Summary of Pat Dorsey’s book, ” THE LITTLE BOOK THAT BUILDS WEALTH”. The knockout formula for finding great investments.
Pat Dorsey’s little book THAT BUILDS WEALTH
THE GAME PLAN:
- IDENTIFY businesses capable of generating above average returns over many years.
- WAIT until they begin to trade at OR below their intrinsic value.
- HOLD till
- business deteriorates
- shares are extremely overvalued
- a better investment is found
- REPEAT till you die.
If you are able to identify moats properly, your risk of permanent loss of capital comes down drastically.
Instead of becoming an expert in a set of industries, why not become an expert in firms with economic moats, regardless of what business they are in ?
A business that can generate above average cash for a long time is better than a company which can generate excellent cash flows only for a short time.
ROCE is the best way to judge a companies profitability. It measures how well the company is using Shareholder Funds to generate returns on it.
A company whose ROCE is just about to get leveraged is better than one whose ROCE is matured or deteriorating even if the ROCE is excellent.
High ROCE is ammunition to protect itself from competition.
A pig with lipstick is still a pig.
Some businesses are just better positioned than others, irrespective of managerial brilliance.The most commonly mistaken moats or disguised moats
- Great Products –Can create fantastic short term results. Eg. Fords EcoSport. Great car but this will be replaced soon by other similar offerings in the market. Compare this with PATENTED engine components from BOSCH.
- Strong Market Share
- Pure market share is not a moat. How a company got to being a market leader is more important to understand than just where it stands in marketshare.
- A strong market share is just a competitive advantage.
- Great Execution –It is a great strategy to have a fine execution strategy, but that in itself is not a moat, it is at most a competitive advantage that is not sustainable, unless its is based on a proprietary process that is bug free and cannot be easily copied. e.g. there have been many instances where the Big McD has suffered bad execution despite standardised practices.
- Great Management
- Smart people at the HELM are not sustainable. Sooner or later an idiot may be brought in to run the business.
- Even more important in the Indian scenario as most businesses are family owned and family run.
THE REAL DEAL MOATS
- Regulatory Licenses
These should be the REASON that the company is able to sell its products or services and they should be beyond reach of competition.
Customer Switching Costs
- Addiction to certain flavour like cigarettes
- Very big replacement costs like SAP systems
- This inability for customers to change their minds easily should give the firm PRICING POWER. The high switching costs without pricing power is not really a moat.
- Competition can be locked out for a long time.
- Networks also depend on trust and payments terms which can lead to huge advantages on the Working capital.
- Unique asset or raw material
Learn to differentiate MOATS from COMPETITIVE ADVANTAGES.Greatness is largely a matter of circumstance. Become an expert in identifying these circumstances.Competitive advantages are nice to have and super tempting at times, but, they alone are not enough for prolonged superior returns.
Intangible Asset – Brands
All popular brands are not profitable. Brands cost money to establish and even more money to sustain.A brand allows a company to sell almost the exact, same product at a price way higher than its competition.e.g – Tiffany’s diamonds.On the contrary though Sony is more established a brand than Samsung, sony cannot price way above samsung and still hope to be in business.These brands form formidable economic moats, however lots of brands loose lustre and when you invest in a brand, its extremely important to keep check on whether consumers are happily willing to pay premium price for the same product.Again a brand may be popular, without getting people to fork out extra e.g. Bata.
Intangible Asset – Patents
Patents give you legal protection by completely barring competitors from selling your product.Patent life is always finite. Always check how long it is still valid.Patents are also likely to be challenged i.e they are not irrevocable.When you bet on a company based on a patent, their track record of cranking out patents and their ability to generate money off these patents is utmost importance.Companies with a wide network of patents such as Apple, 3M, Eli Lily etc are generally a better bet than companies who are one patent wonders, much like singers who are one hit wonders. e.g Gangam Style versus say A.R. Rehman.
Intangible Asset – Regulatory Control
A company that can price like a monopoly, without being regulated is a long, deep economic moat.e.g CRISIL -you need a rating before you can raise money from the market.The moat, apart from one large approval can also consist of a whole bunch of mini approvals from various departments or regulators. E.g. for mining licenses.In short – Moats from Intangibles are only ones which:
- Brands – Pricing Power
- Regulatory Approval – Limits Competition
- Patents – Diversified with a history of Innovation
When switching is a royal pain, some companies have a royal gain !Usually boring back-end companies are joined with companies at the hip and companies can find it almost impossible to get rid of them. e.g Ebay’s platform working on Oracle databases. Switching would not only mean transferring all the data seamlessly but alee reworking/ rebuilding all the programs that are based on the db and reattach all the programs to the web.
Where there is LOW TOLERANCE FOR FAILURE, costs advantages are low priority. e.g medical devices, defence equipment, heavy engineering equipment and companies are more willing to pay a little extra and be sure of quality rather than take a change. i.e the risk reward relationship is totally skewed.
