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El pequeño libro que genera riqueza
Para ganar dinero en un contexto como el actual, en el que los mercados son tan dinámicos, hay que invertir en empresas que puedan soportar bien la presión constante de la competencia. Pero ¿cómo identificar aquellas empresas que no solo están bien hoy, sino que lo estarán también dentro de unos años? La clave está en las ventajas competitivas y los fosos económicos. Si puedes identificar las compañías que tienen foso y puedes comprar sus acciones a precios razonables, construirás una cartera de negocios que aumentará tus posibilidades de triunfar en el mercado bursátil. En El pequeño libro que construye riqueza, Pat Dorsey explica cómo identificar estas empresas sólidas, analiza por qué los fosos económicos son tan buenos indicadores de salud empresarial y analiza los cuatro pilares fundamentales de la ventaja competitiva: activos intangibles, ventaja en los costes, flexibilidad para adaptarse a las nuevas necesidades del mercado y economías de escala. Aunque el concepto de foso económico no es nuevo, con este libro como guía, el lector aprenderá a utilizarlos como herramientas básicas a la hora de elegir qué compañías son beneficiosas para su cartera de acciones.
240 pages, Hardcover
First published January 1, 2008
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December 24, 2014
This book surprised me. While aimed at a lay audience, it covers moats in surprising detail. First it explains what moats are not (and what things are commonly mistaken for moats). Then it categorizes moats into several types and sub-types. It also discusses how moats erode and how to find moats.
In each section, I found a number of insights and useful comments, most of which are copied below (apologies for poor formatting / editing):
MISTAKEN MOATS
In my experience, the most common “mistaken moats” are great products, strong market share, great execution, and great management. These four traps can lure you into thinking that a company has a moat when the odds are good that it actually doesn’t.
TYPES OF MOATS
Intangible assets
As economic moats, they all function in essentially the same way—by establishing a unique position in the marketplace. Any company with one of these advantages has a mini-monopoly, allowing it to extract a lot of value from its customers.
Brands
One of the most common mistakes investors make concerning brands is assuming that a well-known brand endows its owner with a competitive advantage.
A brand creates an economic moat only if it increases the consumer’s willingness to pay or increases customer captivity.
Brands cost money to build and sustain, and if that investment doesn’t generate a return via some pricing power or repeat business, then it’s not creating a competitive advantage.
Ask whether the company is able to charge a premium relative to similar competing products. If not, the brand may not be worth very much.
the ability to brand a true commodity product is relatively rare—most brands are attached to differentiated products
The big danger in a brand-based economic moat is that if the brand loses its luster, the company will no longer be able to charge a premium price.
Patents
patents have a finite life
Legal maneuvering can sometimes extend the life of a patented Product
Patents are also not irrevocable
be wary of any firm that relies on a small number of patented products for its profits, as any challenge to those patents will severely harm the company and will probably be very hard to predict.
The only time patents constitute a truly sustainable competitive advantage is when the firm has a demonstrated track record of innovation that you’re confident can continue, as well as a wide variety of patented products. (Think of 3M)
Regulatory licenses
regulatory licenses that make it tough—or impossible—for competitors to enter a market. Typically, this advantage is most potent when a company needs regulatory approval to operate in a market but is not subject to economic oversight with regard to how it prices its products.
a company that can price like a monopoly without being regulated like one (The bond-rating industry)
sometimes a collection of smaller, hard-to-get approvals can dig an equally wide moat
Switching costs
You find switching costs when the benefit of changing from Company A’s product to Company B’s product is smaller than the cost of doing so.
companies that benefit from switching costs can be hard to find because you need to put yourself in the customer’s shoes to really understand the balance between costs and benefits. And, like any competitive advantage, switching costs can strengthen or weaken with time.
one broad category of switching costs, which you might think of as companies that benefit from tight integration into their clients’ businesses.
it becomes part and parcel of their daily operations, and untangling it from their business to start afresh would be costly, and possibly risky as well.
This type of competitive advantage isn’t limited to just service and software companies. Precision Castparts that sells high-tech, superstrong metal components used in jet aircraft engines and power-plant turbines. Think for a minute about the low tolerance for failure in these kinds of products.
engineers actually work together with customers when they design new products.
Look at the cost/benefit balance. The only benefit of switching to a new supplier would likely be monetary, as long as the current supplier keeps up its quality standards. Customers would need to find a supplier of similar reliability if they wanted to save money by switching.
The explicit cost is meaningful—the new company would need to spend time getting to know the new products as intimately as it knows the existing ones—but the real cost in this case is risk. Given the incredibly low tolerance for failure, it doesn’t make sense to try to shave the production cost if it increases the risk of product failure. It would take only one high-profile failure to seriously damage the company’s reputation, which would definitely hurt future sales.
switching costs show up in all kinds of industries.
Switching costs can be effective when explicit cost of switching is low if most people perceive the benefits of switching as uncertain.
very hard many for consumer-oriented firms, such as retailers, restaurants, packaged-goods companies to create moats around their businesses. That’s because low switching costs are the main weakness of these kinds of companies. You can walk from one clothing store to another, or choose a different brand of toothpaste at the grocery store, with almost no effort whatsoever.
Some can do it through economies of scale and some can create moats by building strong brands—but in general, consumer-oriented firms often suffer from low switching costs.
Switching costs can be tough to identify because you often need to have a thorough understanding of a customer’s experience—which can be hard if you’re not the customer. But this type of economic moat can be very powerful and long-lasting
Switching costs come in many flavors—tight integration with a customer’s business, monetary costs, and retraining costs, to name just a few.
Network effects (a special type of switching cost)
the value of their product or service increases with the number of users Network based businesses tend to create natural monopolies and oligopolies.
“Of networks, there will be few.”- Brian Arthur
the very nature of the network effect means that there won’t be a very large number of businesses that benefit from it, given the propensity of networks to consolidate around the leader.
the network effect is much more common among businesses based on information or knowledge transfer than among businesses based on physical capital. This is the case because information is what economists call a “nonrival” good. Most goods can be used by only one person at a time (rival goods). Note this is not exclusively the case.
network-based businesses are usually pretty durable. A competing firm would need to replicate the network—or at least come close—before users would see more value in the new network and switch away from the existing one.
in a fast-growing market with consumer preferences that are still being formed around a new type of service the network effect can be subject to successful attack.
for a company to benefit from the network effect, it needs to operate a closed network, and when formerly closed networks open up, the network effect can dissipate in a hurry. It’s a good question to ask whenever you’re evaluating a company that might benefit from network economics: How might that network open up to other participants?
This is a common effect of network-based businesses:
The benefit of having a larger network is nonlinear, which means that the economic value of the network increases at a faster rate than its absolute size. There is probably an element of critical mass present here, too (to determine the point at which the network becomes valuable). There may also be an element of ‘escape velocity’, in that one or more emerging networks compete and may even both be at critical mass (that is, useful) but when one reaches a certain relative size it becomes dominant (think facebook, nexopia, myspace).
the value of a network to its users is more closely tied to the number of connections than it is to the number of nodes, but the value-to-connection relationship likely slows down as the number of connections becomes extremely large.
Cost Advantages
Cost advantages can sometimes be durable, but they can also disappear very quickly, so as an investor you need to be able to determine whether a company’s cost advantage is replicable by a competitor.
cost advantages matter most in industries where price is a large portion of the customer’s purchase criteria.
these industries are usually characterized as commodity industries, that’s not strictly true.
A useful way to pick out industries in which cost advantages are likely to be a big factor is to imagine whether there are easily available substitutes—products or services that serve the same function for the buyer, even if they are differentiated.
Cost advantages can stem from four sources: cheaper processes, better locations, unique assets, and greater scale.
Process advantages
in theory they shouldn’t exist for long enough to constitute much of a competitive advantage, because competitors should copy them. This generally does happen eventually, but it can take a lot longer than one might expect.
Copy processes can require significant or compete overhauls of business plans. Difficult to do period, and compounded by organizational inertia.
Another reason is that new processes may be advantageous, but a first-mover may actually gain an enduring advantage if they gain scale and prevent followers from being able to adopt their process (that is prevent competitors from copying the business model that uses the process by exploiting scale advantages).
process-based cost advantages can create a temporary moat if incumbents
are unlikely to replicate them immediately, and if new entrants either can’t copy the process or doing so is likely to destroy the industry’s economics.
