February 4th, 2013
Despite the silly name, Pat Dorsey’s second investment book is laser focused on helping investors learn how to identify companies with durable competitive advantages. In his first book, The Five Rules for Successful Investing, he highlights the investment process that he uses at Morningstar.
- Do your homework.
- Find economic moats.
- Have a margin of safety.
- Hold for the long haul.
- Know when to sell.
In The Little Book That Builds Wealth, he spends the majority of his time outlining the characteristics of a company with a sustainable competitive advantage. As the head of equity research for Morningstar, Pat Dorsey has had the opportunity to analyze thousands of companies and the sustainability of their competitive advantages. I’ve read a number of value investing books, but most provide only a cursory overview of what exactly constitutes an economic moat, in the words of Warren Buffett. After reading the book, the importance of only investing in companies with a durable competitive advantage truly dawned on me. All equity valuation is based on cash flow valuation analysis that assumes a stream of cash flows into perpetuity. However, we all know that due to the creative destruction process inherent in capitalism very few companies survive or even thrive over the long-term. If you can identify a company with a sustainable competitive advantage it improves your odds of receiving the cash flows that you are implicitly assuming will be generated through the use of a discounted cash flow valuation analysis. By focusing solely on the characteristics and traits of a company with a durable competitive advantage, Pat Dorsey has made an important contribution to the value investing cannon.
In the first half of the book, Dorsey goes into detail about the four main types of economics moats that he and his team have identified. Moats can be classified into the following four categories:
- Intangible assets – include patents, brands or regulatory licenses that prevent competitors from copying or matching a company’s product or service offering.
- High switching costs – products or services that can’t easily be replaced by a competing product. For example, there are competing products to the Microsoft Office suite. However, the lost productivity and time taken to learn a new software package creates a barrier to switching.
- Network economics – eBay is the perfect example of a company with network economics. The more people that use eBay the greater its value to both potential buyers and seller. As more people begin using eBay it becomes difficult for a competitor to break into the market.
- Cost Advantages – the economic moats listed above all confer the ability to charge higher prices than a competitor. However, companies can also create a sustainable competitive advantage through a lower cost base. Cost advantages can be derived from cheaper processes, better locations, unique assets and greater scale. In my view, cost advantages can be easily competed away over time, especially those that are process focused because they can be copied by competitors. Extra analysis should be taken when assuming a company has a durable cost advantage.
After reading the book, I’ve attempted to screen all my investments through the lens of a sustainable competitive advantage. I’ve been surprised by finding it difficult to identify a moat for a company that I thought originally had a great defensive business. As an exercise, you should go through your current portfolio and try to classify each holding into one of the four categories of competitive advantages listed above. I can guarantee you will be surprised by the results.
Another important aspect of the book, was Dorsey’s identification of companies with eroding moats. It’s important to constantly be assessing the ability of a company to maintain a competitive advantage. One of the examples he uses in his book really brought home the point. Specialist firms on the NYSE exchange employ the individual specialist that manage all trading on the floor of the exchange for a particular stock. For decades being a specialist firm meant having the ability to print money. However, the fragmentation of trading venues and increasing use of algorithmic trading has pushed institutional trading off of the major exchanges. As a result, specialist firms find themselves handling lower and lower volumes, negatively impacting their commissions. As I learned at HBS from Michael Porter, the competitive threats to an industry are in many cases more important than the threats to an individual company.
Warren Buffett has famously stated that “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.” Buffett’s view on management is clearly anathema to most investors. We’ve become accustomed to the myth of the superstar CEO who can turn around any business and is the official determinant of success or failure for any business. The reality is that an excellent management team can’t compensate for poor industry dynamics. Pat Dorsey is one of the first authors that I’ve seen in print support this view on management and investing. He states in the book, “throw a dart at a random asset manager, bank, or data processor, and I’ll almost guarantee that you’ll see higher long-run returns on capital than a randomly selected auto-parts company, retailer or technology hardware company.” Frankly, it’s refreshing to see an author discuss the inability of management teams to turn around businesses with poor competitive dynamics. Obviously it’s possible, but in most cases it’s an exception to the rule.
The major weakness in the book is that Dorsey dedicates only one chapter of the book to finding companies with moats. He actually goes into much more detail in his first book, “The 5 Rules for Successful Stock Investing”. I’m sure he was partly constrained on the length of the book since its part of the Little Book series. Personally, one technique that I’ve used to identify companies with a competitive advantage on an a priori basis is to look for companies with high returns on capital as measured by ROIC. This is essentially the same criteria that Joel Greenblatt uses in his Magic Formula. Typically, companies that are able to generate high returns on capital, should have some form of durable competitive advantage to allow them to earn returns higher than their cost of capital.
Overall, I highly recommend the book. Michael Porter is clearly a thought leader in the space of competitive analysis for both individual corporations and industries as a whole. However, he writes from the perspective of a potential manager trying to improve the competitive positioning of his or her firm. Pat Dorsey takes a unique approach on competitive dynamics by approaching it from the lens of an investor. The book is a short read and should be part of any investors library.