A guide to identifying companies that are great today and are going to be great in the future
What is ‘The Little Book That Builds Wealth’ about?
Pat Dorsey of Dorsey Asset Management (former Head of Equity Research at Morningstar) wrote the popular book ‘The Little Book That Builds Wealth’ in 2006. The main topic of the book is how identifying competitive advantages of companies (intangible assets, high switching costs, network effects, and operational efficiency) will make you money from the great companies of tomorrow.
According to Dorsey, most companies you see enjoying high returns on capital, see it decrease as more competitors come in the sector. However there are some companies that defy this. How do they do it? These companies have competitive advantages (also known as moats). As a result of these moats, some companies can generate profit for a longer stretch of time. You may have heard that a company introduced a new product that is sure to be a hit. The author suggests that it’s not a case of whether new product becomes profitable, but the duration of the profits that really matter i.e. moat companies increase their intrinsic value over time. According to Dorsey, great products, great management, strong market share, and great executions are fake moats. i.e they are not real sources of competitive advantage.
Intangible assets are the first type of moats to look out for. Consider companies that have recognisable brands, such as Coca-Cola and chocolate bars made by Nestle in the food and beverage industry. Products under recognisable brands (recognisable brands are a form of intangible assets) tend to perform better than counterparts. Recognisable brands can help companies create a competitive advantage (however a well-known brand that doesn’t have pricing power is not a competitive advantage). The rule here is that if a brand doesn’t entice customers to pay more, it may not be a competitive advantage. Intangible assets also take the form of patents and regulatory licenses. The author also highlights the risk associated with this particular moat. For instance popular brands aren’t always profitable brands, and patents do expire.
The second type of moats identified in the book are known as high switching costs. This kind of advantage occurs when the difficulty associated with changing to use another products persuades the customer to stay. Imagine the difficulty of switching bank accounts or moving to a new database. The advantage to companies that benefit for high switching costs is that they are aware of their ability to be able to increase their prices and it will be accepted by the customer’s because said customers are unlikely to switch to a competitor. In such a scenario, charging more means such a company can generate higher returns on capital. To able to unearth this competitive advantage requires a deep understanding of the customer experience.
This kind of advantage is common in software companies, parts companies, asset managers, energy companies, and healthcare equipment’s. You can contrast this kind of companies to restaurants, retailers, and packaged goods companies who cannot afford to increase prices at will (given its relatively easy for customers to switch to competitors).
Need to know
| Competitive Advantage | A condition or circumstance that puts a company in a favourable or superior business position. |
| Moat/ Economic Moat | A moat is a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defence against attack.
The term economic moat, popularised by Warren Buffett, refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. |
| Value investing | An investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value |
| Intrinsic Value | Intrinsic value refers to the value of a company, stock, currency or product determined through fundamental analysis without reference to its market value |
| Market Value | Market value is the price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalisation of a publicly traded company |
Source: Google
The third type of moat can be referred to as network effects. Think of Microsoft Word and its range of software products- Excel, Word, PowerPoint etc. Microsoft isn’t the only company to offer these kinds of software office tools. However, Microsoft has a competitive advantage in this business because the value of its products strengthens with each new customer that begins to use its office tools (unlike Apple’s range of office tools which are incompatible with what the majority of the workforce uses). Microsoft wins in its ability to attract most users here. This moat is so strong that even if a competitor was to come out with his version of office tools that is 5 times faster than Microsoft’s and half the price, it would still face a hard time stealing substantial market share.
Cost advantages are another form of moats talked about in the book. A few companies benefit from this as a result of cheaper production processes, an advantageous location and unique resources. Basically such companies are not competing with substitute products on just price alone. When looking to identify if such an advantage exists, do not mistake process based advantages as being a form of this moat because other companies can copy what another has invented. A good example of this competitive advantage would be a low-cost advantage, such as cheap access to raw materials a paper-making company has because its located in a country with the fastest growing pulp trees.
Who is this book for?
This book is for anyone who is curious about investing, or is looking to explore different strategies to invest in the stock market successfully. Overall, investment decisions are initially based on personality, risk appetite, and understanding various asset classes. This means that investors should be aware of different strategies and choose one or two to implement. Nonetheless, this is a good book to read when starting off in investing as you begin to ground yourself in the basics of financial markets, in my opinion.
Why you should read the book?
This is an accessible book that provides the intuitive basis of how to value a good business; ‘The Little Book That Builds Wealth’ is not rooted in fundamental analysis provided by investment houses. It’s not that the latter should be discounted ( both can be combined for optimal results).
You can think about the advice provided in this book as a way to know what to look for in an industry, before narrowing down on what to invest in. Also, the book is filled with examples of companies and industries with competitive advantages (and some companies that failed). These examples would serve as a good idea to source for investment ideas for you to add to your portfolio.
What not to expect from the book
‘The Little Book That Builds Wealth’ will not solve all your investment problems. To gain the most from the book, you would have to commit to investing using an intrinsic approach. In addition, you must understand what the stock market is, be clear about the basic finance concepts (e.g. value creation), and know your risk appetite. You also have to be willing to do the work i.e. look through the ‘lens of the book’ to examine the Nigerian market for investment opportunities.
Furthermore, some may raise an eyebrow as this book doesn’t believe in the importance of having quality management at the helm of a company (or any other fundamental analysis considerations). Nevertheless, this book still an important addition to any investors library.
Key takeaways:
- A company’s value is equal to all the cash it will generate in the future
- The key to sound investing is to understand the structural characteristics of a business, as some businesses are just structurally better than others
- There are some mistaken moats such as new products, and strong market share
- Invest in moats at bargain prices i.e. keep buying when it’s low. And sell when overvalued. Rinse and repeat.
- Make a list of companies you would like to own at some price, wait, and then buy (when prices are low relative to intrinsic value of the company’s stock)
Dig Deeper:
Audiobook: The Little Book That Builds Wealth. Click here
Talks at Google: The Little Book That Builds Wealth. By Pat Dorsey. Highly entertaining presentation at Google HQ. Dorsey shows off his wit and explains the material of the book, while taking questions . Click here