Book Review #32: The little book that builds wealth: Author: Pat Dorsey

Note: I have updated this book review with contents of presentation made by Mr.Dorsey at Texas Lutheran University (TLU). You can watch the presentation here. All the updates are marked in italics

The book is written by Pat Dorsey who is a director of equity research at Morningstar Inc. He played an integral part in the development of the Morningstar Rating for stocks as well as Morningstar's economic moat ratings. 

In addition to this book, Mr.Dorsey is also the author of the book 'Five Rules for Successful Stock Investing'.

You can watch his Google Talk on the book here.

The book, 'The Little Book that Builds Wealth', aims to provide a conceptual anchor to help you evaluate stocks and build a rational portfolio. It is spread over 14 Chapters.

The approach followed by Morningstar is as follows. Each analyst builds a detailed discounted cash flow model to arrive at a company's fair value. The analyst then assigns a moat rating -Wide, narrow or none. The objective is to identify companies with wide moats available at discount to fair value.

Making investment decision based on company's economic moats is a smart long-term approach.

The book details the economic power of moats by studying how specific companies with wide moats have generated above-average profits over many years.

The book aims to provide a solid foundation for making smart investment decisions.

The investment strategy should be to buy wonderful companies at reasonable prices and let those companies compound cash over long periods of time. The steps to implement this strategy are:

1. Identify businesses that can generate above average profits for many years.

2. Wait until the shares of those businesses trade for less than their intrinsic value and then buy

3. Hold those shares until either the business deteriorates, the shares become overvalues, or you find a better investment. This holding period should be measured in years, not months.

4. Repeat as necessary

As per the author, 'Return on Invested Capital is the best benchmark for a company's portfolio. It measures how effectively a company uses all of its assets - Factories, people, investments - to make money for shareholders.

The book is broadly divided into two parts. The first part covers understanding of  'Economic Moats'. These are traits that endow companies with truly sustainable competitive advantage. There are four parameters to valuing a company. These are, risk, earnings growth,  return on invested capital and durable competitive advantage. 

The last factor is also known as economic moat. Economic Moats are structural and sustainable qualities that are inherent to the business.Moats generally manifest themselves in pricing power. A company that can't raise prices is unlikely to have a strong moat. The wider it is, the better is the company as an investment destination. Four factors can generate economic moat. These are availability of intangible assets like patents and brands, high switching costs for the customer, network effect and cost advantages. Cost advantages could be due to better processes, location near to the customer group, access to unique assets or economies of scale generated due to wider distribution network, cheaper manufacturing and access to niche markets. 

Once a foundation for moats is established in the first part of the book, the second part discusses the erosion of moats, role of Industry Structure in creating moats and how management can create or destroy moats. There is discussion on valuation as well so that the investor can decide if they are paying a fair price for the moat. The final chapter of the book covers four reasons why an investor should sell her stock. 

This is a good book that provides an overview of the value investing. This book is targeted towards beginners and gives a fair grounding on the concepts of value investing and sates the reader's curiosity to explore the wide and beautiful world of value investing.

Read on for the chapter summary...

Chapter 1: Economic moats

This chapter covers the importance of moats. Moats is defined as 'Durable Competitive Advantage that can provide strong and increasing free cash flows for the company over extended periods of time'. Hence these companies are more valuable than the companies without moats. Since moats provide durable competitive advantages, when you buy shares of companies with moats, you are buying a stream of cash flows that are protected from competition for a long period of time. Thinking about moats can protect your investment capital in a number of ways. One, it enforces investment discipline, making it less likely that you will overpay for a hot company with shaky competitive advantage. While the hot companies may have fat margins and profits in a short term, it is the duration of the profits and margins that matter. Moats provide us a framework of separating the fly by night companies from those with durable advantage.

Another reason why moats are important is that they significantly reduce the risk of permanent capital loss. Companies with moats are likely to increase their intrinsic value over time, so if you wind up buying their shares at a value that is somewhat high, the growth in intrinsic value will protect your investment returns.

Companies with moats also have greater resilience and can recover quickly from temporary troubles (remember Bata and Nestle?). This resilience of companies with moats is a huge psychological backstop for an investor who is looking to buy wonderful companies are reasonable prices, because high quality firms become good values only when something goes awry. If you analyze these companies thoroughly, you will know if the troubles of the company are temporary or permanent and take the necessary investment action.