A moat that is built on lazy or stumbling competitors is not a terribly strong one. So, 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.
Location Advantages
This type of cost advantage is more durable than one based on process because locations are much harder to duplicate.
This advantage occurs most frequently in commodity products that are heavy and cheap—the ratio of value to weight is low—and that are consumed close to where they’re produced. They create mini-monopolies in their immediate vicinity.
Unique assets or superior access to resources
A type of cost advantage that is generally limited to commodity producers is access to a unique, world-class asset.
Cost advantages can be extremely powerful sources of competitive advantage, but some are more likely to last a long time than others.
Process-based advantages usually bear close watching, because even if they do last for some period of time, it’s often because of some temporary limitation on competitors’ ability to copy that process. Once that limitation disappears, the moat can get a lot narrower very quickly.
Location-based cost advantages and low costs based on ownership of some unique asset are much, more durable and easier to hang one’s analytical hat on. Companies with location advantages often create mini-monopolies, and world-class natural resource deposits are by definition pretty hard to replicate.
Scale (a special type of cost advantage)
When you’re thinking about cost advantages that stem from scale, remember one thing: The absolute size of a company matters much less than its size relative to rivals.
Very broadly speaking, the higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be, because the benefits of size are greater.
We can break down scale-based cost advantages into three categories: distribution, manufacturing, and niche markets.
manufacturing scale tends to get most of the attention, but the cost advantages stemming from large distribution networks or dominance of a niche market are just as powerful—and, in an increasingly service-oriented economy, they are more common as well.
Distribution scale
Large distribution networks can be the source of tremendous competitive advantages, and you can easily see why when you think about the economics of moving stuff from point A to point B.
Although building and operating the delivery network is an expensive proposition for a base level of service, the incremental profit on each item that the truck fleet delivers is enormous.
once the fixed costs are covered, delivering an extra item that is on a delivery route is extremely profitable because the variable cost of making an extra stop is almost nothing.
imagine that you need to try to compete with a company that has an established distribution network. It has likely covered its fixed costs and is making large incremental profits as it delivers more stuff, while you’ll need to take on large losses for a time until (if) you gain enough scale to become profitable.
Many businesses with delivery networks can dig this type of economic moat.
Large distribution networks are extremely hard to replicate, and are often the source of very wide economic moats.
Manufacturing scale
The closer the factory is to 100 percent capacity, the more profitable it is, and the larger the factory, the easier it is to spread fixed costs over larger volume of production.
Also, the larger the factory, the easier it is to specialize by individual tasks or to mechanize production.
the prevalence of this type of cost advantage has diminished somewhat in the recent past as enormous low-cost pools of labor in China and Eastern Europe have become integrated into the global economy, causing some manufacturing to shift away from Europe and North America.
Manufacturing scale needn’t be limited to owning a larger production facility than the competition. As long as costs can be spread over a sales base, this advantage exists: e.g. over subscribers or gamers.
Niche market scale
Even if a company is not big in an absolute sense, being relatively larger than the competition in a specific market segment can confer huge advantages.
companies can build near-monopolies in markets that are only large enough to support one company profitably, because it makes no economic sense for a new entrant to spend the capital necessary to enter the market.
this type of competitive advantage is often found in smaller manufacturing firms, it’s not limited to the industrial world.
Small markets don’t attract giants.
ERODING MOATS
The best analysis in the world can be rendered moot by unforeseen changes in the competitive landscape.
Although change can be an opportunity, it can also severely erode once-wide economic moats. critical to continually monitor the competitive position of the companies in which you have invested, and watch for signs that the moat may be eroding.
There are two sides to this threat.
The first is the risk that a company that sells technology and it loses out in the furious race to stay on the cutting edge.
Being technologically supplanted by a competitor is simply a fact of life for most technology companies, because they typically win business by having a product that is better/faster/cheaper than their peers’ products.
“In the long run, everything is a toaster.”
Technological disruption is a more unexpected—and 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 hurts their economics.
the kind of technological disruption that structurally damages the economics of an entire industry is relatively rare
One thing to remember is that disruptive technologies can hurt the moats of businesses that are enabled by technology even more than businesses that sell technology shifts in the structure of industries can also cause lasting damage to companies’ competitive advantages. One common change to watch out for is consolidation of a once-fragmented group of customers.
Changes in the industry landscape needn’t be local. The entry of low-cost workforces elsewhere into the global labor pool has permanently damaged the economics of many manufacturing businesses.
In some cases, the labor differential is so large that companies that may have once benefited from a location-based moat have seen that competitive advantage disappear, as the cost savings from low-cost labor is large enough to offset high transportation costs.
One final change to watch out for is the entry of an irrational competitor into an industry.
Some kinds of growth can cause moats to erode. the single most common self-inflicted wound to competitive advantage occurs when a company pursues growth in areas where it has no moat. A company can fill in its own moat by investing heavily in areas in which it has no competitive advantage.
If a company that has regularly been able to raise prices starts getting pushback from customers, you’re getting a strong signal that the company’s competitive advantage may have weakened.
In each section, I found a number of insights and useful comments, most of which are copied below (apologies for poor formatting / editing):
MISTAKEN MOATS
In my experience, the most common “mistaken moats” are great products, strong market share, great execution, and great management. These four traps can lure you into thinking that a company has a moat when the odds are good that it actually doesn’t.
TYPES OF MOATS
Intangible assets
As economic moats, they all function in essentially the same way—by establishing a unique position in the marketplace. Any company with one of these advantages has a mini-monopoly, allowing it to extract a lot of value from its customers.
Brands
One of the most common mistakes investors make concerning brands is assuming that a well-known brand endows its owner with a competitive advantage.
A brand creates an economic moat only if it increases the consumer’s willingness to pay or increases customer captivity.
Brands cost money to build and sustain, and if that investment doesn’t generate a return via some pricing power or repeat business, then it’s not creating a competitive advantage.
Ask whether the company is able to charge a premium relative to similar competing products. If not, the brand may not be worth very much.
the ability to brand a true commodity product is relatively rare—most brands are attached to differentiated products
The big danger in a brand-based economic moat is that if the brand loses its luster, the company will no longer be able to charge a premium price.
Patents
patents have a finite life
Legal maneuvering can sometimes extend the life of a patented Product
Patents are also not irrevocable
be wary of any firm that relies on a small number of patented products for its profits, as any challenge to those patents will severely harm the company and will probably be very hard to predict.
The only time patents constitute a truly sustainable competitive advantage is when the firm has a demonstrated track record of innovation that you’re confident can continue, as well as a wide variety of patented products. (Think of 3M)
Regulatory licenses
regulatory licenses that make it tough—or impossible—for competitors to enter a market. Typically, this advantage is most potent when a company needs regulatory approval to operate in a market but is not subject to economic oversight with regard to how it prices its products.
a company that can price like a monopoly without being regulated like one (The bond-rating industry)
sometimes a collection of smaller, hard-to-get approvals can dig an equally wide moat
Switching costs
You find switching costs when the benefit of changing from Company A’s product to Company B’s product is smaller than the cost of doing so.
companies that benefit from switching costs can be hard to find because you need to put yourself in the customer’s shoes to really understand the balance between costs and benefits. And, like any competitive advantage, switching costs can strengthen or weaken with time.
one broad category of switching costs, which you might think of as companies that benefit from tight integration into their clients’ businesses.
it becomes part and parcel of their daily operations, and untangling it from their business to start afresh would be costly, and possibly risky as well.
This type of competitive advantage isn’t limited to just service and software companies. Precision Castparts that sells high-tech, superstrong metal components used in jet aircraft engines and power-plant turbines. Think for a minute about the low tolerance for failure in these kinds of products.
engineers actually work together with customers when they design new products.
Look at the cost/benefit balance. The only benefit of switching to a new supplier would likely be monetary, as long as the current supplier keeps up its quality standards. Customers would need to find a supplier of similar reliability if they wanted to save money by switching.
