Pat Dorsey presents at the 14th Annual Value Investor Conference in Omaha, NE.

a little bit about dorsy Asset Management The Firm that I run right now we about three years just to give you some context for what I'm about to talk about for the next uh 30 minutes or so um we launched about three years ago uh we're about 250 million in assets under management um we have three research professionals uh and a CFO coo we're very concentrated 10 to 15 positions uh Global mandate so we can invest anywhere in the world uh and we look for businesses with competitive advantages runways for reinvestment and strong Capital allocation and I want to spend just a moment on that because it's a big it's a important for framing uh my discussion over the next 30 minutes or so um unlike some firms which really focus more on mature firms with established modes we're much more focused on firms that are still building their modes firms that are reinvesting capital back into the business because in our view the value of an economic mode of a competitive Advantage is maximized when you can reinvest back into the business if my end Market is only growing 3 or 4% I got to sped out all the cash to either shareholder that's really nice but I'm not maximizing the value of my competitive Advantage if my n Market is growing very quickly and I can reinvest back into the business at a high 20 30 40% incremental rate of return that's when you get laip loes that's when you get the value of the mo being really maximized and those are the kinds of businesses that myself and my colleagues focus on and so that's what I want to talk about today I want to talk a little bit about economic modes um I recognize a lot of familiar faces here and so you will be very happy to know that I'm not repeating the same thing I did past couple of years going to try to rip through that reasonably quickly because what I want to spend more time on is capital allocation I think Capital allocation frankly is kind of under thought about and underd discussed because people just sort of blly say oh Tom you know Malone is a great capital allocator okay great well what does that mean and how do you find great Capital allocators without waiting for them to compound capital for 40 or 50 years I think that would be sort of useful uh since none of us have the Wayback machine and can go back and invest with those folks 40 50 years ago so I want to spend a fair amount of time talking about Capital allocation and identifying The Good the Bad and the Ugly uh in that field so economic modes uh Basics here capitalism works uh High profits attract competition if I gave each of you 10 million bucks and said go start a business you would not go start a newspaper or a buggy whip business you would go start sorry Warren I know he owns a newspaper um you would go out and invest in businesses or start a business that's doing really well that's generating High returns so you can compete with those and bring them down intuitively this makes sense empirically it is also true if you take large data sets of of businesses uh you know the csfb Hol one is probably one of the better ones look at you know the top quintile or desile of Returns on Capital at T1 roll the clock forward to T10 T20 T30 generally speaking those businesses will have lower Returns on Capital as competition has come in and taken away their excess profits um we also know however that of course a small minority of businesses basically defy economic gravity they enjoy many many years of high Returns on Capital and I argue that they do this by creating economic modes struct Cal competitive advantages things that are inherent to the business so why Moes matter is very simple because an extended period of high Returns on Capital increases business value by lengthening the period during which capital can be reinvested so conceptually the wide Moe Business here has all this time to reinvest Capital back into the business at a high rate of return right the noot business has only a few years before somebody shows up knocks off their product copies what they're doing and they no longer have that opportunity to reinvest so very simply the PV of current cash flow tends to be higher here because your duration of excess profits the duration of the period during which you can reinvest is longer it's not infinite you can still overpay for these things but empirically businesses with Moes that have that reinvestment period you can pay an optically higher multiple today and still generate a higher return than paying a lower mul mble for the business with a very short reinvestment period so I want to briefly talk about some different types of competitive Advantage before I talk about Capital allocation these are the four kinds of Moes that we uh distilled down at Morning Star after looking at lordy uh tens of thousands of businesses over about a 40-year period just empirically looked at the ones that had generated Returns on capital of 15% or better for 15E stretch or more so basically they've done done it they've defied economic gravity and then what are their common characteristics and these were the most common characteristics we found so brands are pretty obvious but I think it's important to understand what kind of brand you're paying for so a brand can lower search costs I grab a bud because I think it tastes good God forbid why I would think it tastes good um but I do and I recognize the