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Pat Dorsey explains why moats matter

For decades, Warren Buffett has invested in companies with protective "moats" that are wide and deep.

Buffett's reasoning is logical. Businesses with significant moats are able to withstand the shock of a 2008 type downturn, they require less trading, are more tax-efficient and can be held for decades.

To help my Texas Lutheran University students understand the moat idea better, I called upon Pat Dorsey, president of Dorsey Asset Management.

During the past 20 years, Dorsey has become the authority on protective moats. He has written two books outlining what to look for and how to assess them.

Both "The Little Book That Builds Wealth" and "Five Rules For Successful Stock Investing" are written so anyone can understand them but in enough detail to offer significant depth.

Dorsey was incredibly gracious to fly from his home in Chicago to spend the afternoon with my students at TLU. I think it helped that when Dorsey left, there were four inches of snow on the ground while the wildflowers were in full bloom in Texas.

Pat's background is unconventional from an investment perspective. He went to a liberal arts college earning an undergraduate degree in government and masters in political science. He has never taken an accounting or finance class, and yet he holds the esteemed Chartered Financial Analyst designation.

This unorthodox background landed Dorsey the job as head of equity research at Morningstar - a position he held for 12 years. When he was hired, he was the only research analyst. By the time he left he oversaw a staff of 100.

In discussing his approach, the understated investment expert said most of investing should be commonsense.

He added the first goal is to determine how money comes into a company, how it leaves and what you, as a shareholder, have to pay for your share of the earnings.

Furthermore, Dorsey prefers to concentrate his portfolio in a handful of names.

Although his current portfolio has 13 holdings, he prefers 10 or fewer.

This allows a wise manager to concentrate on his best ideas allowing them to have a much higher degree of expertise.

It is an acknowledgement that there are not that many "wide moat" ideas to consider and even fewer trading at an attractive price.

Contrary to popular belief, Dorsey said a true wide moat company does not have a "hot" product or the latest technology.

In dispelling this, he referenced Krispy Kreme doughnuts and Heelys as once beloved "hot" products that failed the test of time.

Dorsey also warned a moat does not come from high market share.

He used General Motors and Compaq as examples of large firms that have delivered poor long-term results.

Instead, it was explained that moats come from the ability to maintain pricing power over very long time frames - multiple decades.

The most valuable are able to reinvest profits back into the business with high returns on capital.

Dorsey's decades of research revealed that, in general, moats come in four major categories.

Intangible assets can be created from strong brands(Coca-Cola or Tiffany), patents or licenses (a casino or landfill).

A second moat comes from significant switching costs. He explained that a Fortune 500 company is very unlikely to change custom software just to save a few dollars.

The cost savings would be far more hassle than it's worth once the time and training needed to convert is factored in.

The next category involved the "network effect." Simply, the larger a network becomes the more people go there. The network effect offers cost advantages and scale by aggregating demand in a fragmented marketplace. A good example of this would be credit card networks.

The fourth moat involves cost advantages allowing fixed costs to be spread over a larger base, like UPS, or a way to deliver a service that is cheaper, like Geico.

Dorsey also shared that much of his current portfolio is invested in companies outside the United States.

This helped the students to realize that although capitalism works well here, it is not limited to the U.S.

Furthermore, it was explained that a great manager running a mediocre business will produce mediocre results.

However, a mediocre manager running a great wide moat business can still produce terrific results. As such, the wide business moat overcomes deficiencies in many other areas.

Lastly, the talk served as an effective education that wide moat businesses can grow wealth while reducing risk.

Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other week.

Originally published April 14 2015, Victoria Advocate