The explicit cost is meaningful—the new company would need to spend time getting to know the new products as intimately as it knows the existing ones—but the real cost in this case is risk. Given the incredibly low tolerance for failure, it doesn’t make sense to try to shave the production cost if it increases the risk of product failure. It would take only one high-profile failure to seriously damage the company’s reputation, which would definitely hurt future sales.
switching costs show up in all kinds of industries.
Switching costs can be effective when explicit cost of switching is low if most people perceive the benefits of switching as uncertain.
very hard many for consumer-oriented firms, such as retailers, restaurants, packaged-goods companies to create moats around their businesses. That’s because low switching costs are the main weakness of these kinds of companies. You can walk from one clothing store to another, or choose a different brand of toothpaste at the grocery store, with almost no effort whatsoever.
Some can do it through economies of scale and some can create moats by building strong brands—but in general, consumer-oriented firms often suffer from low switching costs.
Switching costs can be tough to identify because you often need to have a thorough understanding of a customer’s experience—which can be hard if you’re not the customer. But this type of economic moat can be very powerful and long-lasting
Switching costs come in many flavors—tight integration with a customer’s business, monetary costs, and retraining costs, to name just a few.
Network effects (a special type of switching cost)
the value of their product or service increases with the number of users Network based businesses tend to create natural monopolies and oligopolies.
“Of networks, there will be few.”- Brian Arthur
the very nature of the network effect means that there won’t be a very large number of businesses that benefit from it, given the propensity of networks to consolidate around the leader.
the network effect is much more common among businesses based on information or knowledge transfer than among businesses based on physical capital. This is the case because information is what economists call a “nonrival” good. Most goods can be used by only one person at a time (rival goods). Note this is not exclusively the case.
network-based businesses are usually pretty durable. A competing firm would need to replicate the network—or at least come close—before users would see more value in the new network and switch away from the existing one.
in a fast-growing market with consumer preferences that are still being formed around a new type of service the network effect can be subject to successful attack.
for a company to benefit from the network effect, it needs to operate a closed network, and when formerly closed networks open up, the network effect can dissipate in a hurry. It’s a good question to ask whenever you’re evaluating a company that might benefit from network economics: How might that network open up to other participants?
This is a common effect of network-based businesses:
The benefit of having a larger network is nonlinear, which means that the economic value of the network increases at a faster rate than its absolute size. There is probably an element of critical mass present here, too (to determine the point at which the network becomes valuable). There may also be an element of ‘escape velocity’, in that one or more emerging networks compete and may even both be at critical mass (that is, useful) but when one reaches a certain relative size it becomes dominant (think facebook, nexopia, myspace).
the value of a network to its users is more closely tied to the number of connections than it is to the number of nodes, but the value-to-connection relationship likely slows down as the number of connections becomes extremely large.
Cost Advantages
Cost advantages can sometimes be durable, but they can also disappear very quickly, so as an investor you need to be able to determine whether a company’s cost advantage is replicable by a competitor.
cost advantages matter most in industries where price is a large portion of the customer’s purchase criteria.
these industries are usually characterized as commodity industries, that’s not strictly true.
A useful way to pick out industries in which cost advantages are likely to be a big factor is to imagine whether there are easily available substitutes—products or services that serve the same function for the buyer, even if they are differentiated.
Cost advantages can stem from four sources: cheaper processes, better locations, unique assets, and greater scale.
Process advantages
in theory they shouldn’t exist for long enough to constitute much of a competitive advantage, because competitors should copy them. This generally does happen eventually, but it can take a lot longer than one might expect.
Copy processes can require significant or compete overhauls of business plans. Difficult to do period, and compounded by organizational inertia.
Another reason is that new processes may be advantageous, but a first-mover may actually gain an enduring advantage if they gain scale and prevent followers from being able to adopt their process (that is prevent competitors from copying the business model that uses the process by exploiting scale advantages).
process-based cost advantages can create a temporary moat if incumbents
are unlikely to replicate them immediately, and if new entrants either can’t copy the process or doing so is likely to destroy the industry’s economics.
A moat that is built on lazy or stumbling competitors is not a terribly strong one. So, 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.
Location Advantages
This type of cost advantage is more durable than one based on process because locations are much harder to duplicate.
This advantage occurs most frequently in commodity products that are heavy and cheap—the ratio of value to weight is low—and that are consumed close to where they’re produced. They create mini-monopolies in their immediate vicinity.
Unique assets or superior access to resources
A type of cost advantage that is generally limited to commodity producers is access to a unique, world-class asset.
Cost advantages can be extremely powerful sources of competitive advantage, but some are more likely to last a long time than others.
Process-based advantages usually bear close watching, because even if they do last for some period of time, it’s often because of some temporary limitation on competitors’ ability to copy that process. Once that limitation disappears, the moat can get a lot narrower very quickly.
Location-based cost advantages and low costs based on ownership of some unique asset are much, more durable and easier to hang one’s analytical hat on. Companies with location advantages often create mini-monopolies, and world-class natural resource deposits are by definition pretty hard to replicate.
Scale (a special type of cost advantage)
When you’re thinking about cost advantages that stem from scale, remember one thing: The absolute size of a company matters much less than its size relative to rivals.
Very broadly speaking, the higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be, because the benefits of size are greater.
We can break down scale-based cost advantages into three categories: distribution, manufacturing, and niche markets.
manufacturing scale tends to get most of the attention, but the cost advantages stemming from large distribution networks or dominance of a niche market are just as powerful—and, in an increasingly service-oriented economy, they are more common as well.
Distribution scale
Large distribution networks can be the source of tremendous competitive advantages, and you can easily see why when you think about the economics of moving stuff from point A to point B.
Although building and operating the delivery network is an expensive proposition for a base level of service, the incremental profit on each item that the truck fleet delivers is enormous.
once the fixed costs are covered, delivering an extra item that is on a delivery route is extremely profitable because the variable cost of making an extra stop is almost nothing.
imagine that you need to try to compete with a company that has an established distribution network. It has likely covered its fixed costs and is making large incremental profits as it delivers more stuff, while you’ll need to take on large losses for a time until (if) you gain enough scale to become profitable.
Many businesses with delivery networks can dig this type of economic moat.
Large distribution networks are extremely hard to replicate, and are often the source of very wide economic moats.
Manufacturing scale
The closer the factory is to 100 percent capacity, the more profitable it is, and the larger the factory, the easier it is to spread fixed costs over larger volume of production.
Also, the larger the factory, the easier it is to specialize by individual tasks or to mechanize production.
the prevalence of this type of cost advantage has diminished somewhat in the recent past as enormous low-cost pools of labor in China and Eastern Europe have become integrated into the global economy, causing some manufacturing to shift away from Europe and North America.
Manufacturing scale needn’t be limited to owning a larger production facility than the competition. As long as costs can be spread over a sales base, this advantage exists: e.g. over subscribers or gamers.
Niche market scale
Even if a company is not big in an absolute sense, being relatively larger than the competition in a specific market segment can confer huge advantages.
companies can build near-monopolies in markets that are only large enough to support one company profitably, because it makes no economic sense for a new entrant to spend the capital necessary to enter the market.
this type of competitive advantage is often found in smaller manufacturing firms, it’s not limited to the industrial world.
Small markets don’t attract giants.
ERODING MOATS
The best analysis in the world can be rendered moot by unforeseen changes in the competitive landscape.
Although change can be an opportunity, it can also severely erode once-wide economic moats. critical to continually monitor the competitive position of the companies in which you have invested, and watch for signs that the moat may be eroding.
There are two sides to this threat.
The first is the risk that a company that sells technology and it loses out in the furious race to stay on the cutting edge.
Being technologically supplanted by a competitor is simply a fact of life for most technology companies, because they typically win business by having a product that is better/faster/cheaper than their peers’ products.
“In the long run, everything is a toaster.”
Technological disruption is a more unexpected—and 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 hurts their economics.
the kind of technological disruption that structurally damages the economics of an entire industry is relatively rare
One thing to remember is that disruptive technologies can hurt the moats of businesses that are enabled by technology even more than businesses that sell technology shifts in the structure of industries can also cause lasting damage to companies’ competitive advantages. One common change to watch out for is consolidation of a once-fragmented group of customers.
Changes in the industry landscape needn’t be local. The entry of low-cost workforces elsewhere into the global labor pool has permanently damaged the economics of many manufacturing businesses.