label and I grab it uh I use tide because png's immense marketing budget has convinced me it cleans better than anything else which is not true true uh and one reason why their next 10 years are going to be tough for them but there we are um Brands can create positional value right the Rolex watch does not tell time any differently than the Mickey Mouse watch I had as a kid it's the same time gang but of course it what it signals to people is that I have a lot of money right and so no right I mean that's what it signals I have a lot of money I am successful um there's probably an evolutionary thing with mating behavior that we could get into um you know like a peacock um or they can confer legitimacy so you think of gfk you think of neiel you think of Moody you know Pat dorsy Bond rating service isn't worth you know a pound of nothing um a bond rating for Moody is worth a lot right an audience measurement from neelon is worth a lot an audience measurement from Bob miles audience measurement service sorry Bob is not worth very much so the brand can confer legitimacy now you also have patents and licenses and approvals which are other types of intangible assets that confirm Oates but I want to spend a minute on the brand thing because it's I think it's really really important to think about right now especially so positional and legitimacy brands are based on strong social consensus CTI Rolex have positional value because there is a social consensus that agrees that they do right and so if I say wow I don't really think CTI is very nice but I want to signal to people that I have a lot of money and I buy an unheard of luxury brand that signaling isn't going to be as strong because frankly you don't all necessarily agree with me uh neelen if I decide that neelon is not a very good measurement of audience but I'm trying to you know basically let's say I'm a media company trying to sell to advertisers and I say wow this new upstart audience measurement that you've never heard of it's a lot better yeah so what show me the Neila numbers right that social consensus has to break down for the mo to break down big big difference with low search cost Brands if I suddenly decide that I can get a razor from Dollar Shave Club a lot cheaper than Gillette and it does the same job as the one from Dollar Shave Club I get full value from that product without any of you having to change your mind right so the my ability to defect has way less cost for me and fragmentation of mass media has dramatically lowered the cost of reaching a mass Market Dollar Shave started with a five $5,000 YouTube video or it might even me less if none of you have seen the original Dollar Shave YouTube video please do it's amazing and it's one of the things that made the company worth a billion bucks in five years when uh Unilever unver yeah unver bought it recently um and so this was not possible 15 years ago right if I wanted to create Mass a mass Bur BR I had to go to CBS ABC NBC and pay a lot of money for an ad on Seinfeld or Oprah or Days of Our Lives now I create a YouTube video that's a much much lower barrier to entry moreover I can use tools like Facebook and Google to Target extremely effectively and so Challenger Brands like Dollar Shave and Chobani do not require a change in Social consensus to deliver full value to the new user the person who tries Chobani or dollar shave for the first time and so I would ask you and to think about this very carefully how inevitable are the inevitables I think this is something that if you are a s big cpg investor in consumer product companies you need to think about this really carefully and now I'm not saying go out and put your life savings shorting uni Li right now gang I'm simply saying think about it because the barriers to entry for creating a mass brand are dramatically lower today than they were over the past 10 20 30 40 years switching costs are just what they sound like when it costs more for the user to switch to the competitor than to stay with the incumbent you have this typically more prevalent in B2B um because it's integrated with a business process if you try to rip out an Oracle database you're essentially ripping out the Beating Heart of a business uh very difficult thing to do so Larry Ellison just raises prices a little bit every year goes buys a bigger yacht every year or invests in a new um you know tennis uh uh tournament if you haven't been to Indian Wells it's pretty amazing I mean what he's done with Indian Wells uh there's a little bit of social good there perhaps less so with the big boats that he buys um you also had this with products with high benefit cost ratios any of you familiar with Christian Hansen in Denmark wow it's like one of the modest business in the world all right one of you good point points for the guy in the back um so Christian Hansen is about 70% global market share in Dairy cultures wooo Dairy cultures um but of course without a dairy culture milk doesn't become yogurt milk doesn't become cheese and the culture has a huge impact on the shelf life of the yogurt or cheese The Taste the feel in your mouth but because it's biological process the culture you use if the cow is eating silage of one type in the US is very different than the culture you might want to use in France or other parts of the world and dairies are continuous process there's constantly milk coming in so you get to shut down if it doesn't