The Little Book That Builds

Wealth
By Pat Dorsey

Review by Ajay K. Merchant

 Game Plan – Simple Strategy but not
Easy
Steps to buy wonderful companies at reasonable prices

1. Identify business that can generate above average

profits for many years.
2. Wait until the shares of those business trade for less
than their intrinsic value, and then buy.
3. Hold these shares until either the business
deteriorates, the shares become overvalued, or you
find better investment.
4. Repeat as necessary.
 Chapter 1:
Economic Moats
• Moats are structural characteristics inherent to a business
and the cold truth is that some business are simply better
then others.
• Companies with moats are more valuable then company
without moats.
• Each share of a company gives the investor a very small
ownership interest in that firm.
• A company with an economic moat is able to invest its cash
flows at a high rate of return for longer periods. Also the
cash flows are protected over longer periods of time.
• Economic moats also protect one’s investment from
permanent capital impairment.
 Chapter 2:
Mistaken Moats
• Unlike horse racing which bets on the jockey, in
business one needs to bet on the horse(business)
• Moats are structural characteristics that are likely
to persist for a number of years & hard for
competitors to replicate.
• Mistaken moats are great products, strong
market share, great execution and great
management. These are traps and absence of
economic moats will make financial results turn
on a dime.
 4 Economic Moats
1. Intangible Assets / Regulatory licences – like
brands, patents, or licences which competitors cant
match.
2. Customer switching costs – products or
services customers find hard to give up.
3. Network Economics – Can be very powerful
economic moat and enduring for a long period of
time.
4. Cost Advantages – stemming from process,
location, scale, or access to a unique asset.
Chapter 3: Moat 1 – Intangible Assets
A. BRANDS
• One of the most common mistakes investors make is to
assume well know brands give competitive advantage.
• Brand can be considered a moat if (i) Increases the consumers
willingness to pay. (pricing power). (ii) Increases consumer
captivity (repeat business).
• Eg. Sony brand – Generally customers of electronics are
looking for features & price over brand.
• Examples of brand commanding premium are Tiffany & USG.
• Kraft cheese was a strong brand in cheese till it lost its
competitive advantage to the private labels.
• Brands can create competitive advantages, but more then
popularity is whether it actually affects consumer’s behaviour.
 Moat 1 – Intangible Assets
B. Patents
• Patents have a finite life, and its virtual certainty that
competition will arrive quickly when the patent
expires.
• Patents are also not irrevocable – they can be
challenged, and the more profitable a patent, more the
lawyers will attack it.
• One should be wary of firms that relies on a small
number of patented products for its profits.
• Patents constitute a truly sustainable competitive
advantage is when the firm has demonstrated track
record for innovation that will continue as well as well
as a wide variety of patented products. Eg. 3M, Merck.
 Moat 1 – Intangible Assets
C. Regulatory Licence
• This moat is most potent when regulatory approval is
coupled with pricing freedom.
• The bond-rating industry is an example of regulatory
advantage with near monopolistic position. Moody’s has
operating profit margin > 50% and ROCE of 150%.
• Moody’s, the slot machine industry and for profit education
industry are all examples of single licence giving companies
sustainable competitive advantages.
• Even a number of small licences or local rules for land fill
and stone quarry are extremely valuable as getting new
ones is difficult.
• Eg. Of a regulatory licence not giving high returns on capital
are refiners.
 Chapter 4:
Moat 2 – Switching Costs
• Switching costs are valuable competitive advantages
because a company can extract more money out of its
customers if they are unlikely to move to a competitor.
• Banks involve switching costs as customers do not change
bank accounts for at least 6-7 years and switching also
involves filling a lot of forms, new instructions etc.
• Eg. Of switching costs are Quick Books accounting software
by Intuit, Databases by Oracle, Data processors & Securities
custodians like State Street Corporation.
• Precision Castparts, selling high-tech, super strong metal
components in jet aircraft and power-plant turbines is
another eg. Of strong switching costs as. This is because of
the low tolerance for failure.
• However consumer-oriented firms like clothing often suffer
from low switching costs.
 Chapter 5:
Moat 3 – The Network Effect
• A very powerful moat which is not insurmountable but
tough for competitors to crack.
• Network based businesses tend to create natural
monopolies and oligopolies. Eg. Large credit card networks
of Visa, Master card, Amex and Discover account for all
spending on credit cards in USA.
• If the value of a good or service increases with the number
of people using it, then the most valuable network based
products will be the ones that attract the most users,
creating virtuous circle that squeezes out smaller networks
and increases the size of dominant networks.
• Microsoft is another eg. ff strong network effects.
• It is not possible to have large number of businesses having
network effects because of the propensity of the business
to consolidate around the leader.
 Moat 3 – The Network Effect
continued
• The network effect is much more common among
businesses based on information or knowledge transfer
than among businesses based on physical capital.
• eBay had 85% of the Internet auction traffic in USA. It
dominates this market. However in Japan Yahoo dominates
as it had the first mover advantage. However in China it had
a 90% share of traffic but was dislodged by a local
competitor. In fast growing market with consumer
preferences still forming the network can be subject to
successful attack.
• Financial exchanges benefit from network effect much as
eBay does. However differentiate between Chicago
Mercantile Exchange and New York Mercantile Exchange