In some cases, the labor differential is so large that companies that may have once benefited from a location-based moat have seen that competitive advantage disappear, as the cost savings from low-cost labor is large enough to offset high transportation costs.
One final change to watch out for is the entry of an irrational competitor into an industry.
Some kinds of growth can cause moats to erode. the single most common self-inflicted wound to competitive advantage occurs when a company pursues growth in areas where it has no moat. A company can fill in its own moat by investing heavily in areas in which it has no competitive advantage.
If a company that has regularly been able to raise prices starts getting pushback from customers, you’re getting a strong signal that the company’s competitive advantage may have weakened.
May 30, 2021
This book is almost exclusively about one idea: the “economic moat”. If you haven’t seen Warren Buffett talk about this, it’s the idea that you want to invest in companies that have something that makes it difficult for other companies to compete with them. Buffett’s example that I remember is Coca-Cola, which has such a unique brand that it makes it difficult to compete in terms of selling cola.
Pat Dorsey defines what makes an economic moat in what feels like a comprehensive breakdown. Even better, Dorsey spends almost as much time talking about what *isn’t* an economic moat, so hopefully you won’t make significant mistakes in that regard. He also includes a couple of essential chapters on how to find companies with an economic moat and a primer on how to value them so you know whether their stock price is a good deal, whether they have a moat or not.
The book is really good. It’s direct, it feels comprehensive, and it’s 200 pages so it doesn’t spend too long discussing the narrow topic. I do have a bit of a moral issue with economic moats: by definition, moats stifle competition, so they are antithetical to capitalism. But, if you’re looking to pick specific companies to invest in, it’s definitely going to be better for your returns.
Pat Dorsey defines what makes an economic moat in what feels like a comprehensive breakdown. Even better, Dorsey spends almost as much time talking about what *isn’t* an economic moat, so hopefully you won’t make significant mistakes in that regard. He also includes a couple of essential chapters on how to find companies with an economic moat and a primer on how to value them so you know whether their stock price is a good deal, whether they have a moat or not.
The book is really good. It’s direct, it feels comprehensive, and it’s 200 pages so it doesn’t spend too long discussing the narrow topic. I do have a bit of a moral issue with economic moats: by definition, moats stifle competition, so they are antithetical to capitalism. But, if you’re looking to pick specific companies to invest in, it’s definitely going to be better for your returns.
September 13, 2020
Excellent Book on Moats
The best book I've read about moats and wealth investments in stocks. Bookmarked and will read again and again 🙏
Take away quote : “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
The best book I've read about moats and wealth investments in stocks. Bookmarked and will read again and again 🙏
Take away quote : “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
July 30, 2020
Good book....It explains in great details about the kind of business one should own i.e., business with large and durable moats...Business with large moats can only generate very high Return on Capitals....The author identifies the four major categories which covers a large part of businesses having moats...
1. Intangibles - Brands, Patents (Pharma), Regulatory Licenses (Ratings)
2. Switching Costs - Banks/ Financials, IT Software Companies, Money managers
3. Networking effect - One platform used by many people like Internet Companies (eBay, Microsoft),
Exchanges (NSE, NASDAQ etc), TV Stations
4. Cost Advantages - Process Adv, Location Adv, Unique Assets, Size Adv.
Overall it was fun reading this book. Thanks
1. Intangibles - Brands, Patents (Pharma), Regulatory Licenses (Ratings)
2. Switching Costs - Banks/ Financials, IT Software Companies, Money managers
3. Networking effect - One platform used by many people like Internet Companies (eBay, Microsoft),
Exchanges (NSE, NASDAQ etc), TV Stations
4. Cost Advantages - Process Adv, Location Adv, Unique Assets, Size Adv.
Overall it was fun reading this book. Thanks
November 28, 2020
Moats. Moats. Moats.
What qualifies and what doesn't. Everything you'd want to know about moats and how to spot one.
What qualifies and what doesn't. Everything you'd want to know about moats and how to spot one.
July 26, 2023
Pat Dorsey explains in detail several criteria you should consider if looking to invest in an individual stock. He particularly focuses on the idea of economic moats. I listened to the audio version and found it to be quite informative.
June 13, 2021
Can one of the best business books of all time actually be an investment book?
Well, at least I think it can be (and Dr. Bob Froehlich from Deutsche Asset Management seems to agree with me to some extent).
Structural competitive advantages or as Pat Dorsey calls it "Economic Moats" are truly the characteristics of a company that can define a business as an outstanding business that has the potential to be around for a long long period of time and keeps printing money for its shareholders or just as a mediocre one which will be gone with any market whim.
Moats are structural characteristics inherent to a business, and the cold hard truth is that some businesses are simply better than others. Great products, great size, great execution, and great management do not create long-term competitive advantages. They are nice to have, but they are not enough.
The author categorizes structural advantages as following:
- Intangible assets: like brands, patents, or regulatory licenses that allow a company to sell products or services that can't be matched by competitors
- Products or services that may be hard for customers to give up, which creates customer switching costs
- Network effects: that with each new user the value of the business increases for its users
- Cost advantages: stemming from the process, location, scale, or access to a unique asset, which allows a company to offer goods or services at a lower cost than competitors
I noticed while watching the "Shark Tank" show that all investors recognizing the same characteristics as their investing criteria.
Absolutely insightful and educative. I feel like I got a new lens which through it I can see much better.
Well, at least I think it can be (and Dr. Bob Froehlich from Deutsche Asset Management seems to agree with me to some extent).
Structural competitive advantages or as Pat Dorsey calls it "Economic Moats" are truly the characteristics of a company that can define a business as an outstanding business that has the potential to be around for a long long period of time and keeps printing money for its shareholders or just as a mediocre one which will be gone with any market whim.
Moats are structural characteristics inherent to a business, and the cold hard truth is that some businesses are simply better than others. Great products, great size, great execution, and great management do not create long-term competitive advantages. They are nice to have, but they are not enough.
The author categorizes structural advantages as following:
- Intangible assets: like brands, patents, or regulatory licenses that allow a company to sell products or services that can't be matched by competitors
- Products or services that may be hard for customers to give up, which creates customer switching costs
- Network effects: that with each new user the value of the business increases for its users
- Cost advantages: stemming from the process, location, scale, or access to a unique asset, which allows a company to offer goods or services at a lower cost than competitors
I noticed while watching the "Shark Tank" show that all investors recognizing the same characteristics as their investing criteria.
Absolutely insightful and educative. I feel like I got a new lens which through it I can see much better.
September 6, 2020
A must-read for any stock investor.
The book does not contain any gimmicks or fancy formulas (unlike the book "The little book that beats the market' by Joel Greenblatt . Instead, it contains a systematic process for identifying & valuing stocks.
Other books recommended by the author:
Key takeaways:
1. Strategy
• Identify the business with moats
• Wait until the shares trade at less than intrinsic value & then buy them
• Hold the shares until the business deteriorates, shares become overvalued, or you find a better investment
2. Just as moats around medieval castles kept the opposition at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies.
3. Chapter 1 – economic moats
• Return on capital is the best way to judge a company’s profitability. It measures how good a company is at taking money from investors and generating returns on it
4. Chapter 2 – mistaken moats
• Myth – bet on the jockey not the horse i.e. quality of management is greater than the quality of the business
• 4 common mistaken moats – Great PRODUCTS, strong MARKET SHARE, great EXECUTION (aka Operational efficiency) and great MANAGEMENT
• Myth of Great products- Chrysler rolled out the first minivan in 1980s (automotive industry is highly competitive- so, rivals crashed the minivan party), Wall street ethanol craze
• Myth of strong market share – fleeting in highly competitive industries – Kodak (film), IBM (PCs), general motors (automobiles)
• Signs of moats
o Intangible assets like brands, patents
o High customer switching costs
o Network economics
o Cost advantages – stemming from process, location, scale or access to a unique asset
5. Chapter 3 – intangible assets
• 3M, merck, eli lilly have many patents
• Companies offering higher-degree education need accreditation
• Trash & Gravel i.e. Not In My Backyard (NIMBY) companies
6. Chapter 4 – switching costs
• Restaurants, packaged-food companies, retailers have low-switching costs
• Bank – high switching costs
7. Chapter 5 – network effects
• American express - The top four—Visa, MasterCard, Amex, and Discover—account for 85 percent of all spending on credit cards nationwide. That’s a huge amount of market concentration, and it illustrates a fundamental reason why the network effect can be an extremely powerful competitive advantage: Networkbased businesses tend to create natural monopolies and
oligopolies.
