Review: The Little Book That Builds Wealth

Each Friday, The Simple Dollar reviews a personal finance book.

littleThe Little Book That Builds Wealth is the fifth book in the Little Books series from Wiley Publishing, each of which focuses in on describing a particular investing strategy in layman’s terms.

This time around, the focus is on competitive advantage, or “moats” – the basic idea that Warren Buffett uses when investing. The author, Pat Dorsey, is the director of research at Morningstar, the well-known investment research firm, so he’s fairly authoritative on the subject.

When I read a book like this one, I’m hoping to really learn the nuts and bolts of an investment strategy, enough so that I can understand how it works and how I might use it to compare companies to one another and decide which one I should invest in. If I learn that without being bored to death, I look at the book as a success – if I’m at the end and still confused, or if the book lulls me to sleep, then I’m not impressed.

Does The Little Book That Builds Wealth live up to this standard, or does it fall short? Let’s take a look.

Looking At The Little Book That Builds Wealth

Chapter One – Economic Moats
The book opens by defining the concept of a moat. In a nutshell, a moat is a significant competitive advantage that one company has over another. The great example used in this chapter is McDonalds – in 2002 and 2003, Mickey D’s caught a lot of bad press because of their poor customer service and perceived slipping food quality. For a restaurant chain without a huge moat, this could have been devastating – for example, look at the implosion of the Little Sambo’s chain in the 1970s, which went from 1,200 restaurants to one in less than a decade. However, McDonalds had some very important moats that gave them time to survive and retool a bit – they had a globally recognizable brand and strong customer loyalty. Those provided a nice moat for McDonalds to keep the competitors from attacking too fiercely and gave the company time to fix their problems and rebound.

Chapter Two – Mistaken Moats
From that explanation, it’s easy to visualize moats for almost any company. Any company with any size is doing something right, and it’s easy to confuse immediate success with competitive advantage. However, quick success usually has very little to do with true competitive advantage. Take Tommy Hilfiger, for example. Once, it seemed they were building a globally competitive brand – but now you can find Tommy clothes on discount racks. The dot-com busts like Pets.com are in the same boat – they seemed to have a competitive advantage because of the internet, but it was a mistaken advantage. There are really only four sources of true competitive advantage: intangible assets (like patents or licenses), customer switching costs (meaning it’s hard for a customer to give up that specific product – think Microsoft), network economics (like an ingrained shipping network), and cost advantages (control over some method of making the product cheaper than competitors are able to). A company with at least one of these and a nice return on capital is a good one to invest in.

Chapter Three – Intangible Assets
Intangible assets are those that don’t have physical form but do produce value. For example, a brand strong enough that people will pay a premium price for it. Take Tiffany’s – if you buy an item from Tiffany’s, you’re going to pay a significant premium for that little blue box, yet the company is consistently able to charge premium prices and customers are willing to pay it. On the other hand, look at Sony – their brand is valuable, but people are quite often willing to choose an identical item with a different brand on it (is your DVD player a Sony?). Patents and regulations are also good moats, but the most valuable ones are those that are composed of lots of small patents and regulations, not a few big ones.

Chapter Four – Switching Costs
I’m a Photoshop user. I know how to use the program quite well and I also know that I’m often frustrated when I attempt to use other image editing packages. For me, there is a large intangible switching cost for abandoning Photoshop, and I’m loathe to pay that cost. This is a clear-cut example of a moat – Adobe can charge a high price for Photoshop because many image editing folks are trained in it and it’s difficult to switch. Lots of businesses have moats along these lines – banks, software vendors, and so on.

Chapter Five – The Network Effect
Any company that has an already-running distribution network for their product, like Anheuser-Busch, has this type of moat. Because of the cost and effort in getting a distribution network set up – and often the challenge of fighting through distribution agreements – a pre-existing distribution network can be a huge moat. It is this reason why it is almost impossible for another large-scale beverage company to independently become as large as Coca-Cola or Pepsi – they can’t afford the costs of distribution. A similar logic occurs with internet companies – they use the internet as their network and reduce brick and mortar costs that way.

Chapter Six – Cost Advantages
Cost advantages come in the form of better locations, better access to resources, and better processes. All of these allow a company to cut costs in ways that their competitors cannot. However, some cost advantages are stronger than others – for example, another company can easily copy the cost advantage of a process, while they can’t easily copy the advantages that a maple syrup company would have in a giant forest of old maples.

Chapter Seven – The Size Advantage
Larger companies simply have a natural advantage over smaller ones. They can execute their plans on scales much larger than the smaller companies and because of their size find efficiencies and discounts unavailable to smaller groups. They can use their size as leverage, promising plenty of business to suppliers in exchange for exclusivity, for example. They can also find efficiencies in processes that smaller companies can’t, like having a person devoted to one tiny nuance of the production while other companies must multitask their workers. Thus, large companies often have an inherent moat, albeit one that can be superceded by other companies over time.

Chapter Eight – Eroding Moats
Obviously, moats can erode over time. One of the biggest factors in moat erosion is technological change. When a new technology arrives on the scene, particularly one that has the potential to change that market significantly, there’s usually a big opportunity for a competitor to severely erode the moat of another company. Similarly, when a company with a moat begins to make bad decisions, they cause their own moat to erode – think of the earlier McDonalds example.

Chapter Nine – Finding Moats
There is no true sure-fire way to find a moat. You have to investigate the business, see how they operate, and then see if they have anything that might be construed as a true moat. Some industries have many companies with moats; others have basically none. Your only true recipe for success is learning how a company really operates, and that takes some research.