work it's got to continuously work so a culture is about 2 and half% of the cost of goods uh making yogurt or cheese your switching costs are immensely high and so they're able to raise prices every single year and you have this huge mismatch between the cost to the input and the value in terms of the output you tend to get very high switching costs Network effects are just what they sound like when the product the value of a product or service increases as the number of users expands they're maintained by subsidizing one side of the network right none of you pay for Adobe Reader right you can get Adobe Reader for free but if you want to create a PDF or manipulate a PDF you got to pay Adobe some money so they subsidize one side of the network same thing with Uber Uber when it moves into a new city subsidizes the cars they'll guarantee a minimum wage a minimum payment for the vehicles why because you're not going to pull up your app and use Uber if there are no Ubers around so they subsidize one side of the network and then once they have lots of people driving they pull away the subsidies and everybody screams um but that's how you build a network also driving engagement if Facebook today with the same Facebook as 5 years ago with no live video no new features you wouldn't be as interested you have to continuously keep people engaged in your network network effects are destroyed when pricing power is abused Bloomberg is the canonical example here that is incredibly abusive when it comes to pricing and so the more you abuse price the higher you raise the ceiling and the margins and the more possibility you give the competitor to come in or if the user experience degrades as you may know Myspace and orcut in Brazil were much much bigger than Facebook uh for the early years of Facebook's life and one of the reasons there were many that they declined was that the user experience degraded they didn't invest in servers when news when uh News Corp bought Myspace they plastered ads all over the place user experience stunk and so I said let me try this new Facebook thing if they had kept that user experience you know par puru with Facebook the incentive to switch would have been much lower cost advantages are just what they sound like um you know but what I want to point out here is I think a type of cost advantage that people don't pay a lot of attention to which is when you dominate an industry with a very high market share relative to the total addressable Market there are some markets that are so small Niche markets that they'll only profitably support one or two players okay and so the a new entrant would have to invest so much to come in and start a product that they would drive returns down for everybody in the market uh and so this is an insanely profitable area for businesses uh spyre Saros is a a UK company that specializes in Steam wow doesn't sound very exciting but steam is highly highly expensive to produce because it's very energy intensive and so if you can reduce the cost of making Steam for a uh food process or disinfecting you can save people a lot of of money and they are the global specialists in Steam not an End Market that's growing very fast but one that allows high 20s operating margins very very consistently let's talk about management for a minute management sorry Warren is not a mo but Management's actions create preserve widen and Destroy Moes Moes should always drive strategy from day one Amazon has been about improving the customer experience Bloomberg increase user switching cost continue encroaching into your life with Excel apis and everything else that makes it difficult to switch Uber increase vehicle liquidity Howen joinery a small company in the UK that we own solve the Builder problems Facebook Drive user engagement the point here is that if you're investing in a business and you think they have a moat and management strategy is not centered around widening that mode they're probably at risk for disruption so let's talk a little bit about Capital allocation which is the link between business value and shareholder value capitals uh deploy destructively shareholders don't benefit from increased business value right the business value grows but if that cash is taken and spent on stupid Acquisitions or overpriced stock or whatever it might be value gets vaporized you the shareholder do not benefit from the full value of the business Val incre the full amount of business value increasing now the converse is that when you get intelligent BuyBacks you get value of creative m&a shareholder value actually can increase faster than business value the share count shrinks at good prices and so in that case there's not leakage but there's actual amplification of the returns you receive so I think this is really important to think about um so let's get some ground rules on Capital allocation usually and I think I mean 90% the CEOs I talk to would agree with this growth is good organic growth is always good BuyBacks BuyBacks are awesome Dividends are great especially and we'll get to this there are certain countries that have what I call the dividend fetish and we'll talk about that in a minute but these are always good things right which is totally freaking wrong all three destroy value if you're plowing back money into the business and organic growth sub cost of capital that's stupid if you're making Acquisitions and your hurdle rate is you know