• General rule - you’re most likely to find the network effect in businesses based on sharing information, or connecting users together, rather than in businesses
that deal in rival (physical) goods.
• The Corporate Executive Board publishes best-practices research for large corporations, essentially helping executives figure out how to solve some of the problems they encounter by sharing the experiences of other companies that have faced similar issues. You can see the network effect already—the more companies that are in the Corporate Executive Board’s network, the more likely it is to have relevant information for its members. It also helps members by connecting
them together for one-off problems.
8. Chapter 6 – Cost advantages
• Cost advantages matter most in industries where price is a large portion of the customer’s purchase criteria. Although these industries are usually characterized as commodity industries, that’s not strictly true. Intel, for example, has a massive cost advantage over Advanced Micro Devices (AMD), and microprocessors are not exactly commodities. (Technically, commodities are products with no differentiating factor other than price.)
• Locational advantage – cement companies are usually near the cities. Some steel companies have cheaper costs based on tough-to-replicate decisions
9. Chapter 7 - Size advantage
• To understand scale advantages, it’s important to remember
the difference between fixed and variable costs. If
you think about your local grocery store, its fixed costs
are rent, utilities, and salaries for some base level of
staffing. The variable costs would be the wholesale cost
of the merchandise that the store needs to stock the
shelves, and perhaps extra compensation costs for hightraffic
times of the year like the holidays. A real-estate
brokerage office, by contrast, would have almost exclusively
variable costs. Aside from an office, a phone, a
car, and a computer with a link to the database of homes
for sale, an agent doesn’t have many costs aside from
commissions, which vary with real-estate sales: no sales,
no commissions.
Very broadly speaking, the higher the level of fixed
costs relative to variable costs, the more consolidated an
industry tends to be, because the benefits of size are greater.
It’s no surprise that there are only a few national packagedelivery
companies, or automobile manufacturers, or microchip
producers—but there are thousands of small real-estate
agencies, consultancies, law offices, and accounting agencies.
A law firm with 1,000 lawyers has no cost advantage
over a law firm with 10 lawyers. It may have a greater range
of services it can offer, and it may get additional business from that angle, but it is not going to have a meaningful
cost advantage over a smaller competitor.
We can break down scale-based cost advantages further
into three categories: distribution, manufacturing, and niche
markets. Although manufacturing scale tends to get all of
the attention in Economics 101, my experience is that the
cost advantages stemming from large distribution networks
or dominance of a niche market are just as powerful—and,
in an increasingly service-oriented economy, they are more
common as well.
• Companies with niche-market moats can generate
fabulous returns on capital while making very mundane
products. For example, I doubt that you’ve ever thought
much about industrial pumps, but it turns out that you
can make a lot of money manufacturing high-quality paint
sprayers and pumps for food processing. A wonderful
little firm in Minneapolis called Graco, Inc. makes both,
and it generates 40 percent returns on capital in the
process.
How is this possible? First, the total market for high-end
industrial pumps is not all that large, limiting its attractiveness
to large, well-financed competitors. Second,
Graco spends liberally—about 3 to 4 percent of sales—on
research and development, ensuring that it continually
stays at the cutting edge of customers’ requirements.
Third, Graco’s products often deliver results that are
highly visible to the end consumer, but represent a small
fraction of total production costs. Think of the stain and
lacquer on a piece of furniture or the paint job on a new
car—the finishing touch is not expensive relative to the
product’s total cost, but it’s the first thing the consumer
sees. As a result, Graco can extract premium pricing
from customers like furniture manufacturers or automakers.
The extra spending doesn’t affect the cost of the
table or the sports car very much, but it definitely boosts
Graco’s profit margins.
10. Chapter 8 – eroding moats
• One thing to remember is that disruptive technologies can hurt the moats of businesses that are enabled by technology even more than businesses that sell technology, even though investors in technology-enabled firms may not think they own a tech stock
• The list of sinkholes into which Microsoft has poured
money is longer than you’d think—the Zune, MSN, and
MSNBC are just a start. Did you know that the company
once tried to launch a series of kids’ toys called Actimates?
Or that it blew more than $3 billion on a bunch of European
cable companies in the late 1990s?
11. Chapter 9 – finding moats
• In technology, you can see that software companies
tend to have an easier time creating moats than hardware
companies. This is not simply an accounting artifact—
hardware firms are generally more capital-intensive than
software firms—but has a strong basis on the way these
two broad categories of products are used. A piece of
software often needs to be integrated with other pieces
of software to work properly, and this integration leads to
customer lock-in and higher switching costs. Hardware
is more frequently based on common industry standards,
and can be swapped out for new hardware with less effort.
There are important exceptions, of course, especially when
a hardware company—like, say, Cisco Systems—is able to
embed software in its products and create switching costs.
• Companies that cater directly to the consumer, like
restaurants and retailers, often have a very hard time
building competitive advantages—the percentage of consumer
services companies with wide moats is one of the
smallest of all the market sectors. The culprit here is
low switching costs, because walking down the street from
one shop or cafe to another is incredibly easy, and popular
concepts can almost always be copied with ease. Popular
fashion retailers or restaurant chains often present the
illusion of a moat due to their fast growth and the buzz
that surrounds a new type of store that is opening up
several new locations every month, but be wary, because
the odds are good that a knockoff concept is not far off.
The moats that do exist in consumer services—companies
like Bed Bath & Beyond, Best Buy, Target, or Starbucks—
are generally the result of getting a lot of little things
consistently right for years, which results in the kind of
dependable consumer experience that drives loyalty and
repeat traffic. It can be done, but it’s not easy.
Companies that provide services to businesses are in
many ways the polar opposite of the restaurants and retailers.
This sector has one of the highest percentages of
wide-moat companies in Morningstar’s coverage universe,
and that’s largely because these firms are often able to
integrate themselves so tightly into their clients’ business
processes that they create very high switching costs, giving
them pricing power and excellent returns on capital.
• ROA vs ROE v/s ROCE – one flaw of ROE is that companies can take on a lot of debt and boost ROE without becoming profitable. ROCE combines both ROA and ROE
12. Chapter 10 – management
13. Chapter 11 – competitive analysis
• Has the firm generated solid Return on capital in the past
• Does the firm have low switching costs or low cost of production or intangible assets or network economics
• How long is the moat likely to last i.e. wide moat or narrow moat
14. Chapter 12 – whats a moat worth
Think of free cash flow like the money a landlord
clears at the end of every year. The owner of an apartment
building gets rent (sales), pays for the mortgage and
some annual upkeep (operating expenses), and occasionally
spends some money for major repairs like a new roof
or new windows (capital expenditures). What’s left over
[ 1 6 4 ] THE L I T T L E BOOK THAT B U I L D S WE A LTH
is his or her personal free cash flow, which can be
tucked away in a bank account, spent on a nice Florida
vacation, or used to buy another apartment building. But
whatever the landlord uses it for, it’s not money that is
needed to keep the apartment building functioning as a
cash- generating enterprise.
Sticking with the landlord example, let’s think about
what would make a building full of rental apartments worth
more or less to a prospective purchaser. Growth would
certainly push the value up—if a building had an adjacent
patch of land on which a landlord could build more apartments,
it would be worth more than a building without that
land, as the stream of potential future rental income would
be larger. The same goes for the riskiness of the rental
income—a building full of seasoned wage-earners would be
worth more than the same building full of college students,
because the landlord would be more confident of actually
collecting the rent each month without a big hassle.
You’d also imagine that a higher return on capital
would make a building worth more—if you thought you
could raise rents in a certain building and essentially get
more income with no investment, that property would be
worth more than a building with stagnant rents. Finally,
let’s not forget competitive advantage—a building that
was the last to go up before a zoning ordinance prevented
adjacent new apartment buildings would be worth more
WHAT’ S A MOAT WO RTH? [ 1 6 5 ]
than a building that potentially faced lots of new apartments
competing with it.
