Book Summary : The Little Book That Builds Wealth by PAT DORSEY

We all know the significance of books. And still most of us are not able to read books as often as we’d like to. There could be various reasons for that like

  • Which book to read
  • Lack of time and energy
  • Short attention span (due to social media distraction)
  • Boring content

This article or blog will help you with the right summary of good investing books. This is the second book chosen in this series (1st book summary link to “coffee can” is here )

I have tried to compile a summary of a book which needs a detailed study. Although i have tried my best effort to include important points from book but of-course some minute details could have been left behind so that summary should remain summary.

I will recommend you to buy and read this book as i feel this book can act as a reference every single time.

The Little Book That Builds Wealth, where Pat Dorsey, director of stock research for leading independent investment research provider Morningstar, Inc., guides the reader in understanding “economic moats,” learning how to measure them against one another, and selecting the best companies for the very best returns. Pat explains why making investment decisions based on companies’ economic moats is such a smart long-term approach—and, most important, how you can use this approach to build wealth over time. You’ll learn how to identify companies with moats and gain tools for determining how much a stock is worth, all in a very accessible and engaging way.

There are lot of ways to make money in market

  • You can play the Wall Street game, keep a sharp eye on trends, and try to guess which companies will beat earnings estimates each quarter, but you’ll face quite a lot of competition.
  • You can buy strong stocks with bullish chart patterns or super-fast growth, but you’ll run the risk that no buyers will emerge to take the shares off your hands at a higher price.
  • You can buy dirt-cheap stocks with little regard for the quality of the underlying business, but you’ll have to balance the outsize returns in the stocks that bounce back with the losses in those that fade from existence.

or you can simply buy wonderful companies at reasonable prices, and let those companies compound cash over long periods of time.

  • Identify businesses that can generate above-average profits for many years.
  • Wait until the shares of those businesses trade for less than their intrinsic value, and then buy.
  • Hold those shares until either the business deteriorates, the shares become overvalued, or you find a better investment. This holding period should be measured in years, not months.
  • Repeat as necessary.

This Little Book is largely about the first step—finding wonderful businesses with long-term potential. How can you identify companies like these—ones that not only are great today, but are likely to stay great for many years into the future? You ask a deceptively simple question about the companies in which you plan to invest: “What prevents a smart, well-financed competitor from moving in on this company’s turf ? ” To answer this question, look for specific structural characteristics called competitive advantages or economic moats. 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. If you can identify companies that have moats and you can purchase their shares at reasonable prices, you’ll build a portfolio of wonderful businesses that will greatly improve your odds of doing well in the stock market

What’s an Economic Moat, and How Will It Help You Pick Great Stocks?

Economic moats can protect companies from competition, helping them earn more money for a long time, and therefore making them more valuable to an investor. Durable companies—that is, companies that have strong competitive advantages—are more valuable than companies that are at risk of going from hero to zero in a matter of months because they never had much of an advantage over their competition. This is the biggest reason that economic moats should matter to you as an investor: Companies with moats are more valuable than companies without moats.

You can see that returns on capital for the company on the left side—the one with the economic moat—take a long time to slowly slide downward, because the firm is able to keep competitors at bay for a longer time. The no-moat company on the right is subject to much more intense competition, so its returns on capital decline much faster.

Thinking about moats can protect your investment capital in a number of ways. For one thing, it enforces investment discipline, making it less likely that you will overpay for a hot company with a shaky competitive advantage. High returns on capital will always be competed away eventually, and for most companies—and their investors—the regression is fast and painful. Companies with moats also have greater resilience, because firms that can fall back on a structural competitive advantage are more likely to recover from temporary troubles. But if you analyze a company’s moat prior to it becoming cheap—that is, before the headlines change from glowing to groaning—you’ll have more insight into whether the firm’s troubles are temporary or terminal.

Mistaken moats – Great products, great size, great execution, and great management do not create long-term competitive advantages. They’re nice to have, but they’re not enough!!

Focus on moats like intangible assets, customer switching costs, the network effect, and cost advantages.

INTANGIBLE ASSETS” sounds like a grab-bag category for “ competitive advantage, and in some ways it is. On the surface, brands, patents, and regulatory licenses have little in common. But 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. The flip side is that moats based on intangible assets may not be as easy to spot as you think. Brands can lose their luster, patents can be challenged, and licenses can be revoked by the same government that granted them. The best kind of regulatory moat is one created by a number of small-scale rules, rather than one big rule that could be changed.

Companies that make it tough for customers to use a competitors’ product or service create switching costs. If customers are less likely to switch, a company can charge more, which helps maintain high returns on capital. Switching costs come in many flavors—tight integration with a customer’s business, monetary costs, and retraining costs, to name just a few.

Very simple way to understand network effect is the way the network effect helps Microsoft. Lots of people use Word, Office, and Windows because, well—lots of people use Word, Office, and Windows. I hope you get the essence. In fact, there has been an Office competitor called “OpenOffice” on the market for several years, selling for a lot less than Excel and Word—it’s actually free, which is a tough price to beat.But it really hasn’t gained much market share among mainstream businesses because there are some small differences, and since the rest of the world still uses Microsoft Office, people don’t want to bother using a program that produces files they might not be able to share with others. If a product that is pretty good and costs nothing can’t dent a company’s market share, I think you can safely say that company has a competitive advantage. 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.

