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.
Today’s guest on The Long View 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 charterholder.
00:00:00 Defining Economic Moats and Moat Source Mistakes
00:05:34 Shifting Landscape for Returns on Invested Capital as a Metric
00:07:52 Inevitable vs. Noninevitable Moats
00:09:36 Moat Durability, Network Effects, and Lessons From PayPal
00:13:46 Management Quality, Founders, and Pricing Discipline
00:24:02 High-Quality Companies, “Too Hard” Bucket, and AI Uncertainty
00:29:29 Premortem, Behavioral Edge, and Opportunity Cost
AI Isn’t an Economic Moat Killer, but It Will Disrupt Industries
Lawrence Lam: ‘The Types of Companies That Attract Me Are Founder-Led and Profitable’
How to Measure a Company’s Competitive Advantage
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Ben Johnson: Hi, and welcome to The Long View. I’m Ben Johnson, head of client solutions with Morningstar.
Amy Arnott: And I’m Amy Arnott, portfolio strategist for Morningstar.
Johnson: Today’s guest on The Long View 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 charterholder.
Well, Pat, welcome to The Long View. Thank you so much for joining us today.
Pat Dorsey: Yeah, you bet. Happy to be here.
Johnson: Pat, I want to start with, I guess, maybe a question of identity, specifically, you’ve developed a reputation as sort of the “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?
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 in any way. And so that was the moat framework that I helped develop. And there’s obviously been lots written about it since, but 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 codify it, categorize it, probably why the label stuck.
Arnott: You mentioned a couple of types of moats. What would you say are the most common moat sources?
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, you’re going to have really brands. In B2B software, switching costs tends to be the most common. People don’t use SAP because they have a huge affinity for the brand. They use it because the switching costs are really high. I think it really does depend on the type of business, the industry that you’re analyzing.
Johnson: I’m curious because moats, I think, really involve, in both my lived experience and all my reading, and I think you see this in your work, 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 XYZ company has a moat for ABC reasons?
Dorsey: Yeah. No, 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. I mean, 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 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 those quantitative metrics like return on capital are frankly not that useful for many types of businesses in determining whether they have a moat 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. People use a product, they experience a service, and they say, “Wow, that’s awesome. This must be a great business.” And you have to think through how sustainable is that demand, how much pricing power is it going to have over time? How easy would it be to replicate it? And 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.
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 have done some things to maybe shift sizable investments that they’re making off their balance sheet. 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?
Dorsey: Yeah. So to level-set, 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 user captivity, driving incremental value from each user via 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 in industrial businesses, for example. I think for those types of businesses or businesses that do heavy M&A, return on invested capital is still a super-useful metric. But I think anytime that you have a fairly capital-light business, you’re much better leaning on the qualitative side than the quantitative side.
Arnott: You’ve also written about the difference between companies that have what you call an inevitable moat versus a noninevitable moat. Can you walk us through the difference there, and is one type more compelling than the other?
Dorsey: Yeah. I mean, Buffett used this originally, I think, back in the ’80s to refer to 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 in dynamic industries like semiconductors or software or aerospace 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’s 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 if the facts change, change your mind. And the nice thing about these less inevitable moats that operate in dynamic industries is that they typically have greater scope for reinvestment because their end markets are growing faster than the 2, 3, 4% that nonchangeable, nondynamic industries like waste management or soft drinks are typically growing at.
Johnson: Pat, I’m curious about moat surprises that you’ve experienced 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.
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. The company liked to talk about its large network of 400 million users and higher levels of conversion from merchants who 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 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 go to Amazon and buy something. 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 their inability to access those new entrants, Google’s 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, 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.
Arnott: 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?
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 frankly false. You have to consider both the type of the network, is it interstitial or radial, which 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 their numerator, which was transactions, was being driven by their Braintree backend-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 was not nearly as strong as many people, ourselves included, had assumed.
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?
Dorsey: I mean, probably the biggest thing is just humility and a willingness to listen to alternative viewpoints. 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 are not listening to other viewpoints. And if you’re only listening to yourself because you think 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 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 the contrary information was available, but the people at the top were either unaware of it or unwilling to listen to it.
Johnson: 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.
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, and then I’m able to ask questions around culture, around mistakes, 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 have to describe the business or answer questions for maybe an audience that’s less familiar with the company, just think about: How do they describe it? Do they really overemphasize the positive, or do they present a more balanced viewpoint? Do they answer questions in a straightforward way, or do they dodge the meaning of more critical questions? YouTube videos, YouTube interviews are fantastic.
Again, not a resource really available 15, 20 years ago. Members of management will often get interviewed in a wide variety of forums that you can find on YouTube and then 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 certainly the resources available to the investor are far greater than they were even a decade ago.
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?
Dorsey: Yeah. No, 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 … 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, as a venture capitalist, that’s a very sensible thing to do. But as an investor in larger organizations, you need to differentiate between the fact that a founder’s job is to rally the 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 nonfounders when evaluating management.
And I think maybe one of the key things to look out for is, 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? 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. 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 nonfounders, and don’t give them the benefit of the doubt.
