The Exchanges, every show

Q Where did that academic path take you through school?

A My undergrad was in political science, sub-discipline called comparative politics, where you're studying how different political systems evolve and trying to draw conclusions from that. Look at a dozen countries that have transitioned from dictatorship to democracy and say, hey, can we observe any patterns? Which turned out to be unknowingly good training for what we do as investors, because you're looking at different businesses, understanding them in a deep manner, developing pattern recognition. I didn't know that at the time. After undergrad, I had a couple crappy jobs in finance just to pay the bills. One was with a newsletter, one in a brokerage firm, both parts of our industry that are focused on making money off of clients and making money for clients. It didn't really sit well with me, so I went back to graduate school to get a PhD in poli-sci. I discovered there are no jobs for PhDs in poli-sci. Which they don't tell you if you apply. At that point, I was in Chicago. I'd met the woman who is now my wife and didn't want to leave. Morningstar was here. They had a reputation for being on the investor's side, which sat well with me, being willing to take a chance on liberal arts dudes like me. I wound up in Morningstar around the time when they were starting up coverage of individual equities.

AI assessment note: “My undergrad was in political science... I went back to graduate school to get a PhD”

Q How have you thought about managerial style as a lens at looking in the success of someone running one of these businesses?

A There's a subset of managers who are in the trust me category. As an investor, you're betting on the person as much as you are betting on the business. You're betting this person's second act. They've had a successful business, they've sold it, now they're starting another one. Because this person is, quote unquote, a moneymaker, you're willing to maybe overlook some related party stuff or some excessive compensation, and that's totally reasonable. That is a style of manager that History has shown can create a lot of value for shareholders. It is not a style of manager we tend to gravitate towards. That's just personal choice. It's a chocolate versus vanilla thing. I don't think they're good or bad. I do think they have greater risk of left-tail outcomes, of not listening or taking the company down a path that destroys value and not changing course when things are observably not going well. Especially in a concentrated portfolio, we have to think about that left tail risk differently than if we ran 50 stocks. If you run 50 stocks, okay, fine. I'll take a three percent bet on somebody who might be the most amazing manager of all time, but there's a little, some of that left tail risk. 12 stocks, it's a little harder. It hurts.

AI assessment note: “It is not a style of manager we tend to gravitate towards.”

Q When you had a universe of 1700 companies you're following to get to 12, what filters have you used to narrow that lens?

A To be clear, we had to cover the waterfront at Morningstar. That 1700 included utilities and oil and gas and life insurance and auto parts and auto OEMs, which are all not good businesses. Those are easy ones that just throw out. Step A is, is the industry structurally attractive or not? This is one of the hard truths that early investors have to learn is that some industries are tough. You got to respect the managers who are in them and got to respect the CEOs who try to make money there. Making money as an airline is hard. Making money as an auto parts company or a life insurance company or an oil and gas, you're a price taker. Huge parts of your future are not under your control. You can invest in these businesses and do well with them if you develop pattern recognition and understand that world. They're not conducive to creating moats. Those are areas that we largely ignore. The second is, can we understand it? We are global. Historically, about 30, 40% of our portfolio has been outside the U.S., but we're a bunch of folks raised in the U.S. and in Chicago. There's smart investors in Sao Paulo who are going to understand a local drugstore chain a lot better than we are. You have to not get over your skis in thinking you can understand things on the ground better than somebody who's lived in that culture all their lives. We definitely avoid stories where the moat is based on…

AI assessment note: “Step A is, is the industry structurally attractive or not?”

Q What was that initial rubric that you built?

A We had data back to the sixties and looked at every company that had done more than 15% returns on capital for more than 15 years. Totally arbitrary numbers. The idea was, instead of theorizing, let's just get the data. Let's get the companies that have done this and generated sustainably high returns on capital and see if we can observe patterns. Most of the companies that had done that could be sourced to some kind of a intangible asset, like a brand or a patent or a government approval. High customer switching costs, like you see with databases, network effects, or scale advantages, cost advantages. Most of them fit in one of those buckets, and it was like, well, that's what the data says. Let's use that framework going forward.