v/s exchanges that deal in shares like NYSE & NASDAQ. The
lesson here is that for a company to benefit from the
network effect, it needs to operate a closed network.
 Moat 3 –
The Network Effect continued
• Western Union is another example of network effects
in the money transfer business.
• The benefit of having a larger network is nonlinear,
which means that economic value of the network
increases at a faster rate than its absolute size.
• Third party logistic company Expeditors International is
another example of network effects through its
extensive branch network. The company can push
more cargo through each branch, the companies
income per branch increased as new branches add
cargo flow to existing ones.
 Chapter 6:
Moat 4 – Cost Advantages
• The first 3 moats focus on price that can be extracted
from customers.
• Cost advantages can sometimes be durable but
disappear quickly. The key is to determine if the cost
advantage can be replicable by the competitor.
• Cost advantages matter most in industries where price
is a large portion of the customers purchase criteria.
• Another important way to identify industries with cost
advantages is to imagine whether there are easily
available substitutes.
• Costs matter a lot to automakers as price is a huge
component of the buyers decision.
 Moat 4 – Cost Advantages continued
• Four sources of Cost Advantage – (i) cheaper processes (ii)
better locations (iii) unique assets (iv) greater scale
• Process based cost advantages can create a temporary
moat if incumbents are unlikely to replicate them
immediately. Eg. Dell & Southwest.
• Better Location occurs most frequently in commodity
products that are heavy & cheap. Eg Cement Industry.
• Unique Assets is limited to commodity producers and
include resource deposit with lower extraction costs than
any other comparable resource producer. Eg. Ultra
Petroleum.
• Location based & Unique assets are much more durable
and hard to replicate.
 Chapter 7:
The Size Advantage
• The absolute size of a company matters much less than its
size relative to rivals.
• In this type of moat it is very important to remember the
difference between fixed and variable costs. Higher fixed
costs relative to variable costs implies more consolidated
the industry tends to be.
• Scale based costs are further broken down into 3
categories: distribution, manufacturing and niche markets.
• Distribution networks is a very wide moat & hard to
replicate. Eg. United Parcel Service (UPS) v/s rival FedEx.
Coca-Cola & Pepsi are other examples.
• Manufacturing type of advantage has diminished with low-
cost pools of labour in China.
• Niche market Eg. Would be a private airport where there is
no scope of a second airport.
 Chapter 8: Eroding Moats
• Disruptions are seen by specialist on the NYSE, Polaroid,
long distance telephony, newspaper & music publishing
business.
• Technology replacement by a competitor is a fact of life for
most technology companies. Technology disruptions are
unexpected & severe. Eg. Eastman Kodak saw a decline of
85% of cumulative operating income between 2002 – 2007.
• Disruptive technologies can hurt the moats of businesses
that are enabled by technology even more than business
that sell technology.
• Even shifts in the structure of industries like consolidation
can erode strong moats.
• Investors should look out for the entry of irrational
competitor into an industry.
• Look out for companies that pursue growth in areas where
it has no moat. Eg. Microsoft – investment in Zune, MSN,
MSNBC & toys.
 Chapter 9:
Finding Moats
• Distinguish between industries which have brutal
competition and industries which have less competition.
Eg. Auto ancillary which has very few moat companies v/s
AMC.
• In technology companies software companies have easier
time to create moats then hardware. Software needs to be
integrated with other software to work properly & leads to
customer lock-in & higher switching costs. CISCO is an
exception which is a hardware company which embed
software in its products & create switching costs.
• Moats in telecom companies are dependent on having
either a favourable regulatory structure or niche position.
Media companies control unique content. Eg. Disney.
Restaurants & Retailers have very low switching costs.
 Chapter 9:
Finding Moats continued 1
• Companies providing services to business have wide moats.
Eg. DST Systems, Fiserv, IMS, Dun & Bradstreet & Moody’s
Investor Service.
• In financial services like Goldman Sachs there are sticky
assets & many companies in this sector have strong moats.
Another example are the exchanges which benefit from
network effects. However Insurance companies are more
like commodity companies.
• Consumer companies like Coca-cola, Colgate, P&G, Wrigley
etc have durable brands that don’t go out of style. Moats
are constantly maintained through advertisement &
product innovations.
• Moat erosion took place at Tommy Hilfiger, Kraft & del
Monte by private labels and steel industry through low
labour costs. Exceptions are Graco, Oil Gas pipeline.
 Finding Moats continued 2
• Measuring a Companies Profitability –
1. ROA – Return on Assets
2. ROE – Return on Shareholders capital
3. ROIC – Return on Invested Capital (Combines
both equity & debt)
• Investors should study the moats, its
endurance and companies that use capital
efficiently.
 Chapter 10:
The Big Boss
• Long term competitive advantages are rooted in the
structural business characteristics and managements
have limited ability to affect them.
• Moats are determined by the competitive dynamics of
an industry & not managerial decision. Eg. Airline
business has brutal dynamics.
• Human mind is biased towards CEO ability though
evidence suggest otherwise. Warren Buffet said “When
management with a reputation for brilliance tackles a
business with the reputation for bad economics, it is
the reputation of the business remains intact.”
Chapter 11 – Where the Rubber Meets
the Road
Step 1 Step 2 Step 3
Has the firm Does the firm have How strong is the
historically one or more of the company’s competitive
generated solid Yes>> competitive Yes>> advantage? Is it likely to
returns on capital? advantages listed last a long time or a
below? relatively short time?
No