a whack that's depressed by generationally low interest rates that's dumb if you're paying out 50% of your Capital when you could be reinvesting it back into the business at a high rate of return or you fund the dividend with Equity raises which is like I mean Hello that's dumb too m&a is usually destructive use of capital right this is B School 101 big mergers are bad we have giant McKenzie studies that show mergers destroy value well no uh not always um always is a very dangerous word in this profession I find there's this huge right tale of companies right this is your right this is my right okay there's this huge right tale of companies that have built huge value via intelligent m&a m&a can be massively massively valuable if carried out with discipline and intelligently and I'll talk a little bit about some of the ways I I think to sort kind of the the idiots from the ones who actually create value um and a creative Capital allocation requires discipline and focus this is the critical thing the fact that someone is a good capital allocator or that Capital allocation of a business is not going to be value destructive for you the shareholder this is a thesis that must a Hy sorry a hypothesis that must be proved it is not something you can assume you can't assume that Capital allocation isn't going to screw you is it often does that's a technical term CFA level three screw you um so let's talk about growth for a minute obviously if you have high roic investment opportunities for goodness sake grow as much as you can reinvest heavily so here's a quote obviously when your opportunity set is all of global retail for God's sake keep hunting back in the business but if you can't don't try maturing companies usually keep going for way too long and continue to invest despite declining Returns on invested Capital there's a very simple reason for this there is a linear relationship between the size of the business and CEO pay there is not a linear relationship between Returns on Capital and CEO pay so I am CEO I am a self- maximizing individual I like to line my own pockets in conjunction with my complacent board with a conversation on the uh disgustingness of CEO compensation in in the US which we can have another time what's my incentive right grow the business keep growing aging is tough for companies as well as people it's very hard for a business that was a growth business that made a CEO who made tons of money by growing to suddenly wake up one day and say wow I got a bald spot not great a little harder to get out of bed in the morning kind of hurts those new stores not generating the Returns on Capital they used to hey Wall Street we're going to slow down square footage growth nobody wants to admit this I mean the list is so long of companies that just kept going and going going and just hit this wall and then had to retrench and begin returning Capital this is my favorite example uh phei uh novakovich her first Journey's call a General Dynamics uh those of you who don't know the GD story it's an amazing one uh Nick chabria took it over and basically shrunk it to Greatness and then um somehow I can't remember the story but a real idiot took it over and destroyed Capital with a bunch of stupid it Acquisitions um and then Phoebe took it over um and so General Dynamics has a lot of great businesses one of them uh is called electric boat and it makes nuclear submarines this is a Modi business they are the only one making nuclear submarines this is a monopoly it is not a growth business there are not 30 new nuke Subs being built per year which is probably good for Global Security um but it's not good for the growth profile of General Dynamics so some you know idiot analysts asks her I guess the question is about the parts of the business you where you don't have growth what do you do with those what do you do with this electric boat thing that has a monopoly but doesn't grow and she just gave him a Smackdown well then you're going to drive Runnings in cash aren't you there's no point in chasing revenue or pretending you have growth when you don't I could have crawled through the phone and kissed her this is what you want somebody who knows that when a business is growing and when it's not and is willing to say you just drive the cash drive for cash and put the money elsewhere that's the right attitude for a no- growth business so let's talk about returning Capital Dividends are not a an adition of defeat they're a declaration of Victory it says I have more money than I know what to do with is that a good thing or a bad thing I think it's a good thing right but how often do you hear companies say we're a Growth Company growth companies don't pay dividends it's just you know that's when you just like oh my car is leaving my flight's in an hour I got to go you know hoarding cash we see is pillared in the US I mean Apple now I think can buy most of the S&P 500 uh more like cash pile but there say it has this evil twin in Europe and Australia called the dividend fetish where companies pay dividends when it's just the worst idea possible because Dividends are not normatively good if they're funded poorly via an equity raise I got caught in that one once with a company we owned or if they represent a large opportunity cost great little UK business we were looking at management had done phenomenal creative Acquisitions driving High Teens Returns on capital for 20 years