Chapter Ten – The Big Boss
Many investment strategies put a lot of importance on the leadership of a company. However, Dorsey makes it quite clear that moats and leadership have little to do with each other. A great leader is not a moat, and a truly great leader cannot usually create a moat, either. On the other hand, even a merely average CEO will not erode an existing moat. Thus, if you’re looking at competitive advantage as a reason to invest, don’t spend much time worrying about the CEO – worry about the business itself.

Chapter Eleven – Where the Rubber Meets the Road
There is one strong way of finding companies that might potentially have a moat, although it’s not a sure indicator: long-term return on capital. Dig into online research tools like Yahoo! Finance and take a look at a company’s return on capital, especially compared to competitors. Is it substantially higher than the competitors? If so, that company may in fact have a moat, and it’s worth your time to start digging into information about the company to see if you can identify their moat.

Chapter Twelve – What’s a Moat Worth?
This chapter is basically an argument for value investing. In other words, a company with a great moat can still be overvalued. Rather than offering an exact recipe for the value of a moat, Dorsey instead suggests looking for companies that are reasonable values to begin with (using factors like a low P/E ratio) and then identifying from among those which ones have moats.

Chapter Thirteen – Tools for Valuation
Dorsey recommends looking at the price-to-sales ratio as well as the price-to-book ratio. The P/S is particularly useful for companies that are temporarily unprofitable, while P/B is great for companies that offer services, particularly financial service firms. P/E (price-to-earnings) is a good general indicator, but make sure that you study this one over the long term in order to minimize the fluctuations in the economy.

Chapter Fourteen – When to Sell
Homework, homework, homework. Moat-based investing isn’t for people who don’t want to put in the time to do some homework. Basically, if you buy a company’s stock, you should have a specific reason for doing so. When that reason changes or goes away, that’s the time to sell. Better yet, that specific reason should have nothing whatsoever to do with what other people are doing in terms of buying and selling – if your reason for investing still exists, you shouldn’t sell it just because the herd is panicking because of a down market.

Buy or Don’t Buy

Much like the other entries in the Little Books series, The Little Book That Builds Wealth is a strong introduction to a particular investment strategy. After reading it, I feel I have a pretty strong grip on how to invest in companies based on competitive advantage and I know some of the basic techniques for identifying companies that might have a good competitive advantage.

Dorsey’s style is perhaps not as animated as others, but he still gets the point across. His writing actually reminds me of an old economics professor in a rumpled sweater, teaching in a world-weary style that doesn’t necessarily make you leap out of your chair and take action now, but holds your attention and makes you think.

If you’ve ever wanted a good introduction into the model of investing that Warren Buffett uses, this is a very good place to start. Dorsey lays it out in a very approachable way and offers up enough concrete examples that anyone can actually see the principles at work. That, my friends, makes for a worthwhile read.

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8 thoughts on “Review: The Little Book That Builds Wealth

  1. Saving Freak says:

    Before I read the last paragraph of this post I was thinking this sounds a lot like Warren Buffet. This synopsis is a great example of how to pick companies that will experience long term growth. Just find the ones with an advantage and ride them to the bank.

  2. Trent,
    This book appears to be geared toward the conservative investor and it is likely that a lot of these companies will pay a dividend.
    We may be able to take this a step further by looking at the dividend growth rate of these companies with a moat to identify those that pay increasing dividends year after year.
    An increasing dividend is like getting a raise for simply holding the stock.
    Just a thought.
    Thanks again for the review!!
    -Tyler

  3. Thanks for the review trent, I want to check this out now. Increased dividends are not a sure indicator like every thing else, but worth an investigation.

  4. For a detailed step-by-step strategy, read Phil Town’s “Rule # 1 Investing” … I mention it in a number of places on my blog because it is such an easy/good way to implement Buffet-like strategies …

  5. Frugal Dad says:

    Great review, Trent – as always! I’ll add this one to my 2008 book series. Sounds like a good read, and if there ever was a model to follow it would be Buffett’s! I imagine the “When to Sell” section was particularly relevant given the recent market downturn, and the “herd” of sellers.

  6. George says:

    Nice review, Trent. I need to get a hold of a copy of this book. Economic moats are the central component of my Fat Pitch investing style. I’ve read a lot of Pat Dorsey’s articles in the past, but somehow I missed the fact that he was writing this book until I read your review. I decided to bookmark you article at Value Investing News so other investors get a chance to find your post.

  7. bodhi says:

    price to sales and price to book?? you have to be FREAKING kidding me. the best advice here is to find out what metrics the sector trades on (get some Wall Street research – you can purchase loads at Reuters; or find a site that records portfolio managers’ televised views and conversations by stock name – eg. Stockchase.com here in Canada) and use those. Price to book wouldn’t get you too far with REITs, for example, which trade off P/AFFO and NAV discounts. If you INSIST on general metrics, the two USEFUL ones are P/E and EV/EBITDA.

  8. bodhi says:

    further to the above, take some real life examples to show how flawed those metrics are:

    1. price to sales – I set up a lemonade stand and sell my lemonade below cost, perhaps because I’m math-challenged. Of course I have higher total sales than the guy down the street. Is my lemonade stand worth twice as much if my sales are twice as high? No. I’m in the red and he’s in the black.

    And if the sector you’re looking at is too early cycle for ANYONE to have earnings or cash flow, avoid it, use DCF, quant/momentum trade it, or realize it’s a complete spec. and for fun. N.B. price/sales relative to sales growth was a realllly popular one to use on tech stocks, ’round about 2 months before Mar 13/2000 implosion.

    2. price to book – uses out of date info (just for a start – there’s lots more wrong with it). Your flat screen LCD TV from 4 years ago has a book value of $3000. Your neighbour’s, that he bought yesterday, book value $800. Identical TVs. Is yours worth 4x your neighbour’s? um no, not at a garage sale. It’s that big garage sale called the stock market that counts, not the book value.

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