Arnott: And I would imagine that to be a successful founder, you have to have 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.
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, giving 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 six- to seven-year payout as opposed to a 20-year value-creation story.
Arnott: Yeah, that’s a helpful distinction.
Dorsey: But to your point, certainly, I think that not many founders become good capital allocators. 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 it’s simply not going to grow at the rate it did when alternative accommodations were going from nonexistent to a meaningful competitor to hotels. All accommodations are now a scaled business with competitors like Booking, and Airbnb generates way more cash than it can profitably reinvest back in the business. But the odds that he says, “OK, the rational thing for us to do is 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 a common flaw that you see in founder-led businesses.
Johnson: Pat, 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.
Dorsey: I think the key to look at is 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 six, but the value you’re giving me went up by four. I mean, optimally the value went up by eight and you’re charging for six, 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 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 milking what will eventually become a melting ice cube.
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 4,000 or 5,000 publicly traded stocks to a very small list of companies that you actually invest in?
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. 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’ve spent almost no time on auto parts or insurance companies or banks in the US 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 winnow down our universe by spending more time in areas like aerospace or semiconductors or enterprise software or internet advertising that have good market structures in terms of being oligopolistic, tend to have good pricing power, and then also have good secular growth prospects. It’s really just a matter of thinking about where the moats are, where the fish are, and fishing in those ponds.
Johnson: Pat, on that note, and I think oftentimes what you’ve just described, it gets termed as being your “too hard” 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 you’re setting those aside irrespective of how compelling the valuations may or may not be. Could you speak a little bit more to your decision process there, why things that many might say, “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?
Dorsey: Yeah, so I think for us, there are two categories of “too hard” bucket. One is where we think we’ll be the proverbial patsy at the table and that others are likely to simply be structurally more able to understand the business than we are. So this would be the case for say a non-US business. 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 put a confident assessment on the lower bound of that range, that’s when we also tend to put things in the “too 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-averse nature of the user base, I think, makes the cone of potential outcomes much tighter than 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, 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.
Arnott: You’ve also written about something that you call a premortem, 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?
Dorsey: Yeah. The way we tend to frame it is, OK, 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? And then you’re kind of imagining, OK, is it because the multiple hasn’t rerated the way we thought? Is it because they have not been able to exercise price the way we thought they would? Is it because 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.
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’d probably own every business for about 20 minutes. What the premortem does is says, OK, 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 adjustable market or pricing or whatever it might be, you can attach higher signal to it. You can weight it more heavily in your decision process and help to create signal out of noise.
Johnson: Pat, I’m curious to get your take on 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—
Dorsey: I still call it Facebook. That’s fine by me.
Johnson: The Willis Tower will forever be the Sears Tower to me, Pat. I’ll die calling it the Sears Tower.
Dorsey: Exactly. Exactly. Something, something, something.
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 insane. 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?
Dorsey: Yeah, it’s a super-duper question. And I think it’s frankly an error that many investors make, and I’ve once made, thinking that weirder is better. The key, I think, is going back to an old paper by Russell Fuller called “Three Sources of Alpha” that thinks about different types of “edge” and 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 “edge,” is knowing more or having information about the company that is 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 Reg FD, but for a company like an ASML 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 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. 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 at the index.
And because there’s more and more capital like that out there, which you can think of as moving shares one way or the other for reasons that are not oriented around converging long-term value and price, 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 “the cycle had turned.” But eventually, if you buy more chips, you need more lithography machines. And so we owned it and just sat on it for a while and it wound up working out OK, 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 the poor analyst at a pod shop probably doesn’t have.
Arnott: 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?
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 faceless ETF buyers. The other big issue, frankly, is flows. If you are managing a mutual fund or an ETF, those structures have daily liquidity, and they may have shareholders who will react poorly to a month or quarter or whatever of poor performance, and 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.
Johnson: Pat, I want to, first of all, give you credit for emulating in your communications to your investors many of the things that you alluded to before that are the characteristics of what you look for in management, which is candor. And in many of your letters, you frame the opportunity cost or you speak to the opportunity cost of some of the decisions you’ve made with respect to 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 toward that framing?
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 an expected return of, let’s say, 12%, and that’s just fine, and you come across WidgetCo, 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 WidgetCo. And because of endowment bias, the behavioral quirk 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 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 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.
In fairness, we are very fortunate that the bulk of our investors are nontaxable, and so the friction between moving from Acme to WidgetCo 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 AcmeCo might incur a large capital gain. And so that’s something that we would need to consider because it impacts our clients that we, 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 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 managing money for taxable individuals just has different factors that they need to consider.
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.
Dorsey: Sure. Anytime. Happy to do it again.
Arnott: Thanks, Pat. This has been super interesting.
Dorsey: You bet. Take it easy, folks.
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 @MstarBenJohnson on X or at Ben Johnson, CFA on LinkedIn.
Arnott: And at Amy Arnott on LinkedIn.
Johnson: George Cassidy is our engineer for the podcast. Jessica Bebel produces the show notes each week, and Jennifer Gierat 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 thelongview@morningstar.com. Until next time, thanks for joining us.
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