years they pay out 40% dividend and we asked them Point Blank and what I'm expecting is well there just aren't that many opportunities each year so this is the most Capital we can put to work and maintain High Returns on Capital okay that's a pretty good reason the answer because our shareholders expect it my response get new shareholders but that that was not the way they wanted to go um now BuyBacks this is an active use of valuable Capital not a passive tool for mify buying shareholders they should always be driven by an objective assessment of intrinsic value this is an actual conversation that I had I am not making this up CFO I asked him so how do you think about BuyBacks how do you think about you know returning Capital Point Blank said we have no opinion about our shares value this is me and then he says that's the job of our shareholders every year we ask them would you prefer a dividend or a buyback the company's trading it 30 times EV to even he has no opinion about the value of a stock no he doesn't and I mean I sure do um and this isn't I'm not you can't make this stuff up they just mechanically buy back stock it's ridiculous now this is a phenomenal business it's actually Christian Hansen the one I mentioned before phenomenal mode but I mean just Capital allocation that is hard to fa so let's talk about m&a for a minute another major use of capital m&a should always serve strategic goals not paper over strategic failures which is frequently what it does Microsoft and aquan Microsoft buying a digital ad Network someone explained this to me Nokia that was 8 billion down the tube diimler 30 billion ab and Amro 60 billion M eight autonomy 18 billion I mean just but all of these notice all of these were defensive deals all of these were papering over strategic failures by companies that did not regularly engage in m&a m&a is a learned skill it is not something you just do because a great PowerPoint lands on your desk from Marl Lynch no offense to anyone here from Mar Lynch I could have used any bulge recr um if m&a is supped to have a faint hope of creating value it has to be a central part of management strategy it requires a disciplined process that is iterated and measured few companies that we found that do a phenomenal job with this but the point is it's iterated it's measured it's part of who they are they actively work to get better at it and I'll talk in a few minutes about some specific questions I found valuable in asking management to see whether they they get it or not so assessing Capital allocation some of the things to think about you know has the share count increase decreased when did large changes happen why if you're analyzing a business and you look over time and the share count has changed meaningfully and you can't identify why or how you don't really know anything about Capital allocation m&a look at the cash flow statement for evidence how much was paid what was the result again you have to see what the result was and then go look in the future for writeoffs for discussions about it because the ones that don't work out they'll just bury them companies will just bury them as much as possible so you got to go and do the work you got to go and find out out they laid out 400 million bucks for that business what did they get from it did they learn something from what they did right or did wrong did the company ever pay a dividend and raise equity in the same calendar year Run for the hills trust me I should have it's a bad one um if roic is declining are you seeing Capital coming back are you seeing the percentage of capital coming back to the shareholders going up as well you should are share repurchases opportunistic or mindlessly regular like the 30X EVD evit dude I talked about a minute ago is it discussed explicitly and rationally are the words Capital allocation even in the annual report is this something management knows how to verbalize and discuss are there words consistent with actions this is the big one because you know after 30 years people are finally waking up to this dude in Omaha and you know how he talks about the world and so you're starting to see Buffett wannabes you're starting to see people like you know talk about I mean when present management took over you know um I you know and then and then do things that I mean would probably set Buffett's hair on fire uh in terms of capital allocation so are the words consistent with the actions are the actions and words consistent over time critically what are the CEO's incentive how does she get paid are there any Roi components I see an Roi component in maybe 10 15% of the pay packages I look at maybe 15 % is it including compensation targets because if they're being paid on EPS goals or income goals or sales goals and they can just buy it they will because their incentive is to hit the Target and get paid okay here's a great story so UK company I met with just last week um uh I confirmed that m&a so organic the this okay let me try just describe this right so CFO statement in the annual report organic growth is one of our core kpis great director's remuneration report no mention of organic growth Mandy sorry her my name was Mandy can you explain this to me like this is a core kpi right but the directors don't see fit to pay management Bas on it you want to help me out um oh well we have good corporate governance and you know if we do big m&a and you know the organic