AI assessment note: “looked at every company that had done more than 15% returns on capital”

Q Are there other important quantitative metrics beyond the original ROIC that you look at when you're trying to figure out if a company has a good moat?

A No, I find it's best to stay away from that because you go down the route of, oh, it should have high margins. What about a distributor? Distributors are often beautiful businesses. They have relatively low margins, but they don't have a lot of capital employed, but they're great companies. So, okay, we can't use profit margins. It really comes down to free cashflow. Okay, fine. But what if they're reinvesting? What if they're putting capital back into high return projects that have a high NPV? Free cashflow may not be the best metric. Obviously, if a company has gone a decade with cruddy financial metrics, there's probably nothing much there. But the point is that the bulk of it is qualitative. Understanding what kind of price the company can take, if it has pricing power, or whether, in some examples, there's what the nomad guys called scale economies shared, where the benefit is not taking price, but passing scale benefits along to customers. Costco is One of the canonical examples, Medline, which recently came public as another great example of passing on scale benefits to customers. They're even saying, oh gee, moats are all about pricing power. Well, no, they often are. It's squishy, and that's why the qualitative angle is more useful than a quantitative metric.

AI assessment note: “No, I find it's best to stay away from that”

Q How do you think about the power of brands when it comes to moats?

A That's a lot of early investors, certainly mine, initial introduction to what is a moat from Buffett's letters a long time ago. I'm talking about the inevitables with Gillette and Coke and whatnot. I've historically invested less in consumer-facing businesses because I don't have a good feel for what a good brand is, but it's useful to kind of distinguish brands in terms of the classic Coke or Gillette, lowering your search costs. You go to the shelf and you see the label, it's what you want, and you don't have to spend a whole bunch of time thinking, what do I want? You just grab it. The consumer can decide to defect with no cost to you. If you say, I would rather try President's Choice Cola than Coke, You can do that, and if you don't like it, you go back. Big deal. If you think about a luxury brand, that's more consensual. I'm not wearing a Rolex because it tells time better. It's because I want people to know I have money. I'm signaling something, but that signal value is only useful if everybody else agrees that a Rolex has signal value. If I decide one day to say I'm going to wear some no-name watch that nobody's ever heard of that cost a 100,000 dollars because I want to signal my wealth, If nobody's ever heard of it, I don't achieve that. We all have to agree. If I defect, there's a cost to me. If I defect out of that luxury positioning ecosystem, the cost is nobody get…

AI assessment note: “useful to kind of distinguish brands in terms of the classic Coke or Gillette”

Q I'd love to ask you about the impact of management. You start with the Warren Buffett line that you want a business so great that any idiot can run it because eventually someone will. How do you think about the importance of management with Motes?

A That's been the biggest evolution in me as an investor over the past decade. When Dorsey Asset launched in 2014, I was probably 60, 70 moat and 30 management. So you want to weight things, and I'm probably the reverse today. That's largely because I've seen just how poorly people can behave and how much damage they can do to even a great business. We only need 12 stocks, so why Suffer with the people who don't know what they're doing when you can partner with people who do know what they're doing. Management is hugely important. That phrase from Buffett has probably done more harm than good over time to a lot of investors in not interrogating the quality of management or underweighting signals that maybe capital allocation is poor, that management's incentives aren't aligned because they're so hyper-focused on the business. My attitude is why not have both good management and the great business?

AI assessment note: “I was probably 60, 70 moat and 30 management... I'm probably the reverse today.”

Q When you took these years of research into moats and how to think about them as great investments into an investment fund, what did you decide you wanted to do as an investment strategy?

A Concentrated, because that was something I hadn't had the opportunity to do at Morningstar, because we covered 17, 1800 companies. You can't get that in depth on any of them. Because moats are qualitative, you can have more confidence in the non-obvious ones when you are able to have the time to do the work, to talk to customers, to talk to former employees, to go to the trade shows, all the usual true leather stuff that we know about. You can't do that in a 50 stock portfolio without some gigantic team, which I didn't want. Concentrated was the only way to go in terms of the structure. We were long only because I've never shorted a stock in my life. I would be dangerous shorting. That was never on the table.