Finally, moats can help you define your 'circle of competence', a set of industries where you  develop expertise.

The idea of this book is to help you identify companies with moats and those without...

Bottom line to Chapter 1:

1. Buying a share means that you own a tiny piece of business.

2. The value of the business is equal to all the cash it will generate in the future

3. A business that can profitably generate cash for a long time is worth more today that a business that may be profitable only for a short time

4. Return on capital is the best way to judge a company's profitability

5. Economic moats can protect companies from competition helping them earn more money for a long time, and therefor making them more valuable to investors

Chapter 2: Mistaken moats:

The four common 'mistaken moats' are:

1. Great Product: This can be copied or competition can design a similar product at much less cost.

2. High market share: This can be quickly eroded. The investor should focus on how the market share was achieved. If the market share is achieved due to a moat, then it is good. Market share is mostly an outcome of the moat rather than a moat in itself.

3. Great Execution: This can be replicated, especially if there is an outside force pushing standardization

4. Great Management: Moats are structural in nature and the cash flow continues over a relatively long term. This has mostly nothing to do with the management.

So what generates moats for a business. There are four characteristics that are mostly create moats.

1. Intangible assets like brand, patents or regulatory licenses.

2. High Switching costs

3. Network economics

4. Cost advantage stemming from process, location, scale or access to unique asset which allows them to offer goods or services at a lower cost than competition.

Bottom line to chapter 2

1. Moats are structural characteristics inherent to a business. Some business are simply better than others.

2. Great products, market share, great execution and great management do not create moat.

3. The four sources of structural competitive advantage (moat) are intangible assets, customer switching costs, network economics and cost advantages. Any company with solid return on capital and any one of these characteristic is worth a decko.

Chapter 3: Moat 1: Intangible assets

There are three intangible assets that can create a moat under certain circumstances. First is the brand. Brand can generate customer loyalty. A brand can become a moat if they can raise prices without fall in market share. (Green Trends is an example. Once they go there, ladies continue to go to that place only. Maggi noodles could be another example). Brand is an economic moat if it results in either 'willingness to pay more' or in 'lowering of search costs'.

While talking about the power of brands, Mr.Dorsey explains why Amazon brand is very powerful. Mr.Bezos understood very early that 'online retail' is different from 'offline retail'. Trust plays a big part in online retail. You trust Amazon with your personal details, including credit card details, you buy the product without seeing it trusting that the quality will be good, you trust that the product will be delivered to you on the promised date, you trust that company will seamlessly take back a product once it is returned etc. Bezos understood the value of trust in online retail. That is the power of brand Amazon.

Brands are valuable if they can deliver a consistent or aspirational experience.

Patents can create an economic moat if the the firm has a demonstrated track record of innovation shown by large number of patents it has. The problem with patents is that they are heavily challenged in courts.

Regulatory licenses are most effective as a moat when the company needs approval to enter the industry, but is not subject to price control. Utilities and Pharma are a comparison. While both need regulatory approval to set up business, the government controls price that can be charged by utilities.

A typical example of regulatory licenses acting as a moat is the NIMBY (Not in my back yard) companies like waste management which need licenses but discourages new entrants from coming in due to structural barriers to entry.

Bottom Line to Chapter 3

1. Popular brands are not always profitable brands. Brands should deliver consistent or aspirational experience.

2. Legal challenges are a great risk to patent moat

3. The best kind or regulatory moat is one created by a number of small-scale rules, rather than one big rule that could be changed.

Chapter 4: Moat 2: Switching costs

Switching costs are a valuable competitive advantage because a company can extract more money out of its customers if those customers are unlikely to move to a competitor. Customer may not want to switch from company's product to a competitor's product due to three reasons. One, the product is at the core of the customer's business, ERP is one example. Or Oracle Database is another. Two, switching over to another product could cause a lot if integration issues since this product could be a part of an integrated ecosystem. The third reason is that you provide a product with a high benefits to cost ratio. Henkel adhesives or enzymes used in probiotic yogurt are examples. Their impact on final product cost is negligible, but the benefit they provide is very high. Hence even a 20%  rise in the cost of these products will not significantly impact the final product cost. 