targets aren't going to be met um you know we adjust so why don't you just write it into the comp package oh we're running late meeting's over yeah it wasn't that bad but she she stopped the meeting pretty quick you management managers who are paid handsomely to Mis alligate Capital will do so period incentives matter so try to lighten things up a little this is before we finish up this is my sort of typical conversation with the CEO um so sir or ma'am do you have high Roi investment opportunities well yes of course we all have high Roi investment opportunities now are you sure or is it just really hard to admit that you can't grow at 10% anymore I'm really sure that's usually the answer right you know and then you say well dude demand is growing 4% how are you going to grow at 10% remember Cisco Cisco John Chambers clung to this 15% growth Target like like it was a life raft for years when the server Market was growing at like GDP Plus or the the router Market rather and then this is the answer you get is if I change my guidance to 4% or stock would get killed now stop asking stupid questions know this is the actual conversation you know then okay so you take a step back do you have high Roi investment opportunities okay maybe not anymore thanks for being honest okay do you have a coherent strategy to deploy Capital with m&a someone actually said this to me want I have an investment banker sorry to any investment bankers in the audience you know that means no okay so let's try Plan B this is another actual answer I got once paraphrased I'll create this team with a lot of m&as a lot of NBAs we'll do m&a and our Target will be beating our whack in year three in year three oh really I mean his whack is like 8% this is the best you can do this is your hurdle rate for investing my Capital as a shareholder and then they said again literally this was last week in the UK what's wrong with an 8% hurdle rate and I'm not picking on UK managers I just happen to be there last week um what's wrong with an 8% hurdle rate Pat so wack WR with whack how should we choose our hurdle rate what should it be higher was my answer you know you know it's if you need to ask right if you have to ask about the mileage of the Ferrari you can't afford the Ferrari right if you have to ask why 8% is too low you shouldn't be allocating people's Capital you should have a different job so when you're talking to businesses these are some of the things I found really valuable in elucidating whether management gets it or not who in The Firm is responsible for Capital allocation is it the CFO is it a finance director is it the CEO it's different that's fine but you got it better be a person one person what's the hurdle rate what's been your biggest dare how do you gauge success or failure how do you measure the process how do you measure Roi which what's in the r what's in the I you can fudge that all you want right what have you learned over time this one's critical what have you learned how have you gotten better and that's when you'll find out if it's a learning organization right an organization that learns from its errors that learns from successes and gets better because successful m&a successful Capital allocation is is a learned skill you get better at it over time so summing up competitive Advantage drives ex the duration of XS roic which drives long-term business value Capital allocation is the link between business value and shareholder value can amplify returns or destroy them I would argue that lusas the mangaran laapoa can't believe I just used Munger as an adjective that was weird um occur when competitive advantage and capital allocation work together to compound value at high rates now before I finish this is a very critical point the outputs of competitive advantage in capital allocation are quantitative right the output is a high roic the output is a shorter share is a smaller share count the output is value of creative m&a but these things all require qualitative evaluation you cannot screen for switching costs in Bloomberg and I hope to God never can because I will have a much harder time making money you have to talk to customers and understand the value proposition of the product being offered you can't assume High market share equates to a cost Advantage you have to unpack the individual unit economics you cannot trust that management allocate Capital rationally you have to gather supporting evidence that means going out talking to people digging through past press releases talking to the management team of the companies they bought and saying did they do good diligence on you or did they were they just want to get the deal done that's getting out and talking to people because you can't figure this stuff out if you don't turn off your laptop and get out and talk to people all of the information is in the past but all of the value is in the future quantitative data I would argue is usually priced efficiently and it's getting priced more efficiently every year better data sets faster uh processors qualitative Insight is less efficiently priced because it requires real work it requires sending out 30 emails and getting one person to respond to you it requires getting out to trade shows and talking the floor that's how I would argue you add value [Applause] thanks

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Length: 33min 58sec (2038 seconds)

Published: Mon Jun 19 2017