The book that I picked up to talk about today is – The little book that builds wealth. The sub-title of the book puts forth what you can expect from the book quite clearly – The knockout formula for finding great investments.
The book is written by Pat Dorsey and was first published in 2008. At that time he was in the middle of his 11-year tenure as the Director of Equity Research at Morningstar. In 2011, he left Morningstar to start his own firm – Dorsey Asset Management.
Main Premise
Dorsey is best known for having initiated and popularized the theory of economic moats with respect to stock analysis. Confused?
Just like this castle, some companies manage to build an economic moat around them.
Think of the royal castles of the old era. They all had a trench or a ditch dug all around them, filled with water as a defense mechanism against potential enemies. The wider the moat, the higher the chances of the kingdom being able to fend off attackers.
The author has juxtaposed this idea on to the competitive landscape today. Economic moat then refers to companies having built up enough competitive advantage to be able to protect and create rich cash flows and profits in the future. This theory shares some similarities with Michael Porters’ 5 forces model to predict competitive advantage.
Sources of Economic Moats
Pat Dorsey divides the sources of economic moat into 4 major categories:
1. Intangible Assets
One of the first intangible assets to consider is the brand. However, brands are also a double-edged sword. They take a LOT of money and time to create. Only brands which have customers paying a substantially higher price than their customers can be considered as having a competitive advantage. So, does an Oreo have a competitive edge over Hide ‘n’ seek? Probably not. What about a Harley Davidson vis-à-vis Bajaj Pulsar. Definitely yes.
The second intangible asset to consider is a patent. However, can a company sustain itself on the basis of a single patent that can be easily replicated? Nope. Companies like 3M are known for a string of innovative patents which helps the company diversify its’ risk. In this case, even if one patent comes to its’ end date and gets easily and cheaply replicated, the company has more weapons in its’ arsenal.
The third intangible asset that Dorsey talks about is the regulatory license which makes it more difficult for other upstarts to enter the market, like the banking industry in India. However within such licensing too, one should ideally invest in industries which are not regulated on the price as well unlike industries like utilities.
2. Switching costs
Switching costs is a broad term to define the level of effort a customer needs to make from one manufacturer/product for a good/service to the other.
Suppose you eat at a restaurant and don’t have a great experience. You can easily go to any other restaurant the next time.
On the other hand, have you noticed how patchy your mobile network often is? But, unless things go completely bonkers, in all probability you will continue with your mobile service provider. Even though Mobile Number Portability (retaining the same mobile number after switching providers) reduced the switching cost to some extent, telecom is still a somewhat sticky category.
Overall, Dorsey makes the point that for most consumer categories switching costs are low be it retail, food, clothing etc. However, for most B2B organizations and categories, often providers are deeply entrenched into the system making it more difficult for the customer to switch. For instance, if a company was to switch its accounting software, it is a long-term labor-intensive process.
3. Network economics
Network-based businesses are those that benefit from larger and larger number of user or partner bases. In a vicious manner, there are bound to be less number of such players as they end up squeezing out any potential upstart.
Think about telecom again which as an industry is in the phase of consolidation. Another example given by Dorsey is the industry of card aggregators like Visa and Mastercard. While Rupay in India is trying to build up, it is no longer easy to match up to the network strength of a Visa or a Mastercard.
4. Cost Advantage
Cost Advantage can itself be found in 4 sources:
Process-based: Often companies develop a low-cost process that gives it a massive advantage in the market. But, how long can it last before other competitors figure out the trick or come up with process innovation of their own? Think about Deccan Air, the first low-cost airline in India. Unfortunately didn’t take it long to lose its’ sheen and then sell out.
Location-based: This advantage at one point used to be really big and valid to a lot of industries. As the world is becoming more globalized and a lot of manufacturing is shifting to different parts of the world, this advantage is now limited to heavier industries. Think logistics or metal or coal which need to be transported over long distances. In such industries, location still provides a vital competitive cost advantage.