Switching costs as a moat is widespread. This type of moat can be powerful and long lasting but very difficult to identify.

Chapter 5: Moat 3: Network effect

A company benefits from Network effect when the value of a company's product or service increases as the number of users increase. The more the number of users the more the benefit and ease of transactions for the new users in the network. The network effect can be broad - there are many users transacting in the company's product or service or it can be deep - there are many different products or services of the company that the users are transacting with.

Some examples are Credit card companies (like Amex) where the larger the number of the attached merchants, the more users can use the credit cards of the company, Auction Sites (like eBay) where more the number of existing users, more products and features can be rolled out for new users, Option Exchanges (like CBOE)  where the buying and selling of the options is restricted to the same exchange (unlike stock exchanges), some money exchange sites (like Western Union), third party logistics service providers who connect buyers and sellers of shipping and logistics services etc.

The author seem to have changed his opinion on Western Union after writing this book. In this presentation, he talks about Western Union. Eventhough company has the largest number of branches in the world. However, most of the transactions are between a few select cities. For example, not many people are sending money between Dhaka and Mexico City. So competitors can easily get into these niche corridors and impact the profitability of Western Union. Money transfer is a 'Corridor Effect' and not a 'Network Effect'. 

Since the size of the existing network determine the market power of these companies, it creates a barrier to entry for competitors who has to replicate the network. Hence the companies in the industry tend to form natural oligopolies.

Some of the characteristics of network effect are:

1. Network effect can quickly dissipate due to external activities. For example, if the investor is allowed to buy options in one exchange and sell it in another, the competitive advantage of the option exchanges will quickly dissipate.

2. Network effects are seen in businesses that deal in information or knowledge transfer. The reason is that these companies sell 'Non rival' goods, which can be used by many users in parallel.

3. For a company to benefit from network effect, it has to operate in a closed network. As the network opens up, the effect will wane quickly.

4. The benefit of having a large network is non-linear. It means that the value of a network increases at a faster rate than the absolute size of the network. (Multiplier Effect)

Chapter 6: Moat 4: Cost advantages

Cost advantages matter most in those industries where price is a large portion of customer's purchase criteria. Mostly these are in the commodity sector. Cost advantage is valuable when your ASP, Average Selling Price, keeps falling from year to year. Cost advantages stem from four different sources.

1. Cheaper processes
2. Better locations

3. Unique assets

4. Economies of scale

This chapter covers the first three sources above.

Cost advantages arising out of better and cheaper processes can be transient. However, during the time the company owns the process, it can make windfall profits. While processes can be replicated, sometimes structural issues with the competition can provide a long window of opportunity. Process based cost advantages can create a temporary moat if incumbents are unlikely to replicate them immediately. Process based moats are worth watching closely, because the cost advantage often slips away as competitors either copy the low-cost process or invent one of their own.

Chapter 7: Size advantage: Economies of scale

When it comes to economies of scale, the absolute size of a company matters much less than the size relative to the rivals. To understand economies of scale, we have to understand the difference between Fixed Costs and Variable Costs. Fixed costs are the upfront costs that you have to incur even before you make a single unit of sale. Fixed costs normally cover the cost of machinery, vehicles, salaries, rent etc. Variable costs are the costs that increase with the number of units sold. The main example of variable costs could be the raw material costs - the more you sell, the more you have to buy raw material to produce the products that you sell.

The more the level of fixed costs relative to variable costs, the more the scale advantages the company has. There are three categories of scale based advantages:

1. Distribution

2. Manufacturing

3. Niche Markets

Large distribution networks can be a source of tremendous competitive advantages. The portion of fixed costs are very high for these network and any incremental revenue leads directly to the profits of the company. Large distribution networks are extremely hard to replicate and are often sources of very wide economic moats

Same is the case with manufacturing. Once a fixed cost of setting up a factory is incurred, the incremental revenue can directly go into the profits of the company since the ratio of Fixed Costs to Variable costs is high in this case. Niche refers to markets where the size is not big enough for multiple companies. One or two companies that target this Niche can make tons of money. Even a small company that is strong in a niche market can have a wide moat that is difficult to replicate. Private infrastructure is a good example. In India, GMR owns and operates multiple airports including Bangalore, Hyderabad and New Delhi.

