The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments

This is a remarkably pithy discussion on what constitutes a "real" moat - competitive advantage that is sustainable. Regular readers/subscribers(like myself)of Morningstar products are already familiar with Morningstar's views on the importance of picking companies with moats for long term investing. This book essentially distills all such discussions into a very quick guide on "how to find good investments that can build wealth?". The use of excellent examples and a very down-to-earth (typical of the Little book series) discussion style makes this book an easy and useful read. Prospective readers need to be warned on two aspects - unlike the other books in the series (value investing, growth investing, etc.) this book doesn't have a specific "formula" but more a discipline on stock selection. (to borrow a cliche'd expression, the book aims to provide a method to fish than a fish itself). Secondly, regular Morningstar readers will be hard pressed to find anything new in these discussions in this book. For them, [[ASIN:0471686174 The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market]] may be more useful. For readers just being introduced to Morningstar and its approach, both books are solid additions to a patient investor's library. You can round out that collection with [[ASIN:0470125128 The Ultimate Dividend Playbook: Income, Insight and Independence for Today's Investor]].

Overall, an easy read that gives very worthwhile discussion on identifying companies with sustainable advantage (and how to identify traps in perceiving incorrectly the existence of such an advantage).

The Little Book That Builds Wealth teaches an investment strategy that focuses on long-term investments in companies with enduring competitive advantages. Packed with examples of real companies, this book teaches the reader how to invest wisely rather than speculate.

Key Points

Companies have competitive advantages, or “economic moats,” which enable them to create steady shareholder value. Find one or more of these moats, and you’ve found a company that could be a good long-term investment.

Economics moats come in four basic forms:

1) Intangible Assets
Think enduring brands, patents, and regulatory licenses. All are difficult for competitors to replicate.

2) High Switching Costs
When it is difficult for customers to switch from one company to another. For example, consider the hassle it takes to switch banks—that makes for a “sticky” customer.

3) Huge Networks
When the value of a product or service grows with the number of customers. Microsoft is a great example: “Lots of people use Word, Office, and Windows because, well,--lots of people use Word, Office and Windows.”

4) Cost Advantages
Sustainable lower input costs than competitors. A great example is companies in central locations. Compared to companies that are further away from potential customers, their shipping costs are lower, and likely always will be.

There are also some common false economic moats. Don’t be fooled by these!

False Moats
1) Great Products – these are easily copied by the competition.
2) High Market Share – Market leadership can shift quickly in highly competitive industries.
3) Efficient Operations – also easily copied.
4) A Great Leadership Team – Studies show management simply doesn’t have much of an effect on a company’s performance. As Dorsey says, “The best engineer in the world can’t build a 10-story sandcastle. The raw materials just aren’t there.”

Action Steps

First, keep your eyes peeled. In your daily life, take notice of companies that may have economic moats. Listen to the news, read magazines, and look into companies that look interesting. Check the companies’ balance sheets, and look for evidence of moats in high profits and high returns on investments.

Once you find a company that has one or more economic moats, then you watch it until you think it is undervalued at its current price. Then you pounce!

But wait! How do you know when it is undervalued? (Good question!) That topic is a little beyond the scope of this review, but Dorsey offers a few easy steps to follow to get a feel for when a company is selling for less than what it’s probably worth. His strategy stresses that you don’t have to know the future. He gives some simple tools for evaluating the investment return of a stock (the earnings growth or dividends of that stock), and speculative growth (driven by expectations of other investors moving the stock price up or down.) It’s not the entire financial picture of a company, but it’s a very useful starting point and probably sufficient for most new investors.

My Take

If you’re toying with the idea of investing in individual stocks, this is a great book to start with. Individual stock investing is thrilling and scary, and a great blueprint when you start out can make a world of difference. I myself used this book when my husband and I first started buying stocks, and it gave me a handy framework to apply to each company we were considering.

I also love that Dorsey is so honest about how most people find companies—when he shows examples of looking for moats, he starts with five companies that he observed through real life or happened to hear mentioned on the news or in money magazines.

