Why Your Favorite Company’s Economic Moat May Not Be Built to Last

On this episode of The Long View, Pat Dorsey, founder of Dorsey Asset Management and previous director of equity research for Morningstar, discusses the development and definition of economic moats, common moat mistakes, and how to find high-quality companies to invest in.

Here are a few excerpts from Dorsey’s conversation with Morningstar’s Amy Arnott and Ben Johnson.

Are You Making These Common Economic Moat Mistakes?

Ben 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?

Pat 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.

What PayPal and Visa Reveal About Moat Durability

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 PYPL, 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 V and Mastercard MA 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.

Why Network Effects Don’t Guarantee a Competitive Advantage

Amy 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.