Chapter 8: Eroding Moats

Moats can be quickly eroded due to changes in the business environment. If you can get an early read on a weakening competitive advantage, you can improve the odds of preserving your gains. There are two sides to this threat. For a company that sells technology, threat of a better technology is a given. However, technological disruption is a severe threat when it affects non-tech companies because these companies can look like they have very strong competitive advantages before a technological shift permanently eroded their moat. Examples abound. Eastman Kodak before digital photography was a cash making machine selling photo films. BSE, with its manual transactions was the King before NSE came into prominence with electronic trading. Telephone companies ruled the roost before the age of VOIP and Skype.

Another type of change that can erode a moat is the change in the structure of industries. For example, the advent of big ticket retail chains has eroded the pricing power of their suppliers.

The changes need not be local. The entry of low-cost Chinese labour has eroded the competitive advantages of many US manufacturers.

Yet another change could be the entry of an irrational competitor. For example, when British Government started deciding on the pricing policies for Rolls Royce after the take over, the changes impacted the few competitors in the aircraft engines business.

Companies using excess cash to move into unrelated businesses can severely erode the moat.

Another change that could erode the moat will be the transfer of bargaining power from the seller to the buyer, as Oracle experienced for its support services.

Chapter 9: Finding moats

It is easier to find moats in some industries than others. It is easier to find a moat in an asset management company than an auto components manufacturer. In technology, a software product developer could have a wider moat than a hardware manufacturer. Former gets integrated into the customer business and lead to switching costs, while the later is standardized and easily replaceable with a competitor product.

For Telecom companies, a favourable regulatory environment (like in UAE) creates a moat. While media is more susceptible to competition and moat erosion, control of vast amounts of content can act as a moat for  some media companies.

While Pharma companies are subject to regulatory environment, a wider product portfolio gives them a moat. Also small Pharma companies in specialized niche areas can enjoy moats for a long time.

Companies that provide services to the business can enjoy a wide moat largely because these firm integrate themselves so tightly into their client's business processes that they create very high switching costs giving them pricing power and excellent ROIC.

Companies in consumer sector usually enjoy a wide moat mostly because of the brand loyalty. In this sector, on should look out for small companies in niche areas.

While oil and gas sector is a commodity and hence do not have a moat, some industries that cater to Oil and Gas sector can have a wide moat. One example is the pipes manufacturers.

To measure a company's profitability, we look at how much profit the company is generating relative to the amount of money invested in the business.

There are three ways to measure the return on capital

One is the Return on Assets (ROA). This measures how much income a company generates per dollar of assets. A non-financial company that can consistently generate an ROA of 7 percent or above is likely has some kind of moat.

Return on Equity (ROE) measures the profits per dollar of shareholder's capital. One flaw of this measure is that firms can substantially increase the ROE by taking a lot of debt relative to equity. As a rule of thumb, you should look for ROE of 15 percent and above.

Return on Invested Capital (ROIC) measures the return on the capital invested in the firm including both equity and debt. This helps remove any effect of the firm's financing decision (debt vs equity).

Chapter 10: The big boss: Does management matter?

Managements do not matter much. This goes against popular wisdom. Some industries are more conducive to digging a moat than others. Company's structural characteristics have much more effect on the company's long-term performance than the quality of management. Why then management receives so much of attention? Two reasons. One, the media needs heroes. Two, it is human nature to look for a causal agent to assign success or pin blame. Of course there are companies where the management quality created a moat. Starbucks and Dell being examples. But these are exceptions and not the rule.

Moats can buffer management mistakes. So how to differentiate good managers from bad?

Good managers are constantly looking to widen the moat. Bad managers invest cash outside company's moat, thus lowering ROIC. This is called 'Deworsification'

In summary, while great managers can add value to the business, management by itself is not a sustainable competitive advantage (aka moat).

Chapter 11: Where rubber meets the road: Examples of competitive analysis

This chapter talks about a three step process to determine if the companies have moats.