Is the firms future High Switching Costs

likely to be Network Economics
different than its Low-cost Production
past? Intangible Assets
No No Short Long

No Economic Moat No Economic Moat Narrow Moat Wide Moat

 Chapter 12:
What is a Moat Worth?
• The price one pays for a stock is critical.
• Every company is slightly different so it is difficult to make a
comparison. Secondly the value of the company is directly
tied to its future financial performance, which is unknown.
• One cannot know the exact future earnings so one could
reverse engineer the price to see what expectations were
built in the price.
• 4 important factors to keep in mind in valuation – (i) Future
cash flows materialising (risk) (ii) How large these cash
flows would be (growth) (iii) Investments needed for
keeping business ticking (return on capital) (iv) How long
the business can generate excess profits (economic moat)
What is a Moat Worth? Continued
• 2 things that push a stock up & down. The
investment return, driven by earnings, growth &
dividends, and the speculative return driven by
changes in P/E ratio.
• Companies with economic moats maximise
potential investment returns as they create
economic value & increase earnings over long
periods of time.
• Eg. Microsoft by mid 2007 had increased EPS by
16% per year. However stock appreciated only 7%
as the P/E had reduced from 50 times to 20 times
 Chapter 13
Tools for Valuation
• Price to sales ratio (P/S) is useful for cyclical companies or
companies that are having some kind of trouble that sends earnings
temporarily into the red. It is most useful to evaluate companies
that have temporarily depressed margins.
• Price to book (P/B) is used in asset intensive business where book
value represents bulk of the assets that generate revenue. However
investors should watch BV if it includes goodwill, which needs to be
deducted in calculating P/B ratio. This ratio is very useful in financial
services company though low BV in this industry may mean a
question mark on the BV for bad loans which may need to be
written off.
• Price to earnings ratio (P/E) are because earnings are useful where
earnings are a decent proxy for value creating cash flow. However
awareness of “E” is important as forecast do not always come true.
One should look at how the company has performed in both good
and bad times and arrive at an estimate.
 Tools for Valuation - continued
• Price to cash flow from operations is a very useful tool
for valuation of companies with high cash flows like
companies which collect cash up front or companies
with lot of hard assets with high depreciation.
• Another tool is yield based valuation which compares
results with alternative investments like bonds.
• In conclusion – (i) Always remember 4 drivers of
valuation: risk, return on capital, competitive
advantage, growth. (ii) Use multiple tools. (iii) Be
Patient. (iv) Be tough / contrarian (v) Be yourself.
• Always buy a stock keeping valuation in mind.
 Chapter 14 – When to Sell
• Selling a stock for the right reasons is a very important
decision.
1. Did I make a mistake? This is the most painful reason
when you are wrong. Cut your loss and move on.
Psychological studies have proved that people experience
almost twice as much pain when they loose money then
they gain the exact same amount.
2. Has the company changed for the worst? – If the
fundamentals of the company deteriorate substantially &
unlikely to rebound then sell.
3. Is there a better place for my money? – As capital is
limited switch to stocks which would give a better return.
4. Has the stock become too large a position in the portfolio
 Conclusion – More then Numbers
• Read more on companies and get to know them.
See how companies want to make more money
then their competitors.
• One annual report is worth more then 10
speeches of the Federal Reserve Chairman.
Reading about companies is better then reading
about short term market movements,
macroeconomic trends or interest rate forecast.
• Read companies then Successful money
managers & Quarterly shareholder letters.