Pat Dorsey's Little Book That Builds Wealth really is a big book that contributes volumes to the investment universe. Overlaying Pat's explanation of the different types of moats on Warren Buffett's portfolio helps the professional and the private investor understand the very important investment moat principles. Coke is a brand or intangible asset moat. Wells Fargo is a switching cost moat. American Express is a network effect moat. And although no longer publicly traded and now a wholly owned subsidiary of Berkshire Hathaway, GEICO is a cost advantage moat. This little book is a must read for every participant of the stock market."
-- Robert P. Miles, author The Warren Buffett CEO

Warren Buffett has four main principles for investing in businesses. They need to be within his circle of competence, run by good management, have good long-term prospects and be available at a fair price. The little book that creates wealth gives the investor some well needed filters for how to think about good long-term prospects. In order to achieve high returns over the long term the business needs to have some type of competitive advantage or in Buffet terms, moat. A book that is most often recommended for readers who want to understand the concept of a moat is Michael Porter’s book Competitive Advantage. However, this is a book for corporate managers. Dorsey wanted to write a book for investors and it doesn't disappoint.

Pat Dorsey has had a long career at Morningstar where he was Director of Equity Research and where he was one of the main contributors to the firm’s economic moat ratings. Morningstar follows businesses and rank them in terms of the strength of the moat and an ETF has even been created to track these businesses. For a long-term investor that wants to create wealth without having to continuously find new investment opportunities the business then needs to have some kind of moat. Munger refers to this as "sit on your ass investing" in his usual witty way.

Businesses that are undervalued for the short term may give the investor gains but the challenge is that these gains need to be re-invested, causing the need for continuously making good stock picks. It takes time to find good investments, meaning that it's important to benefit from the opportunities that come up. Having a large analyst team makes it possible to analyze a broad set of companies leading to a higher chance of finding continuously good opportunities. This might be harder for the individual investor.

Dorsey divides moats into four categories: intangibles (brand, patents, licenses), switching costs, network effects and economies of scale. The moat can either be strong, wide moat, or weak, narrow moat. It's rather self-explanatory that a business can't be prosperous over the long term without having some kind of advantage against the competitors. A business may have a patent that shuts out the competition for a set period of time or it may have a brand that enables the business to set a price that is above the cost of production. Some businesses have historically had a high degree of customer retention meaning that the switching costs are high. A typical example of a business with high switching costs are banks. An example of a business with high network effects is Facebook where existing users benefit from having more users on the platform. Interestingly, Dorsey explained during a presentation that it's not always a benefit for a company to have all or many types of moats; a really wide moat in any of the categories may well be better.

The book is focused on the US in terms of the majority of businesses examples that is brought up and especially in terms of how to think about taxation which disturbs the flow a bit for a non-US investor. A topic in the book where value investors often have different opinions is about moat versus management. Dorsey is of the view that moat is more important and uses the quote from Buffett: "When a 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".

I tend to agree with this as there are so many examples of great managers working in tough industries without being able to create sustainable high returns on capital. However, I would also like to emphasize that an excellent manager may well create a corporate culture that could work as a moat in certain instances and through this achieve extraordinary results in highly competitive industries.

For investors who want to understand the concept of moats this book is a great start. It's short but packed with insights and I have already started to benefit from the book in terms of how I think about barriers to enter an industry. I didn't pick that up the first time I read Porter's Competitive Advantages which is why I have to give a lot of credit to Pat Dorsey for helping me to grasp this important concept better. If the concept of moats isn’t part of your set of mental models yet, then begin with reading this book.

This is a review by investingbythebooks.com

Warren Buffett coined the term moat which represents a competitive advantage that a company can possess over its competitors. Pat Dorsey did a great job explaining what a moat is and categorized it into four categories: Intangible Assets, Switching Costs, Network Effect, and Cost Advantages. Whenever I talk to a potential client or give a seminar on investing, I always talk about moats stemming from four sources that Mr. Dorsey explained. I absolutely loved this book.

- Mariusz Skonieczny, author of [[ASIN:0615287484 Why Are We So Clueless about the Stock Market? Learn how to invest your money, how to pick stocks, and how to make money in the stock market]]

This is a quick, easily comprehensible, read to understand the philosophy of Morningstar's analysis approach and fundamental investment thesis. Well worth the money.

Would absolutely recommend this book to any one interested in value investing & basics of understanding the business.
I would also recommend this seller. Very good condition of the book & on time delivery. Would give it 5stars.

A book that fulfilled my expectations. Put the quality in front of the numbers and gave me specific methodology to look through companies choosing those that are more important to those that are just part of the crowd. I believe that I read through business articles with a different set of glasses and see them through a different prism.

This book gives you an excellent framework to choose not only how to invest in companies, but choosing stable companies to work for. Very good.

Everyone who cares for money, professionally or personally should read this little book.