Step 1 focus on the historical performance of the company. Has the firm historically generated solid returns of capital? If the answer to the above question is no, then the next question to ask if the firm's future is likely to be different than the past. It the answer is no to this question also, then we can conclude that this company do not have an economic moat.

If the answer to the first question in step 1 is 'Yes', we move to step 2. In this we check if the firm has any one of the competitive advantages that we discussed earlier vis. High switching costs, Network economics, Low-cost production, economies of scale or Intangible assets (like brands or patents). If the answer to this question is No, we can conclude that this company do not possess an economic moat.

If the answer to the question in step 2 is 'Yes', we move to step 3. Here we assess the durability of the moat. The question is 'How strong is the company's competitive advantage? Is it likely to last a long time or a relatively short time? Based on the duration of prevalence of the competitive advantage, we classify them as 'Narrow Moat', or 'Wide Moat'

Chapter 12: What's a moat worth?

All the chapters till now focused on the step 1 of the Investment Strategy discussed in the Introduction. That is 'Identify businesses that can generate above average profits for many years.' This chapter and the next focus on the step 2 of the strategy 'Wait until the shares of those businesses trade for less than their intrinsic value and then buy'. The focus of this chapter is on calculating the Intrinsic Value of the company. Valuation of a company is difficult due to two reasons. One, every company is slightly different, which makes comparison between peers a tough exercise. Parameters like growth rates, ROIC, strength of the moat..all differ from company to company even in the same industry. Two, value of a company is directly tied to its future financial performance which is unknown.

You need not know the precise value of a company before buying its shares. All you need to know is that the current price is lower than the most likely value of the business. One of the ways is to compare the growth rate implied in the price to your estimate of the potential future growth.

What is value? As per the discounted cash flow method, the intrinsic value of a company is the present value of all the free cash it will generate in the future. Free cash is the cash flow net of operating and capital expenditures. While estimating the future cash flows, four things are important. The risk of the cash flows materializing, the growth rate of the cash flows, ROIC and the duration of the excess cash flows (economic moat).

There are three types of tools for valuing companies, price multiples, yields and intrinsic value. This chapter focus on the valuation of the company. Over long stretches of time, there are two things that pushes the stock price up or down: the investment return, driven by earnings growth and dividends and speculative return, driven by changes in the PE multiple. The investment return reflects the financial performance of the company while the speculative return reflects that exuberance or pessimism of the market.

When we focus on companies with economic moat, we are maximizing our investment return, which we can estimate and is under our control,  and minimizing our negative speculative return which we cannot control.

Overestimating a moat means paying for value creation that will never materialize. Underestimating moat means paying a high opportunity cost.

Why do most of the investors not benefit from moat? A moat takes years to materialize. However, most of the investors do not have that amount of timeframe

One way of finding moat is look for qualitative data which you can only get by talking to the stakeholders and visiting markets.

Chapter 13: Tools for valuation: How to find stocks on sale?

The focus of this chapter is on price multiples. These are the most commonly used, and misused, valuation tools.

The first multiple is the Price to Sales (PS) which is current price divided by the sales per share. This is mostly useful for cyclical companies or companies that are having some kind of trouble. Low margin businesses have low PS ratios compared to high-margin business like pharma. This ratio is most useful for companies that have temporarily depressed margins, or that have room for improvement in margins.

One useful way to use price to sales ratio is to find high-margin companies that have hit a speed bump. These companies might be facing temporary problems, but beaten down by investors. If the company can return to former level of profitability, then the stock is probably quite cheap. This is one instance where PS ratio is better than PE ratio. PE on an under-earning company might be high since earnings are low. Lesson: Look for companies where PS is lower than PE

The second multiple is the Price to Book (PB). Book value can be thought of as representing all the physical capital invested in the company - factories, computers, real estate, inventory etc. The rationale for using book value in certain cases is that the future earnings and cash flows are ephemeral, while the stuff that a company physically owns has a more tangible and certain value.

When using book PB ratio, you have to be clear as to what 'B' represents or do not represent. For an asset intensive firm, the Book value represents all the assets of the company. However, the value of intangible assets like patents, brands or human assets are not reflected in the book value.

Also, book value can be inflated through good will which is the value the company paid for acquiring another company over and above the value of its physical assets. Since low PB ratio is better than high PB ratio, the use of goodwill can inflate the book value and lower the PB ratio.