AI assessment note: “Concentrated was the only way to go in terms of the structure. We were long only”

Q How do you think about the relative merits of a company inside the U.S. where you understand the structure, understand the culture, and businesses outside the U.S.?

A There are two benefits that U.S. companies enjoy that non-U.S. companies do not. One is called the SEC, which is the nastiest securities regulator on the planet, which is great for us as investors. If you see a company that had a choice to invest, anytime you look at a software company, and it's listed in London, and maybe it's not a super U.K.-centric company, I gotta ask, why didn't you choose to list in the U.S.? Why would you not list here and get the higher valuation and access to talent? You saw this with what? BaFin and Wirecard? Good Lord. Unbelievable oversight by the regulators. If something's listed in the U.S., you're probably going to get better disclosure. You've got a higher level of confidence that there's not related party transactions or off-balance sheet, who are we going on? That's a great thing for us as investors. The second is on-balance As overpaid as they are, and 99.9% of American CEOs are overpaid relative to the value they create. They're generally better managers, and they're generally better at capital allocation than you see outside the US. You don't tend to see a US company buying back stock and paying a dividend. That's weird. I see that all the time outside the US, because dividends are sacrosanct in other investing cultures. You see buybacks happening as well. It doesn't make any sense. Some of that also is, generally speaking, corporate talen…

AI assessment note: “There are two benefits that U.S. companies enjoy that non-U.S. companies do not.”

Q I'd love you to take me through your research process. So there's so many nuances you describe in how you like thinking about these businesses and management teams. How does that play out within the organization?

A Everything starts with the creatively named quick idea. It could be a few sentences. It could be a page. What's interesting about this business? What does it look like the mode is and what could the opportunity be? Super easy. Maybe a third of those. I green light for a first pass memo, another creative naming, which is about a week's worth of work where we try to look at critically the vector of the moat. Is the competitive advantage widening or shrinking? What are the key debates? What are the areas where we might have a variant perception on this business? What's the runway for growth? Cause that thing we prioritize and what we look at any red flags on management and kind of a scratch valuation that gets posted to our internal research system. People ask offline Q&A and then we meet on it. We tend to do a lot of offline Q&A on memos because I find that it makes the meeting more robust and more discursive and more of a back and forth because you're not asking, oh, I didn't see what segment margins are for that thing. What was that write off in 2014? We take care of that offline. Makes for a more robust conversation. And it's about, is this the droid we're looking for? If it is, we try to figure out what the correct research vectors are. Is it talking to formers? Is it interrogating clients? Is it understanding their supplier base? It's different for every company. You have to…

AI assessment note: “Everything starts with the creatively named quick idea.”

Q Can you talk more about that weird isn't wonderful?

A That's a lesson from our early years where we launched with a whopping three million in assets under management. It wasn't much. We got a couple of institutional investors relatively early, but we were still pretty small. My thinking is, hey, we're really small. We can buy smaller businesses that are not well known and undervalued. Power can generate great returns. The risk with that way of thinking is that sometimes businesses are small because they've never succeeded. There's a reason why there's all. There's a psychological aspect of you're a newer manager, and you're trying to sound different. You're trying to add value for the client and say, oh, I own all these things nobody else owns. Isn't that neat? I'm going to be a diversifier in your portfolio, or I'm not going to own a lot of NVIDIA or whatever it might be. All that matters over the long run is returns. That's all that matters. If you've got the weird off-the-run business that's going to require some leaps of faith and maybe not offer you great liquidity, And you've got an amazing mega cap staring you straight in the face at some screamingly cheap valuation. It doesn't matter if everybody's heard of it. That's where you're going to generate the returns. Put the money there. That was a wake-up call I had. So our first couple years were okay, but not great. In early 16, I wrote an internal memo called Better. It was …

AI assessment note: “We don't need to be doing weird things just because they're weird.”

Q What are some of the other important qualitative angles that you look at?