If a network-based business increases its invested capital by, say, 50 percent to expand its number of nodes from 20 to 30, it increases the number of connections by almost 130 percent, from 190 to 435.

Cost advantages can stem from four sources: cheaper processes, better locations, unique assets, and greater scale.

Process advantages are fascinating because in theory they shouldn’t exist for long enough to constitute much of a competitive advantage. After all, if a company figures out a way to deliver a product or service at a lower cost, *The new Boeing 787 may change this dynamic, as it incorporates a number of technological advances that Airbus has not yet been able to match. Older-model jets will still likely be sold mainly on price, though. wouldn’t the logical step for its competitors be to quickly copy that process so they can match the leader’s cost structure? This generally does happen eventually, but it can take a lot longer than one might expect. It’s worth understanding why that often takes a fair amount of time, during which the originator of the low-cost process can make a lot of money.

A second type of cost advantage stems from having an advantageous location. 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.

A third type of cost advantage that is generally limited to commodity producers is access to a unique, world-class asset. If a company is lucky enough to own a resource deposit with lower extraction costs than any other comparable resource producer, it can often have a competitive advantage.

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.

Size advantage — Bigger Can Be Better, If You Know What You’re Doing. The absolute size of a company matters much less than its size relative to rivals. Two massive firms that dominate an industry—for example, Boeing and Airbus—are unlikely to have meaningful scale- based cost advantages relative to each other. 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 further into three categories: distribution, manufacturing, and niche markets. Although manufacturing scale tends to get all of the attention, 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.

Eroding Moats – I have lost my advantage and I can’t get up!!

Investing would be relatively simple if all we had to do was look for companies with moats, wait for them to trade at reasonable prices, and then lock them away forever to compound capital in competitively advantaged bliss. Sadly, the world is not a static place, which complicates matters considerably.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. This is why it is 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. If you can get an early read on a weakening competitive advantage, you can greatly improve your odds of preserving your gains in a successful investment—or cutting your losses on an unsuccessful one.

Change in technological scene or industrial structure, customer base getting concentrated or entry of new irrational competitor can really cause the moat to go away. Single most common self-inflicted wound to competitive advantage occurs when a company pursues growth in areas where it has no moat.

Also Read : SWOT analysis

Finding Moats and moats worth

It’s easier to create a competitive advantage in some industries than it is in others. Life is not fair . Moats are absolute, not relative. The fourth-best company in a structurally attractive industry may very well have a wider moat than the best company in a brutally competitive industry.

Management matters, but within boundaries set by companies’ structural competitive advantages. No CEO operates in a vacuum, and while great managers can add to the value of a business, management by itself is not a sustainable competitive advantage. Think about it this way: Which is easier to change, the industry a company is in or its managers? The answer, course, is obvious—executives come and go with regularity, but a company in a tough industry is stuck there for good. Investing is all about 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.

Follow few steps to identify companies and work on it

To see if a company has an economic moat, first check its historical track record of generating returns on capital. Strong returns indicate that the company may have a moat, while poor returns point to a lack of competitive advantage—unless the company’s business has changed substantially.

If historical returns on capital are strong, ask yourself how the company will maintain them. Apply the tools of competitive analysis from book, and try to identify a moat. If you can’t identify a specific reason why returns on capital will stay strong, the company likely does not have a moat.

If you can identify a moat, think about how strong it is and how long it will last. Some moats last for decades, while others are less durable.

Even the Best Company Will Hurt Your Portfolio If You Pay Too Much for It.

In valuing companies, we run into two hurdles. First, every company is slightly different, which makes comparisons tough. Growth rates, returns on capital, strength of competitive advantage, and a host of other factors all affect the value of a business, so comparing two companies with each other is likely to be a difficult exercise.

Second, the value of a company is directly tied to its future financial performance, which is unknown, though we can obviously make some educated guesses. For these reasons, most people focus on the information that is easily attainable about stocks (their market prices) rather than the information that is harder to obtain (their business values). That’s the bad news. The good news is that you don’t need to know the precise value of a company before buying its shares. All you need to know is that the current price is lower than the most likely value of the business.

What is a company worth Anyway? Its quite simple –A stock is worth the present value of all the cash it will generate in the future.

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.

Last but not the least. Money is made or saved when you sell your stocks instead of just holding

WHEN to SELL

Ask yourself these questions the next time you think about selling, and if you can’t answer yes to one or more, don’t sell.

• Did I make a mistake?

If you have made a mistake analyzing the company , and your original reason for buying is no longer valid, selling is likely to be your best option.

• Has the company changed for the worse?

It would be great if solid companies never changed, but that’s rarely the case. If the fundamentals of a company change permanently—not temporarily—for the worse, you may want to sell.

• Is there a better place for my money?

The best investors are always looking for the best places for their money. Selling a modestly under- valued stock to fund the purchase of a super cheap stock is a smart strategy. So is selling an overvalued stock and parking the proceeds in cash if there aren’t any attractively priced stocks at the time.

• Has the stock become too large a portion of my portfolio?

Selling a stock when it becomes a huge part of your portfolio can make sense, depending on your risk tolerance

Also read : COFFEE CAN BOOK SUMMARY

In case you have any questions/ queries, please feel free to reach me through Contact Form

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Enjoy the day and your life. Don’t forget, we are alone in this grand universe and may not get a chance to live again.

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