Where is it best to use PB? It is useful for companies in the financial services. Since most of the assets are 'marked to market', the book value of the company is a good reflection of its tangible value. Only caveat here is that an abnormally low PB ratio can indicate that the book value is not realistic and may contain a lot of NPAs

The third multiple is the Price to Earnings (PE) multiple. PE ratio is useful because earnings are a decent proxy for value creating cash flow, and because earnings results and estimates are readily available. These are tricky because earnings are a noisy number and because a PE ratio has to be seen in comparison.

Another challenge with this ratio is that while there may be only one P, there could be different versions of E including Trailing Twelve Months (TTM), calendar year, fiscal year and estimated future PEs. Forecasting earnings are risky because it is observed that they normally pessimistic before a beaten down company rebounds and is optimistic just before a high-flier slows down.

What this means that you have to come out with your own views of earnings to be used in the PE ratio. Once this is done you can use PE to compare it with a competitor, industry average or the same company at different points in time.

The fourth multiple is the Price to Operating Cash Flow (PC) multiple. Cash flow can present a more accurate picture of the company's profit potential because it simply shows how much cash is flowing in and out of a business, whereas earnings are subject to a lot of adjustments. This ratio is also a bit steadier than earnings. For example, it is not affected by non-cash charges that come from a corporate restructuring or an asset write-down. Cash flow also takes capital efficiency since company's need less working capital will show more cash flow than earnings. Since cash flow do not take depreciation into account, asset intensive companies will have higher cash flow than earnings. This could overstate their profitability. 

These are the four multiple based valuation metric. The next set of metrices are yield based metric.
Advantage is that yield can be compared with bond yields. 

There are two yield based matrices. One is the earnings yield and the other is the cash return. 

Earnings yield is the inverse of PE ratio. If the PE is 20, then earnings yield is 5%.

Cash Return is an improvement over earnings yield. It tells us how much cash flow a company is generating relative to the cost of buying the whole company, including the debt burden. This measure improves on the earnings yield since it looks at Free Cash Flow and incorporate debt into company's capital structure. Cash return is calculated by the formula:

(Free Cash Flow + Interest Expense) / (Market Capitalization + Long - term debt - Cash)

Now that we have covered four multiples and two yields, the question is to know how to use these measures. The following five tips are useful.

1. Always remember four drivers of valuation: risk, return on capital, competitive advantage and growth. All else being equal, you should pay less for higher risk and more for companies with the remaining three. 

2. Use multiple tools. If multiple tools align, it is a sign of a truly undervalued company

3. Be patient: Not making money is more important than losing money.

4. Be tough: Buy when everyone else is selling

5. Be yourself: Put effort in understanding moat and valuation before you invest. 

Remember, the best business in the world will be a bad investment if purchased at an unattractive price.

Chapter 14: When to sell

There are four reasons to sell a stock. They are:

1. You made a mistake

2. The company has changed for the worse

3. There is a better place for your money

4. The stock has become a large portion of the portfolio

You sell a stock if you have made a mistake in your original investment thesis. You missed some critical information while analyzing the company. At the time of purchasing the stock, write down the reasons why you purchased the stock. Review the assumptions regularly. Every time the facts go against the assumptions, sell the stock.

Another reason to sell the stock is when the company's fundamentals deteriorate completely

Third reason to sell is that you have come across a better investment opportunity. Remember that sometimes it is worthwhile staying in cash. For example if the stock has gone significantly out of value, it is better to sell it and stay in cash. 

The last  reason for selling a stock is that it has become a very large portion of your portfolio. So you sell the overweight ones to re-balance your portfolio.

Note that none of the above four reasons is based on stock price. They are all dependent on what happens or likely to happen to the values of the companies. Also, do not look at the past performance of the company before investing in it. Money is made in future, not in past.

Global Investing: Local differences in different countries can create moat. For example, a car washing company can generate moat. Also, accounting standards differ across companies. This can cause significant value. For example, in Europe, companies can write off inventory over three years. This is a significant opportunity since the inventory do not lose real value. 

Finally a quote to end the post: As per Bill Miller, "All of the information is in the past, all of the value is in the future".