Sometime the switching costs themselves are not large, but the benefits are so uncertain that people take the PATH OF LEAST RESISTANCE to simply stay where they are.
Industries with traditionally low switching resistance:
- Packaged Goods companies. They may have good brands, but the switching costs aren’t in a strong position here.
The Network Effect
“Of networks, there will be few!”Network based businesses tend to create natural monopolies and oligopolies.
As dominant networks get bigger, they also get stronger.
Network effect in business models are more likely to be found in businesses based onsharing information or connecting users together rather than in businesses that deal with physical goods.e.g Ebay – traffic and user based ratings,NASDAQ,AMEX – compared to other cards, theirs rewards program is the best, therefore cost/ charges are almost ignored.To benefit from the network effect, the company needs to work in a closed network. i.e if the network is regulated or requires govt clearances, its all the more in favour of the company.The benefits of larger networks are NON-LINEAR. i.e the economic value of the network increases, at a faster rate than the absolute increase in size. indian networks
This moat is not really easy to find, but its worth a lot of investigation when you find it.
Cost matters the most in which Price is a major factor of consumer decision.What one company can invent, the other can always copy, therefor invention ( unless protected ) is more of a first mover advantage.Usually stem from the following:
- Cheaper Processes – more of a competitive advantage rather than a moat as these processes can be implemented by others also.
- Better Locations – sometimes cause mini monopolies. Way more effective than better/cheaper processes.
- Unique Assets – Cheap land/ pre-booked raw materials / resource deposits / forests etc.
- Greater Scale –
- The absolute size of a company matters, much less that the its size relative to its rivals i.e the fish to pond ratio is much more important than the absolute size of the fish.
- The higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be, because the size of benefits are that much greater.
- Scale based cost advantages can further be broken down into
- Distribution –
- In the trucking business, since trucks, salaries and overheads are fixed costs, the larger delivery network and delivery points, the larger the profits.
- A dense ground delivery network has much better returns on capital than an overnight express service as a delivery van only half full is still likely to cover its costs, whereas a half-full cargo with time-sensitive packages likely will not.
- Manufacturing – e.g. china and eastern eurrope low cost pools. However, this is becoming common in the global economy and is becoming less relevant day by day.
- Niche Markets –
- domination of a niche market i.e big fish small pond.
- even by making absolutely mundane products companies with niche market moats can generate fabulous return on capital.
- Distribution –
Signs of Eroding Moats
An early read on weakening / eroding moats can greatly improve your chances of preserving your gains on a successful investment – or cutting your losses on an unsuccessful one.
- Technological Disruption – not of tech companies, but of companies that are enabled by a certain technology. – e.g long distance phone calls, newspapers, music, kodak polaroids, cameras.
- Concentration of customer base – customers gain bargaining power.
- Crazy competition – competition from people looking for something other than money – social causes, ego, emotion or simply regulation.
- Bad Growth – When companies have more money than they need and venture into areas where they have no moat whatsoever, it is better to return that money to shareholders.
It is just easier to build moats in some industries. Stick to them. Life is not fair.
Measure moats on an absolute basis and not on a relative basis. i.e a company could be the one with the deepest moat in an industry, but if the industry itself is a hyper competitive one, its of no use.
Industries with high moats
- health Care Services
- Consumer Services
- Business Services
- Financial Services
- Consumer Goods
- industrial Materials
Management does not matter as much as you think Investing is all about the odds, and a wide moat company managed by an average CEO will give you better odds of long run success than a no-moat company managed by a superstar.Management matters, but within boundaries set by companies’ structural competitive advantages.The best engineers in the world can’t build a 10 storey sand castle
How much to Pay for your Moat –How much you pick up a good stock for is almost as important as how good the stock is.
You need to consider to value your moat
- Risk – likelihood that you estimated future earnings will happen
- Growth – how large are those cash flows
- Capex – what re-investment will be needed to keep the ROCE intact
- Tenure – how long can the company continue to keep making money
Market price is based on
- The Investment Return – earnings, Growth and dividends
- The Speculative Return – Changes in the PE valuation
Hunt for Investment returns, and many times speculative returns will come along as bonus. Hunt for speculative returns and both of them can ditch you.
When and Why to Sell
Assuming you have followed your rules of investing, sell only if you answer yes to anyone of these questions:
- Have you made a mistake in purchasing ?
- Has the company changed for the worse ?
- Is there a better place for your money ?
- Has the stock become too large in our portfolio ?
Other books that Pat Dorsey recommends. ( i dont plan to summarise them, so you better order them 🙂 )
- Why smart people make big money mistakes – and how to correct them by Gary Belsky and Thomas Gilovich
- The Halo Effect by Phil Rosenweig
- Your Money and Your brain by Jason Zweig