Guess what? You’ve just learned the most important
concepts that underpin the valuation of any company: the
likelihood that those estimated future cash flows will actually
materialize (risk), how large those cash flows will
likely be (growth), how much investment will be needed to
keep the business ticking along (return on capital), and
how long the business can generate excess profits (economic
moat). Keep these four factors in mind when using
price multiples or any other valuation tool, and you’re
certain to make better investing decisions.
Invest, Don’t Speculate
There are three types of tools for valuing companies: price
multiples, yields, and intrinsic values. All three are valuable
parts of the investing toolkit, and the wise investor
will apply more than one to a prospective purchase. I’ll go
over price multiples and yields in the next chapter.
there are just
two things that push a stock up or down: The investment
return, driven by earnings growth and dividends, and the
speculative return, driven by changes in the price-earnings
(P/E) ratio.
15. Chapter 13 – tools for valuation
• Multiples – price to sales ratio – not good for low-margin companies like retailers
• Price to book ratio
The key to using the P/B ratio in valuing stocks is to
think carefully about what “B” represents. Whereas a
dollar of earnings or cash flow is exactly the same from
Company A to Company B, the stuff that makes up book
value can vary dramatically. For an asset-intensive firm
like a railroad or a manufacturing firm, book value represents
the bulk of the assets that generate revenue—things
like locomotives, factories, and inventory. But for a service
or technology firm, for example, the revenue-generating
assets are people, ideas, and processes, none of which are
generally contained in book value. SUBTRACT GOODWILL FROM BOOK VALUE
• Earnings yield – inverse of PE Ratio
• Improve on earnings yield by using cash return – Free cash flow/ enterprise value (market value of equity and debt)
• 4 drivers of valuation – risk, return on capital, competitive advantage and growth
The book does not contain any gimmicks or fancy formulas (unlike the book "The little book that beats the market' by Joel Greenblatt . Instead, it contains a systematic process for identifying & valuing stocks.
Other books recommended by the author:
Key takeaways:
1. Strategy
• Identify the business with moats
• Wait until the shares trade at less than intrinsic value & then buy them
• Hold the shares until the business deteriorates, shares become overvalued, or you find a better investment
2. Just as moats around medieval castles kept the opposition at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies.
3. Chapter 1 – economic moats
• Return on capital is the best way to judge a company’s profitability. It measures how good a company is at taking money from investors and generating returns on it
4. Chapter 2 – mistaken moats
• Myth – bet on the jockey not the horse i.e. quality of management is greater than the quality of the business
• 4 common mistaken moats – Great PRODUCTS, strong MARKET SHARE, great EXECUTION (aka Operational efficiency) and great MANAGEMENT
• Myth of Great products- Chrysler rolled out the first minivan in 1980s (automotive industry is highly competitive- so, rivals crashed the minivan party), Wall street ethanol craze
• Myth of strong market share – fleeting in highly competitive industries – Kodak (film), IBM (PCs), general motors (automobiles)
• Signs of moats
o Intangible assets like brands, patents
o High customer switching costs
o Network economics
o Cost advantages – stemming from process, location, scale or access to a unique asset
5. Chapter 3 – intangible assets
• 3M, merck, eli lilly have many patents
• Companies offering higher-degree education need accreditation
• Trash & Gravel i.e. Not In My Backyard (NIMBY) companies
6. Chapter 4 – switching costs
• Restaurants, packaged-food companies, retailers have low-switching costs
• Bank – high switching costs
7. Chapter 5 – network effects
• American express - The top four—Visa, MasterCard, Amex, and Discover—account for 85 percent of all spending on credit cards nationwide. That’s a huge amount of market concentration, and it illustrates a fundamental reason why the network effect can be an extremely powerful competitive advantage: Networkbased businesses tend to create natural monopolies and
oligopolies.
• General rule - you’re most likely to find the network effect in businesses based on sharing information, or connecting users together, rather than in businesses
that deal in rival (physical) goods.
• The Corporate Executive Board publishes best-practices research for large corporations, essentially helping executives figure out how to solve some of the problems they encounter by sharing the experiences of other companies that have faced similar issues. You can see the network effect already—the more companies that are in the Corporate Executive Board’s network, the more likely it is to have relevant information for its members. It also helps members by connecting
them together for one-off problems.
8. Chapter 6 – Cost advantages
• Cost advantages matter most in industries where price is a large portion of the customer’s purchase criteria. Although these industries are usually characterized as commodity industries, that’s not strictly true. Intel, for example, has a massive cost advantage over Advanced Micro Devices (AMD), and microprocessors are not exactly commodities. (Technically, commodities are products with no differentiating factor other than price.)
• Locational advantage – cement companies are usually near the cities. Some steel companies have cheaper costs based on tough-to-replicate decisions
9. Chapter 7 - Size advantage
• To understand scale advantages, it’s important to remember
the difference between fixed and variable costs. If
you think about your local grocery store, its fixed costs
are rent, utilities, and salaries for some base level of
staffing. The variable costs would be the wholesale cost
of the merchandise that the store needs to stock the
shelves, and perhaps extra compensation costs for hightraffic
times of the year like the holidays. A real-estate
brokerage office, by contrast, would have almost exclusively
variable costs. Aside from an office, a phone, a
car, and a computer with a link to the database of homes
for sale, an agent doesn’t have many costs aside from
commissions, which vary with real-estate sales: no sales,
no commissions.
Very broadly speaking, the higher the level of fixed
costs relative to variable costs, the more consolidated an
industry tends to be, because the benefits of size are greater.
It’s no surprise that there are only a few national packagedelivery
companies, or automobile manufacturers, or microchip
producers—but there are thousands of small real-estate
agencies, consultancies, law offices, and accounting agencies.
A law firm with 1,000 lawyers has no cost advantage
over a law firm with 10 lawyers. It may have a greater range
of services it can offer, and it may get additional business from that angle, but it is not going to have a meaningful
cost advantage over a smaller competitor.
We can break down scale-based cost advantages further
into three categories: distribution, manufacturing, and niche
markets. Although manufacturing scale tends to get all of
the attention in Economics 101, my experience is that the
cost advantages stemming from large distribution networks
or dominance of a niche market are just as powerful—and,
in an increasingly service-oriented economy, they are more
common as well.
• Companies with niche-market moats can generate
fabulous returns on capital while making very mundane
products. For example, I doubt that you’ve ever thought
much about industrial pumps, but it turns out that you
can make a lot of money manufacturing high-quality paint
sprayers and pumps for food processing. A wonderful
little firm in Minneapolis called Graco, Inc. makes both,
and it generates 40 percent returns on capital in the
process.
How is this possible? First, the total market for high-end
industrial pumps is not all that large, limiting its attractiveness
to large, well-financed competitors. Second,
Graco spends liberally—about 3 to 4 percent of sales—on
research and development, ensuring that it continually
stays at the cutting edge of customers’ requirements.
Third, Graco’s products often deliver results that are
highly visible to the end consumer, but represent a small
fraction of total production costs. Think of the stain and
lacquer on a piece of furniture or the paint job on a new
car—the finishing touch is not expensive relative to the
product’s total cost, but it’s the first thing the consumer
sees. As a result, Graco can extract premium pricing
from customers like furniture manufacturers or automakers.
The extra spending doesn’t affect the cost of the
table or the sports car very much, but it definitely boosts
Graco’s profit margins.
10. Chapter 8 – eroding moats
• One thing to remember is that disruptive technologies can hurt the moats of businesses that are enabled by technology even more than businesses that sell technology, even though investors in technology-enabled firms may not think they own a tech stock
• The list of sinkholes into which Microsoft has poured
money is longer than you’d think—the Zune, MSN, and
MSNBC are just a start. Did you know that the company
once tried to launch a series of kids’ toys called Actimates?
Or that it blew more than $3 billion on a bunch of European
cable companies in the late 1990s?
11. Chapter 9 – finding moats
• In technology, you can see that software companies
tend to have an easier time creating moats than hardware
companies. This is not simply an accounting artifact—
hardware firms are generally more capital-intensive than
software firms—but has a strong basis on the way these
two broad categories of products are used. A piece of
software often needs to be integrated with other pieces
of software to work properly, and this integration leads to
customer lock-in and higher switching costs. Hardware
is more frequently based on common industry standards,
and can be swapped out for new hardware with less effort.
