How Management Affects Moats

Pat Dorsey: Hi. I'm Pat Dorsey, director of equity research at Morningstar. For those of you who might be familiar with Morningstar's equity research approach, you know that we focus a lot on what we call economic moats or structural competitive advantages, attributes of a firm that enable it to generate higher returns on capital for years into the future even in the face of concerted competition.

We look for things like switching costs, brands, network effect, and so forth. But one point we've always made rather strongly is that management in and of itself is not a moat. Just having smart folks running a company does not endow it with structural competitive advantages. And that, all else equal, you're probably better off with owning a wonderful business run by mediocre folks than a really mediocre business run by really smart folks. Airlines perhaps being the most common example there that even if you are run by a real genius like David Neeleman at JetBlue, well, at the end of the day you are still just owning an airline.

But that still leaves kind of unanswered this question of how management can affect, positively or negatively, competitive advantage? How they can build or destroy economic moats? And that's actually a project that I've been working on over the past few months here at Morningstar, trying to think of, what are the common attributes of management teams that have been able to build or destroy competitive advantage, the effects they can have for good and for ill.

And so, I wanted to share with you a piece of that research, the conclusions that we've come up with, some of the broad themes that have emerged out of the work I've done over the past few months. One, probably the biggest one, is that you think of kind of a commoditization spectrum, sort of more commoditized businesses like banks and miners and energy companies over here, and less commoditized businesses, you know, your Disneys of the world, Coca-Colas over here that have strong competitive advantages, well, management seems to matter a bit more and can do more to affect competitive advantage in the commoditized businesses.

So, if you think about, sort of, I'm an investor, I have limited time, what do I need to really focus on in analyzing this business, perhaps it makes a bit more sense at the margin to spend time analyzing management, the more commoditized the business, and the less commoditized the business, well, management may not be quite so important.

Another one to think about is a very simple issue of focus, and it's just asking yourself whether management really understands what drives the company's moat and does that sort of shape their actions constantly? And that, really, we think is one area in which management teams can add value in terms of building structural competitive advantage.

You might think of Wal-Mart's laser focus on low prices. I mean driving cost down is all that really matters to Wal-Mart. And when they got away from this focus a few years ago, trying to compete more with Target on its own ground, offering more fashion choices, well, returns on capital suffered and the business's, I would argue, competitive advantage suffered a little bit.

So, asking yourself that question seems to be a good theme to think about. You can also think about Strayer Education, which is a business we like very much, an online, a for-profit education firm. They have this laser-like focus on educational quality, and they are willing to sacrifice growth at the expense of quality, opening up fewer campuses a few years ago because they didn't feel like they had enough qualified deans to open up the new schools at the level of quality they expected.

So that kind of focus on just building and increasing your competitive advantage every year and is that what management really focuses all of its actions around really we think is a way, it seems to be, that management can affect competitive advantage.

Buffett talked about this actually in a letter that he sent to all of the managers of Berkshire Hathaway companies just after 9/11, saying, "Hey, what should you do now?" And the quote was, "What should you be doing in running your business? Do what you always do. Widen the moat, build enduring competitive advantages."

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He mentioned this again at the annual meeting of Shareholders this year when asked how he compensates managers, what he thinks about when compensating the managers of the businesses under Berkshire Hathaway's umbrella. And the quote was very simple "The thing I want to pay managers for is widening the moat that separates their business from others."

Second big theme to think about, maybe, is whether management is focused on building the moat or driving growth. And a great example I think of here is Capital One, a big credit card company, which several years ago decided to move away from wholesale funding to buying banks as the sort of the funds they would then lend out to credit card customers. They bought Hibernia in the Southeast. They bought Chevy Chase around D.C. They bought North Fork outside of Manhattan. And what this did is it gave them a very nice, stable, low-cost source of deposits that they could then lend out to credit card customers. But it also slowed down their growth, really bulked up their asset base, which meant that their returns on equity suffered, and their price to earnings multiple came down a lot because basically returns on equity were lower, the business wasn't going to grow as quickly.

It's not often you see management basically reining in growth, deliberately slowing itself down with the goal of building competitive advantage, with the goal of making itself a more stable, stronger business over time.

Finally, just to finish up on the negative side, the most common theme that came up with management teams that destroyed competitive advantage were started with good moats and then kind of shoveled dirt in them over time is what you would call diworsification, either going into business lines in which they have less of a competitive advantage or making acquisitions of businesses that had weaker competitive positions. You might think of H&R Block's purchase of Olde Discount Brokerage several years ago, which really didn't fit very well with the core tax business, added a lot of cost to the business, and weakened the company's overall competitive advantage.

Some years ago Pitney Bowes, which makes postage meters in your mailroom, decided, well, if we have a postage meter in mailroom, we can run your whole mailroom for you. We can basically hire and fire all the workers who run your copiers and do all this kind of stuff. And that's basically a temporary labor business. It has nothing to do with having a postage meter. And of course, it failed miserably, and it was not something that enhanced Pitney Bowes' moat.

I'm Pat Dorsey, and thanks for listening.