Book Review : The Little Book that Builds Wealth
Summary: The Little Book That Builds Wealth
Chapter One – Economic Moats
The book opens by defining the concept of a moat. In a nutshell, a moat is a significant competitive advantage that one company has over another. The great example used in this chapter is McDonalds – in 2002 and 2003, Mickey D’s caught a lot of bad press because of their poor customer service and perceived slipping food quality. For a restaurant chain without a huge moat, this could have been devastating – for example, look at the implosion of the Little Sambo’s chain in the 1970s, which went from 1,200 restaurants to one in less than a decade.
However, McDonalds had some very important moats that gave them time to survive and retool a bit – they had a globally recognizable brand and strong customer loyalty. Those provided a nice moat for McDonalds to keep the competitors from attacking too fiercely and gave the company time to fix their problems and rebound.
Chapter Four – Switching Costs
Dorsey’s style is perhaps not as fancy as others, but he still gets the point across.
Shuchi.P.Nahar
Warren Buffett mentions moats all the time in his talks and writings and emphasizes the importance of finding a company with moats.
It remains one of the more concise and enlightening books for investors looking for great businesses that stand the test of time - historically, the kind of investments that return their worth many times over.
The Little Book That Builds Wealth is the fifth book in the Little Books series from Wiley Publishing, each of which focuses in on describing a particular investing strategy in layman’s terms.
This time around, the focus is on competitive advantage, or “moats” – the basic idea that Warren Buffett uses when investing.
Chapter One – Economic Moats
The book opens by defining the concept of a moat. In a nutshell, a moat is a significant competitive advantage that one company has over another. The great example used in this chapter is McDonalds – in 2002 and 2003, Mickey D’s caught a lot of bad press because of their poor customer service and perceived slipping food quality. For a restaurant chain without a huge moat, this could have been devastating – for example, look at the implosion of the Little Sambo’s chain in the 1970s, which went from 1,200 restaurants to one in less than a decade.
However, McDonalds had some very important moats that gave them time to survive and retool a bit – they had a globally recognizable brand and strong customer loyalty. Those provided a nice moat for McDonalds to keep the competitors from attacking too fiercely and gave the company time to fix their problems and rebound.
Chapter Two – Mistaken Moats
From that explanation, it’s easy to visualize moats for almost any company. Any company with any size is doing something right, and it’s easy to confuse immediate success with competitive advantage. However, quick success usually has very little to do with true competitive advantage.
Take Tommy Hilfiger, for example. Once, it seemed they were building a globally competitive brand – but now you can find Tommy clothes on discount racks.
The dot-com busts like pet.com are in the same boat – they seemed to have a competitive advantage because of the internet, but it was a mistaken advantage.
There are really only four sources of true competitive advantage: intangible assets (like patents or licenses), customer switching costs (meaning it’s hard for a customer to give up that specific product – think Microsoft), network economics (like an ingrained shipping network), and cost advantages (control over some method of making the product cheaper than competitors are able to).
A company with at least one of these and a nice return on capital is a good one to invest in.
Chapter Three – Intangible Assets
Intangible assets are those that don’t have physical form but do produce value. For example, a brand strong enough that people will pay a premium price for it.
Take Starbucks– if you buy an item from starbucks, you’re going to pay a significant premium for that 250ml cup of coffee, yet the company is consistently able to charge premium prices and customers are willing to pay it.
On the other hand, look at Cafe Coffee Day – their brand is valuable, but people are quite often willing to choose an identical item with a different brand on it (doesn't matter if you have your coffee from Mc Cafe or Dunkin' Donuts). Patents and regulations are also good moats, but the most valuable ones are those that are composed of lots of small patents and regulations, not a few big ones.
From that explanation, it’s easy to visualize moats for almost any company. Any company with any size is doing something right, and it’s easy to confuse immediate success with competitive advantage. However, quick success usually has very little to do with true competitive advantage.
The dot-com busts like pet.com are in the same boat – they seemed to have a competitive advantage because of the internet, but it was a mistaken advantage.
