The Little Book That Builds Wealth
04/01/2008 12:00 am EST
Dorsey’s ‘little book’ will be very helpful to investors looking to fine-tune their selection of stocks to purchase. Dorsey is the director of equity research for Morningstar, Inc., a company that provides top quality investment research, and one whose resource?particularly its Web site, www.Morningstar.com—have been very beneficial to me during my many years in the investment business.
This book focuses on economic moats, a term coined by legendary investor Warren Buffett. It simply means ‘sustainable advantages that protect a company against its competitors, the way a moat protects a castle’.
Economic moats define Morningstar’s approach to stock investing, as the company’s analysts focus their efforts on identifying long-term investments with wide economic moats. These are companies that earn excess returns, and whose shares you can hold for a long time, which will reduce your trading costs—adding up to a double bonus.
In fact, the size of a business’ economic moat is so important to Morningstar that it is one of the two primary factors that go into determining their investment ratings. The other is the stock’s discount from its estimated fair value.
Dorsey’s book centers on figuring out how to identify these businesses that will generate above average returns for many years.
He lists four structural characteristics that are crucial for a company to sustain a long-term competitive advantage, or economic moat that protects their high returns on capital.
- Intangible assets, such as a tremendous number of patents or regulatory help that can’t be matched
- Customer switching costs that are so dear that it is difficult for customers to give up
- Network economics, which increases the value of a company as its number of users grows
- Significant cost advantages from process, location, scale, or access to a unique asset
Dorsey devotes a full chapter to recognizing when a moat is eroding, and then moves onto ‘false-positives’—companies that look like they have wide economic moats, but in reality, do not. Here, he discusses mistaken moats, including those often touted by the media as marks of a great company, such as market share and managerial brilliance.
He winds up his book with a brief overview of valuation measurements and tools, offering a few examples of industry and competitive analysis to determine if a company’s return on investment is sustainable over an extended period of time. And lastly, Dorsey presents a short treatise on knowing when to sell—a strategy often avoided by many Wall Street pundits.
I found the book a good start, whetting your appetite to learn more about economic moats. And long-term investors can come away with a different take on fundamental analysis, allowing a much wider view than the ratios that many analysts religiously follow.
Additionally, Dorsey’s stated goal of ‘defining a circle of competence’, resonated with me. He defined this as ‘becoming an expert on firms with competitive advantages, rather than an expert in a set of industries’. I really like that idea, as it widens your universe of potential investments tremendously. And as I always tell my workshop attendees—the same few set of factors can serve you well in analyzing almost any industry, and Dorsey’s explanation of economic moats just adds to that toolbox.