There are important exceptions, of course, especially when
a hardware company—like, say, Cisco Systems—is able to
embed software in its products and create switching costs.
• Companies that cater directly to the consumer, like
restaurants and retailers, often have a very hard time
building competitive advantages—the percentage of consumer
services companies with wide moats is one of the
smallest of all the market sectors. The culprit here is
low switching costs, because walking down the street from
one shop or cafe to another is incredibly easy, and popular
concepts can almost always be copied with ease. Popular
fashion retailers or restaurant chains often present the
illusion of a moat due to their fast growth and the buzz
that surrounds a new type of store that is opening up
several new locations every month, but be wary, because
the odds are good that a knockoff concept is not far off.
The moats that do exist in consumer services—companies
like Bed Bath & Beyond, Best Buy, Target, or Starbucks—
are generally the result of getting a lot of little things
consistently right for years, which results in the kind of
dependable consumer experience that drives loyalty and
repeat traffic. It can be done, but it’s not easy.
Companies that provide services to businesses are in
many ways the polar opposite of the restaurants and retailers.
This sector has one of the highest percentages of
wide-moat companies in Morningstar’s coverage universe,
and that’s largely because these firms are often able to
integrate themselves so tightly into their clients’ business
processes that they create very high switching costs, giving
them pricing power and excellent returns on capital.
• ROA vs ROE v/s ROCE – one flaw of ROE is that companies can take on a lot of debt and boost ROE without becoming profitable. ROCE combines both ROA and ROE
12. Chapter 10 – management
13. Chapter 11 – competitive analysis
• Has the firm generated solid Return on capital in the past
• Does the firm have low switching costs or low cost of production or intangible assets or network economics
• How long is the moat likely to last i.e. wide moat or narrow moat
14. Chapter 12 – whats a moat worth
Think of free cash flow like the money a landlord
clears at the end of every year. The owner of an apartment
building gets rent (sales), pays for the mortgage and
some annual upkeep (operating expenses), and occasionally
spends some money for major repairs like a new roof
or new windows (capital expenditures). What’s left over
[ 1 6 4 ] THE L I T T L E BOOK THAT B U I L D S WE A LTH
is his or her personal free cash flow, which can be
tucked away in a bank account, spent on a nice Florida
vacation, or used to buy another apartment building. But
whatever the landlord uses it for, it’s not money that is
needed to keep the apartment building functioning as a
cash- generating enterprise.
Sticking with the landlord example, let’s think about
what would make a building full of rental apartments worth
more or less to a prospective purchaser. Growth would
certainly push the value up—if a building had an adjacent
patch of land on which a landlord could build more apartments,
it would be worth more than a building without that
land, as the stream of potential future rental income would
be larger. The same goes for the riskiness of the rental
income—a building full of seasoned wage-earners would be
worth more than the same building full of college students,
because the landlord would be more confident of actually
collecting the rent each month without a big hassle.
You’d also imagine that a higher return on capital
would make a building worth more—if you thought you
could raise rents in a certain building and essentially get
more income with no investment, that property would be
worth more than a building with stagnant rents. Finally,
let’s not forget competitive advantage—a building that
was the last to go up before a zoning ordinance prevented
adjacent new apartment buildings would be worth more
WHAT’ S A MOAT WO RTH? [ 1 6 5 ]
than a building that potentially faced lots of new apartments
competing with it.
Guess what? You’ve just learned the most important
concepts that underpin the valuation of any company: the
likelihood that those estimated future cash flows will actually
materialize (risk), how large those cash flows will
likely be (growth), how much investment will be needed to
keep the business ticking along (return on capital), and
how long the business can generate excess profits (economic
moat). Keep these four factors in mind when using
price multiples or any other valuation tool, and you’re
certain to make better investing decisions.
Invest, Don’t Speculate
There are three types of tools for valuing companies: price
multiples, yields, and intrinsic values. All three are valuable
parts of the investing toolkit, and the wise investor
will apply more than one to a prospective purchase. I’ll go
over price multiples and yields in the next chapter.
there are just
two things that push a stock up or down: The investment
return, driven by earnings growth and dividends, and the
speculative return, driven by changes in the price-earnings
(P/E) ratio.
15. Chapter 13 – tools for valuation
• Multiples – price to sales ratio – not good for low-margin companies like retailers
• Price to book ratio
The key to using the P/B ratio in valuing stocks is to
think carefully about what “B” represents. Whereas a
dollar of earnings or cash flow is exactly the same from
Company A to Company B, the stuff that makes up book
value can vary dramatically. For an asset-intensive firm
like a railroad or a manufacturing firm, book value represents
the bulk of the assets that generate revenue—things
like locomotives, factories, and inventory. But for a service
or technology firm, for example, the revenue-generating
assets are people, ideas, and processes, none of which are
generally contained in book value. SUBTRACT GOODWILL FROM BOOK VALUE
• Earnings yield – inverse of PE Ratio
• Improve on earnings yield by using cash return – Free cash flow/ enterprise value (market value of equity and debt)
• 4 drivers of valuation – risk, return on capital, competitive advantage and growth
August 3, 2019
Clearly conveys meaning of moats and gives idea about how to find them.
March 23, 2021
Really liked it. Lots of examples, short, packed with value and with summaries at the end of each chapter 👍
September 4, 2023
Zeroes in on the concept of economic moat. Really well written with great details and plenty of examples, quite a few of which I found to be counter intuitive.
January 15, 2025
Great explanation of that “moat” thing investors love to talk about
August 6, 2021
Pat Dorsey's level of storytelling and ability to distill komplex themes into valuable nuggets is out of this world.
Highly recommend this book.
Highly recommend this book.
April 24, 2024
To the point. Where you should start first before you look at valuation. One of the best books I’ve read on investing.
September 16, 2018
Little book yet very informative about economic moats. Some summary:
A. why moats?
-> overcome competition
-> durable competitive advantages
B. Moat traps
- Great products/services
- Great market share
- Good execution
- Good management
-> Not a moat
1. Intangible assets:
- Brands:
-> how businesses build brands? brands sustain a long time?
-> any special about that brand?
-> brands give businesses pricing power?
- Patents:
-> how many patents? have new patents regularly?
-> any special patents that are hard to copy?
-> businesses overcome legal challenges over patents?
- Regulatory licences:
-> businesses have authority approvals on something that's hard to get?
2. Consumer switching cost
-> businesses have large customer base.
-> does it cost customer something costly enough (not specificly in money term) to keep them switch for another supplier?
3. Network effect (special switching cost)
-> businesses working as intermediaries or brokers, connecting people together for some kind of services
-> have a large customer base so far
-> be one of the firsts to enter the field -> have advantages to build up a large network in the beginning
4. Cost advantages
- Cheaper processes:
-> low material cost, low labor cost, more efficient assembling
- Better location:
-> geographical monopoly due to location
-> be near more demands
-> easier to access the supply or to distribute products/services
- Unique assets
- Greater scale:
-> distribution scale: -> require big fixed cost -> eliminate small and medium competitors
-> manufacturing scale: -> require big fixed cost -> eliminate small and medium competitors
-> market niche: specific market, -> not large enough(low customer base) for many suppliers + -> cost resources to understand better
C. Re-assess moats in cases:
-> the affect of technology advance on businesses
-> businesses extensions, growth
-> changes in industry structure, new competitors entering, customer base fragment
D. Find moats:
- Some industries have more moats than others
- Moats are absolute, not relative
- Some moats are wide, some narrow
- Moats are more important than a star CEO
-> Check past records, use ROE, ROA, ROIC. See if those numbers are strong and consistent
-> If yes, find out the reasons: any moat involved? If yes, how strong it is?