There are really only four sources of true competitive advantage: intangible assets (like patents or licenses), customer switching costs (meaning it’s hard for a customer to give up that specific product – think Microsoft), network economics (like an ingrained shipping network), and cost advantages (control over some method of making the product cheaper than competitors are able to).
A company with at least one of these and a nice return on capital is a good one to invest in.
Chapter Three – Intangible Assets
Take Starbucks– if you buy an item from starbucks, you’re going to pay a significant premium for that 250ml cup of coffee, yet the company is consistently able to charge premium prices and customers are willing to pay it.
On the other hand, look at Cafe Coffee Day – their brand is valuable, but people are quite often willing to choose an identical item with a different brand on it (doesn't matter if you have your coffee from Mc Cafe or Dunkin' Donuts). Patents and regulations are also good moats, but the most valuable ones are those that are composed of lots of small patents and regulations, not a few big ones.
Chapter Four – Switching Costs
A person who is a Apple I-phone user. They know how to use the program quite well and They also know that they are frustrated when they attempt to use other Android or Micro-soft versions of handsets.
So this is a large intangible switching cost for abandoning Apple I-phone, and people are loathe to pay that cost. This is a clear-cut example of a moat – Apple can charge a high price for I-phone because many other I-phone folks are habituated in it and it’s difficult to switch. Lots of businesses have moats along these lines – banks, software vendors, and so on.
So this is a large intangible switching cost for abandoning Apple I-phone, and people are loathe to pay that cost. This is a clear-cut example of a moat – Apple can charge a high price for I-phone because many other I-phone folks are habituated in it and it’s difficult to switch. Lots of businesses have moats along these lines – banks, software vendors, and so on.
Chapter Five – The Network Effect
Any company that has an already-running distribution network for their product, like Coca-Cola, has this type of moat.
Because of the cost and effort in getting a distribution network set up – and often the challenge of fighting through distribution agreements – a pre-existing distribution network can be a huge moat.
It is this reason why it is almost impossible for another large-scale beverage company to independently become as large as Carlsberg or Pepsi – they can’t afford the costs of distribution. A similar logic occurs with internet companies – they use the internet as their network and reduce brick and mortar costs that way.
Chapter Six – Cost Advantages
Any company that has an already-running distribution network for their product, like Coca-Cola, has this type of moat.
Because of the cost and effort in getting a distribution network set up – and often the challenge of fighting through distribution agreements – a pre-existing distribution network can be a huge moat.
It is this reason why it is almost impossible for another large-scale beverage company to independently become as large as Carlsberg or Pepsi – they can’t afford the costs of distribution. A similar logic occurs with internet companies – they use the internet as their network and reduce brick and mortar costs that way.
Chapter Six – Cost Advantages
Cost advantages come in the form of better locations, better access to resources, and better processes. All of these allow a company to cut costs in ways that their competitors cannot.
However, some cost advantages are stronger than others – for example, another company can easily copy the cost advantage of a process, while they can’t easily copy the advantages that a maple syrup company from mapro garden would have in a mapro gardens of fruit pulps.
However, some cost advantages are stronger than others – for example, another company can easily copy the cost advantage of a process, while they can’t easily copy the advantages that a maple syrup company from mapro garden would have in a mapro gardens of fruit pulps.
Chapter Seven – The Size Advantage
Larger companies simply have a natural advantage over smaller ones. They can execute their plans on scales much larger than the smaller companies and because of their size find efficiencies and discounts unavailable to smaller groups.
They can use their size as leverage, promising plenty of business to suppliers in exchange for exclusivity, for example. They can also find efficiencies in processes that smaller companies can’t, like having a person devoted to one tiny nuance of the production while other companies must multitask their workers. Thus, large companies often have an inherent moat, albeit one that can be superseded by other companies over time.
Example: Mondelez (It's subsidiary Cadbury has wide range of product base catering to all the generations , following Nestle ,MARS, etc)
Larger companies simply have a natural advantage over smaller ones. They can execute their plans on scales much larger than the smaller companies and because of their size find efficiencies and discounts unavailable to smaller groups.