Unique world-class asset: This is obviously a rare competitive advantage but some companies do business on the basis of unique assets that are specific to a region. Think De Beers and South African diamonds (the blood diamond controversy notwithstanding)
Scale-based cost advantage: Scale based cost advantage itself has 3 elements as the scale based advantages can be based on differing factors.
Distribution network: To me, this can be a particularly big advantage in India. Think of all the big FMCG companies like HUL, or Colgate Palmolive or ITC. Their distribution network is a HUGE asset for them as FMCG is an industry based on scale (pretty obvious from a name like Fast Moving Consumer Goods right?). For a new brand, it will be pretty difficult to build that kind of a distribution network.
Manufacturing scale: This advantage has been somewhat diminished thanks to the scale of the Chinese manufacturing industry, Today, a lot of brands easily manufacture in China and attain the scale without the investment. However, another manufacturing scale to consider is to spread fixed costs over a larger number of units. So, if the costs are lower to manufacture and launch something like a video game, with little variable cost and can be sold in a large number of units then that is a wide economic moat for sure.
Scale in a niche market: Big fish in a small pond is always more valuable than small fish in a big pond. So, if a company is a specialist with a small market per se, but has a huge profitable share in that market, that is another economic moat to consider.
Management is not that important a factor
Honestly, this was a relief for me to read. I believe management is one of the biggest grey areas of analyzing a company stock. How do you really know what is good management?
Dorsey makes no bones about the idea that management does not matter in the long run. He gives the following analogy which pretty much cleared all my doubts – In a horse race, whom do you bet on? The jockey or the horse? An excellent jockey will still not win with a weak horse whereas even an average jockey can help win the race with a fantastic horse. Companies are like that – when they are inherently strong, the impact of management and the probability of them screwing it up is much lower.
As the author rightly pointed out, what can you change easily? Management or the industry in which a company operates?
3 important factors
Return on Assets (ROA) which essentially means the return generated on the assets by a company. The catch? This does not work for financial companies and even for others, use it only as a preliminary number as debt is not accounted for by this number.
Return on Equity (ROE) is the ratio to depict the profit earned with respect to shareholder equity in a company. This is another number which unfortunately does not take debt into account but gives a good picture of how the company is utilizing the shareholder funds.
Return on Invested Capital (ROIC) is the 3rd number mentioned by Pat Dorsey which looks at returns generated with respect to capital actively being utilized in the business. In this number, all funds employed deducted for non-operating assets are used to arrive at this number. So, ROIC = Net Operating Profit/Invested Capital. However, I prefer ROCE to ROIC which takes into account ALL funds in the denominator.
When to buy companies with an economic moat?
Pat Dorsey mentions a few industries where a lot of companies would automatically have economic moats. However, one of the stand out statements of the book has to be:
Even the Best Company Will Hurt Your Portfolio If You Pay Too Much for It - Pat Dorsey Click To TweetSo, when to buy is as important a decision as what to buy. That is a big chunk of the value that the book provides so I will not go into too many details of it. There has to be some reason for you guys to read the book right?
Suffice it to say, lower the risk, higher the growth probability, better the return on capital employed in the past and wider the economic moat, better is your bet on that company!
Curious? You know you gotta read the book 🙂
When to sell a stock?
While most people focus on the right time to buy a stock, it is equally important and maybe more tricky to understand the ideal point to exit a stock.
For this Dorsey gives 4 simple pointers:
1. When you realize an error in your analysis that led you to buy the stock
2. If the company dynamics or core has changed for the worse
3. If you find a much better bargain stock and not enough cash to put into it
4. If you have an asset or industry allocation in mind and rebalancing tells you to sell off a stock that’s become too big for your portfolio
If you have even a basic idea of how companies operate and are keen to put in place a process for deep stock analysis, this is a great book to start your journey. This little book packs quite a punch.
Let me know what you think in the comments below or email me at aparna@elementummoney.com
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