Author: Pat Dorsey
Genre: Equity Investment
‘The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments’ is one book that gets straight to the fundamentals. The one thing it talks about is probably the only thing you may need as a newbie.
It’s not the first time when Pat Dorsey has written a masterpiece. In this book, Pat talks about Moats. A moat according to the dictionary means ‘a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack’. Using this analogy in investment, a moat becomes a competitive advantage that a business can have that gives it an upper hand, even on a level playing field.
The castle above is a business and the ditch surrounding the castle is the moat.
The bigger and deeper the ditch, the stronger the moat is.
In this book, the author reveals why competitive advantages, or economic moats, are such strong indicators of great long-term investments and examines four of their most common sources: intangible assets, cost advantages, customer-switching costs, and network effect.
The following sections are excerpts from a Morning star article that explain the above Moats.
Here are some of the attributes that can give companies economic moats:
Network Effect. The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. For example, millions of buyers and sellers on eBay EBAY give the company an advantage over other online marketplaces. The more sellers there are on eBay, the more likely buyers are to find what they’re looking for at a decent price. The more buyers there are, the easier it is to sell things.
Intangible Assets. Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products, or allow the company to charge a significant price premium. For example, patents protect the excess returns of pharmaceutical manufacturers such as Novartis NVS. When patents expire, generic competition can quickly push the prices of drugs down 80% or more.
Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, Express Scripts ESRX controls such a large percentage of U.S. pharmaceutical spending that it can negotiate favorable terms with suppliers like drug manufacturers and retail pharmacies.
Switching Costs. When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power. Architects, engineers, and designers spend entire careers mastering Autodesk’s ADSK software packages, creating very high switching costs.
Efficient Scale. When a niche market is effectively served by one or a small handful of companies, the efficient scale may be present. For example, midstream energy companies such as Enterprise Products Partners EPD enjoy a natural geographic monopoly. It would be too expensive to build a second set of pipes to serve the same routes; if a competitor tried this, it would cause returns for all participants to fall well below the cost of capital.
This is just a short introduction on what the above moats mean. For a detailed analysis on how to identify such moat stocks, you must grab the book.
Pre-requisites before reading the book: Economic Moat
Is the content relevant even today? Yes
Vocabulary and Understandability: Easy
Level of investment expertise required: Any
How can it benefit you?
This book can help you identify the competitive advantages a business has. The fundamental analysis or ratios may not support your analysis but if a business has a moat that is strong enough and difficult to compete with, you are with the right investment. There is no other way that is more sustainable than analyzing the moats. One must grab a copy of this book to develop investment ideas at a fundamental level.