A It's independent of the business. Switching costs can cut both ways, because if you have high customer switching costs, then probably your competitors do too. It's hard to get people to switch. You have trouble growing in the high switching cost industries a lot of times. Network effects are often held up as the end-all be-all of modes, but network effects can degrade. People leave the network, the value of the community diminishes, the distinction between radial networks like Western Union or nodal networks It's complicated. And that's honestly one of the fun things about it is that over time you start to, like everything in investing, develop pattern recognition. The great traders that you read about in Money Masters, they develop pattern recognition. I've seen this macro story before, and here's how it usually plays out. So I'm going to make this bet. Analyzing competitive advantage is the same thing. The more companies you look at, the more likely you are to say, okay, I think there's something here. Then you try to think through why? Is it a government approval? Is it a switching cost? Is it scale economies? There's some foundational attribute that enables the company to withstand competition, defy the laws of economic gravity, sustain high returns on capital in a competitive world where both in theory and empirically, most companies don't do that. Most companies do revert…

AI assessment note: “Switching costs can cut both ways... Network effects are often held up”

Q What ends up being the difference between something that's in your portfolio and something that is really close, doesn't quite make it in?

A Sometimes it's the personal comfort level, because at the end of the day, when the numbers are flashing red and the news is bad, I've got to make a decision. That's my job. If I don't have a good feeling about the business, if there's something nagging at me about it, whether it's management or the business model, The analyst can do all the work. They can be confident. They can have everything lined up correctly. But if I'm likely to make the wrong decision when making the right decision is valuable, we should know. It's almost a personality aspect. The PM's got to be comfortable with everything in the portfolio. That often can be a little bit of an edge case. Another one can be confidence in the runway. Things where the business is unlikely to Grow a lot, but might have a great moat and a great valuation because then I'm going to have to do something with the capital. Once it re-rates and we've made our nut, now I've got to put the money somewhere else. That relative to a business that has reinvestment opportunities and is more likely to be able to find incremental things to do with its capital. That's probably a better place to put our capital, because we're likely to own it for longer, and we're likely to not have to replace it in X amount of time once it re-rates, which then frees up research resources to find more businesses like that, as opposed to having to continually b…

AI assessment note: “Sometimes it's the personal comfort level”

Q After having done this for a dozen years, what are you hoping to achieve in the next dozen?

A I'd like us to be a slightly bigger, only slightly, and better version of what we are right now. It's that simple. Some of the things I've learned since our big drawdown in 22 give me some confidence that the next decade might look even better than the past, because I'm a better investor today than I was in 2014. We've got a good structure. Investing is a craft. It's not a profession. It's like woodworking or glassblowing. There is no perfection. You're always getting a little bit better at what you're doing every time you make a decision. Every year try and get a little bit better at who we are and what we're doing. Hopefully, 12 years from now, I'm 12 units better than I am right now.

AI assessment note: “I'd like us to be a slightly bigger, only slightly, and better version”

Q How do you think about capital allocation as a skill of the leader of one of these businesses?

A Rare. How does someone get to be the CEO of a Fortune 500 company or a Euro stocks 50 company? By demonstrating skill as a capital allocator all through their career? That's a giant pile of hooey. They do it by being a good self promoter, a good corporate politician, skilled at whatever their job is running division A or division B. It's not because they're allocating capital. It's almost weird that people rise up to the ranks, get thrown into the CEO seat, and then you're like, you're supposed to allocate capital. It's like, well, they've never had to do that, right? It's a little weird to think about it. It's founders versus non-founders. Believe nothing and trust but verify. Maybe they're a good capital allocator, maybe not, but you can't assume anything. The evidence shows most are not. There have been large academic studies of corporate buybacks, The favorable interpretation of the evidence is that they've neither created nor destroyed value. The less favorable interpretation of the evidence is they've unbalanced destroyed value. You look at some of the larger McKinsey studies of acquisitions, generally pretty bad. Acquiring companies in the way of a Danaher or a Transdime or a Constellation, it's a learned skill. You iterate, you go back and say, okay, what were our deal assumptions and how did they work out? What do we learn from that? What do we lean into? What do we ch…

AI assessment note: “Rare. How does someone get to be the CEO... It's not because they're allocating capital.”