E. Evaluate moats
- A company value worths all future cash that the it can generates
-> Free cash flow FCF (owner's earing) = Net Income from operating activities (Sales - Operating Expense) - Capital Expenditure
- 4 factors affect any business and need to considerate when value a business:
-> risk of materializing future cash flow: how likely it will come true
-> growth of future cash flow: how big it can be
-> return on captial: how much needs to invest
-> economic moats: how long business can generate that cash flow
F. Tools for valuation
- Intrinsic value: many models -> Discounted cash flow
- Price multiples:
-> Price-2-Sales (P/S):
different in each industry
-> Price-2-BookValue (P/B):
be careful with goodwill (should be subtracted from book value), intangible assets (hard to value),
take into account other economic moats as book value
-> Price-2-Earnings (P/E)
compare with other companies, the whole market or other benchmark like bond interest
take into account other financial stats like ROE, profit margins to see P/E is acceptable
do your own P/E calculation
-> Price-2-Free-CashFlow:
true picture about business health, less noise than earnings
take into account depreciation (because cash flow excludes it)
-> P/E-2-Growth(5 year EPS growth) PEG
take into account the affect of the 4 factors when comparing 2 companies PEG, not just PEG alone
- Yield
-> Cash return = (Free cash flow + net interest expense)/(Enterprise value)
Enterprise value = Market Cap + Long-term debt - Current asset (Cash)
-> Compare with some benchmarks to see if acceptable
G. when to sell
- when you realize you make a mistake -> try to overcome and cut loss
- when the business is getting worse -> some criteria that make you buy its stocks in the first place are going worse
- when find some place much better to invest in -> take into account switching cost
- when some stocks take a big part of your portfolio -> consider risk tolerance -> diversify to minimize risks
H. Final words:
- Expand mental database of companies -> practice to see patterns, themes, make comparisons
- Seek successful investors tips and advice
A. why moats?
-> overcome competition
-> durable competitive advantages
B. Moat traps
- Great products/services
- Great market share
- Good execution
- Good management
-> Not a moat
1. Intangible assets:
- Brands:
-> how businesses build brands? brands sustain a long time?
-> any special about that brand?
-> brands give businesses pricing power?
- Patents:
-> how many patents? have new patents regularly?
-> any special patents that are hard to copy?
-> businesses overcome legal challenges over patents?
- Regulatory licences:
-> businesses have authority approvals on something that's hard to get?
2. Consumer switching cost
-> businesses have large customer base.
-> does it cost customer something costly enough (not specificly in money term) to keep them switch for another supplier?
3. Network effect (special switching cost)
-> businesses working as intermediaries or brokers, connecting people together for some kind of services
-> have a large customer base so far
-> be one of the firsts to enter the field -> have advantages to build up a large network in the beginning
4. Cost advantages
- Cheaper processes:
-> low material cost, low labor cost, more efficient assembling
- Better location:
-> geographical monopoly due to location
-> be near more demands
-> easier to access the supply or to distribute products/services
- Unique assets
- Greater scale:
-> distribution scale: -> require big fixed cost -> eliminate small and medium competitors
-> manufacturing scale: -> require big fixed cost -> eliminate small and medium competitors
-> market niche: specific market, -> not large enough(low customer base) for many suppliers + -> cost resources to understand better
C. Re-assess moats in cases:
-> the affect of technology advance on businesses
-> businesses extensions, growth
-> changes in industry structure, new competitors entering, customer base fragment
D. Find moats:
- Some industries have more moats than others
- Moats are absolute, not relative
- Some moats are wide, some narrow
- Moats are more important than a star CEO
-> Check past records, use ROE, ROA, ROIC. See if those numbers are strong and consistent
-> If yes, find out the reasons: any moat involved? If yes, how strong it is?
E. Evaluate moats
- A company value worths all future cash that the it can generates
-> Free cash flow FCF (owner's earing) = Net Income from operating activities (Sales - Operating Expense) - Capital Expenditure
- 4 factors affect any business and need to considerate when value a business:
-> risk of materializing future cash flow: how likely it will come true
-> growth of future cash flow: how big it can be
-> return on captial: how much needs to invest
-> economic moats: how long business can generate that cash flow
F. Tools for valuation
- Intrinsic value: many models -> Discounted cash flow
- Price multiples:
-> Price-2-Sales (P/S):
different in each industry
-> Price-2-BookValue (P/B):
be careful with goodwill (should be subtracted from book value), intangible assets (hard to value),
take into account other economic moats as book value
-> Price-2-Earnings (P/E)
compare with other companies, the whole market or other benchmark like bond interest
take into account other financial stats like ROE, profit margins to see P/E is acceptable
do your own P/E calculation
-> Price-2-Free-CashFlow:
true picture about business health, less noise than earnings
take into account depreciation (because cash flow excludes it)
-> P/E-2-Growth(5 year EPS growth) PEG
take into account the affect of the 4 factors when comparing 2 companies PEG, not just PEG alone
- Yield
-> Cash return = (Free cash flow + net interest expense)/(Enterprise value)
Enterprise value = Market Cap + Long-term debt - Current asset (Cash)
-> Compare with some benchmarks to see if acceptable
G. when to sell
- when you realize you make a mistake -> try to overcome and cut loss
- when the business is getting worse -> some criteria that make you buy its stocks in the first place are going worse
- when find some place much better to invest in -> take into account switching cost
- when some stocks take a big part of your portfolio -> consider risk tolerance -> diversify to minimize risks
H. Final words:
- Expand mental database of companies -> practice to see patterns, themes, make comparisons
- Seek successful investors tips and advice
May 20, 2023
Probably the most realistic book on finance I’ve personally read. Dorsey provides his framework for how to identify a strong investment and whether you disagree with it or not, you cannot deny his wealth of knowledge and experience. Definitely more to learn from this book than making good financial investments but rather a framework for making any business decision
September 20, 2017
This book succinctly summarizes the underlying principles of investing in financial assets e.g. company stocks, for the long-run. The author uses the concept of economic moat as a thought experiment, to differentiate between companies with strong competitive advantages with others. Companies with strong economic moats have high competitive advantages, which cannot be easily nullified/replicated by competitors or new entrants. Factors like customer stickiness, brand image, natural monopoly and production cost advantages, among others, can provide thick economic moats, which may result in higher profitability and cash inflow. This would be an interesting read for those planning to make long term investments in the stock market.
October 13, 2016
I think that this is a very informational and intellectual book that covers the basics of people who want to be successful plus wealthy. I enjoyed the book quite a lot due to the information it provided about different types of techniques the successful investors like Warren Buffet use. I found it to be a guide for those who want to become rich and make money. Stocks, Investments, and financial literacy are something this little book covers the most. Over all a good book that I highly recommend to those who want to be wealthy and make lots of money.
August 14, 2014
Fantastic book for learning about moats. This books clearly explains what the moat is and how they are build around business. Pat Dorsey has neatly written in a simple to understand manner and I could read it very fast and re-read many times.
Some of the key points I take from this are
1. Switching cost
2. Network effects
3. Brand value
4. ROIC with Above all
Some of the key points I take from this are
1. Switching cost
2. Network effects
3. Brand value
4. ROIC with Above all
Read
May 14, 2015Being a fan of Value investing made popular by Graham , Buffet & Munger. This book really talks about what does a Moat means and how to identify for companies. This does not tell you how to value but to see how to see the competitive advantages of company using a simple framework.
April 9, 2016
Fantastic book that breaks down four different types of competitive advantage and why that is so important for finding good investments. Read it in an afternoon. Definitely one I will come back and reference.
January 13, 2017
It's the best thing on competitive advantages ( moats ) I've read. It's well written, includes good case studies, breaks down the different types of moats and ends up being a framework for building or evaluating them. Highly recommend it.
November 21, 2015
A very easy-to-read book about moat and competitive advantages.
August 19, 2015
A simple to be read in couple of days. It pointed out a different way of valuing company. Its was good book and if you read it then surely you i will get couple of good things from this.
September 20, 2015
Very impressive. Contains insight that are timeless.
October 14, 2015
The book covers a lot about identifying moats and some of the easy ways to identify them.
must read...
Price less for new value investors.
must read...
Price less for new value investors.
November 30, 2015
Excellent book on moat however readers and beginners not familiar with the US market will have a hard time following the examples.
Does not cover instrinsic value.
Does not cover instrinsic value.
January 25, 2016
Recommended by Prof. Sanjay
Read
January 16, 2016Small easy book on business-moats.
March 2, 2016
Very resourceful and must read for all investment professionals.
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