters. And that's an advantage that our investors give us that, you know, the poor analyst at a pod shop probably doesn't have.
- [36:41]
Amy Arnott
So as you mentioned earlier, the assets that you're currently managing are in a private investment pool geared toward institutional investors or high net worth individuals. And I'm curious if you would ever consider running a mutual fund or an etf or do you prefer the current structure?
- [37:03]
Pat Dorsey
The nice thing about the current structure is that we have a fairly small number of clients and I know them all and they know me and that's just frankly more enjoyable because they're smart people and I learn from them as opposed to being sort of, you know, faceless ETF buyers. The other big issue frankly is flows. You know, if you are managing a mutual fund or etf, those structures have daily liquidity and you know, they may have shareholders who will react poorly to a month or quarter or whatever of poor performance. And you know, large flows, either positive or negative, definitely can affect the way a manager behaves. And we are fortunately somewhat insulated from that. So it's unlikely that I think we would ever launch a structure like that.
- [37:56]
Ben Johnson
Pat, I want to first of all give you credit for, you know, emulating in your communications to your investors many of the things that you alluded to before that sort of are the characteristics of what you look for in management, which is candor. And in many of your letters you frame the, you know, opportunity cost or you speak to the opportunity cost of some of the decisions you've made with respect to, you know, either buying the wrong things, holding on too long, selling too early, what have you. I'm curious because it doesn't, at least in my experience that term opportunity cost come up in a lot of portfolio manager commentary. Why do you gravitate towards that framing?
- [38:42]
Pat Dorsey
Well, because I think it's, I mean, well, in some ways it's the most intellectually honest. I mean if you own Acme and you own Acme for many years and it continues to have expected return of let's say 12% and that's just fine and you come across widget company which has an expected return of 20% with a similar risk profile, your opportunity cost of owning Acme just went up a lot because you could move that capital into which it go and because of, you know, endowment bias, you know, the behavioral corp that we tend to attribute more value to what we own versus not own and other considerations. I think there's frequently in our industry an unwillingness to consider businesses on a kind of a level playing field, businesses that you don't own and that you do own. And we try to always keep in mind the fact that you know, when you walk in, you rebuy your portfolio every morning like you're making an active decision to continue owning this portfolio versus a different portfolio. And so opportunity cost is something I think about a lot of. In fairness, we are very fortunate that the bulk of our investors are non taxable. And so the friction between moving from Acme to Widgitco is less for us than if we were say, managing money for all mainly high net worth investors in a very, very high tax bracket for whom selling a long held Acme code might incur a large capital gain. And so that's something that we would need to consider because it impacts our clients that we, you know, in our current form don't really have to because that's not the case for the bulk of our investors. And so it makes it a little bit easier to think about opportunity costs in a, in a more frictionless way. But I do want to recognize that that is for us to some extent an attribute of our client base and an investor who is, you know, managing money for taxable individuals, you know, just has different factors that they need to consider.
- [40:54]
Ben Johnson
Pat, I want to thank you on behalf of both Amy and I as fellow former members of the MorningStar Equity Research Department and indeed our audience, for coming on and sharing all your insights with us today. Really enjoyed it.
- [41:10]
Pat Dorsey
Sure. Anytime. Happy to do it again.
- [41:13]
Amy Arnott
Thanks Pat. This has been super interesting.
- [41:15]
Pat Dorsey
You bet. Take it easy folks.
- [41:21]
Ben Johnson
Thank you for joining us on the Long View. If you could please take a moment to subscribe to and rate the podcast on Apple, Spotify or wherever you get your podcasts, you can follow me on social media at mstarbench, Ben Johnson on X, or at benjohnson, CFA on LinkedIn
- [41:41]
Amy Arnott
and at Amy Arnott on LinkedIn.
- [41:44]
Ben Johnson
George Cassidy is our engineer for the podcast, Jessica Bebel produces the show Notes each week and Jennifer Garrett copy edits our transcripts. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at the longviewornings morningstar.com until next time. Thanks for joining us.
- [42:08]
Disclosure Announcer
This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording and are subject to change without notice. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. And its affiliates, which together we refer to as Morningstar Morningstar. Morningstar is not affiliated with guests or their business affiliates. Unless otherwise stated. Morningstar does not guarantee the accuracy or the completeness of the data presented herein. This recording is for informational purposes only and the information, data analysis or opinion it includes or their use should not be considered investment or tax advice and therefore is not an offer to buy or sell a security. Morningstar shall not be responsible for any any trading decisions, damages or other losses resulting from or related to the information, data analyses or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile. Before making any investment decision, please consult a tax and or financial professional for advice specific to your individual circumstances. MorningStar Investment Management, LLC is a registered investment advisor and subsidiary of Morningstar, Inc. The Morningstar name and logo are registered marks of Morningstar Inc.
- [43:45]
Ben Johnson
Sa.