Example: Mondelez (It's subsidiary Cadbury has wide range of product base catering to all the generations , following Nestle ,MARS, etc)
Chapter Eight – Eroding Moats
Obviously, moats can erode over time. One of the biggest factors in moat erosion is technological change. When a new technology arrives on the scene, particularly one that has the potential to change that market significantly, there’s usually a big opportunity for a competitor to severely erode the moat of another company.
Similarly, when a company with a moat begins to make bad decisions, they cause their own moat to erode – think of the earlier Kodak Camera example.
Obviously, moats can erode over time. One of the biggest factors in moat erosion is technological change. When a new technology arrives on the scene, particularly one that has the potential to change that market significantly, there’s usually a big opportunity for a competitor to severely erode the moat of another company.
Chapter Nine – Finding Moats
There is no true sure-fire way to find a moat. You have to investigate the business, see how they operate, and then see if they have anything that might be construed as a true moat. Some industries have many companies with moats; others have basically none. Your only true recipe for success is learning how a company really operates, and that takes some research.
There is no true sure-fire way to find a moat. You have to investigate the business, see how they operate, and then see if they have anything that might be construed as a true moat. Some industries have many companies with moats; others have basically none. Your only true recipe for success is learning how a company really operates, and that takes some research.
Chapter Ten – The Big Boss
Many investment strategies put a lot of importance on the leadership of a company. However, Dorsey makes it quite clear that moats and leadership have little to do with each other.
A great leader is not a moat, and a truly great leader cannot usually create a moat, either. On the other hand, even a merely average CEO will not erode an existing moat. Thus, if you’re looking at competitive advantage as a reason to invest, don’t spend much time worrying about the CEO – worry about the business itself.
Many investment strategies put a lot of importance on the leadership of a company. However, Dorsey makes it quite clear that moats and leadership have little to do with each other.
A great leader is not a moat, and a truly great leader cannot usually create a moat, either. On the other hand, even a merely average CEO will not erode an existing moat. Thus, if you’re looking at competitive advantage as a reason to invest, don’t spend much time worrying about the CEO – worry about the business itself.
Chapter Eleven – Where the Rubber Meets the Road
There is one strong way of finding companies that might potentially have a moat, although it’s not a sure indicator: long-term return on capital. Dig into online research tools like Yahoo! Finance and take a look at a company’s return on capital, especially compared to competitors.
Is it substantially higher than the competitors? If so, that company may in fact have a moat, and it’s worth your time to start digging into information about the company to see if you can identify their moat.
There is one strong way of finding companies that might potentially have a moat, although it’s not a sure indicator: long-term return on capital. Dig into online research tools like Yahoo! Finance and take a look at a company’s return on capital, especially compared to competitors.
Is it substantially higher than the competitors? If so, that company may in fact have a moat, and it’s worth your time to start digging into information about the company to see if you can identify their moat.
Chapter Twelve – What’s a Moat Worth?
This chapter is basically an argument for value investing. In other words, a company with a great moat can still be overvalued.
Rather than offering an exact recipe for the value of a moat, Dorsey instead suggests looking for companies that are reasonable values to begin with (using factors like a low P/E ratio) and then identifying from among those which ones have moats.
This chapter is basically an argument for value investing. In other words, a company with a great moat can still be overvalued.
Rather than offering an exact recipe for the value of a moat, Dorsey instead suggests looking for companies that are reasonable values to begin with (using factors like a low P/E ratio) and then identifying from among those which ones have moats.
Chapter Thirteen – Tools for Valuation
Dorsey recommends looking at the price-to-sales ratio as well as the price-to-book ratio. The P/S is particularly useful for companies that are temporarily unprofitable, while P/B is great for companies that offer services, particularly financial service firms.
P/E (price-to-earnings) is a good general indicator, but make sure that you study this one over the long term in order to minimize the fluctuations in the economy.
Dorsey recommends looking at the price-to-sales ratio as well as the price-to-book ratio. The P/S is particularly useful for companies that are temporarily unprofitable, while P/B is great for companies that offer services, particularly financial service firms.
P/E (price-to-earnings) is a good general indicator, but make sure that you study this one over the long term in order to minimize the fluctuations in the economy.
Chapter Fourteen – When to Sell
Homework, homework, homework!
Moat-based investing isn’t for people who don’t want to put in the time to do some homework. Basically, if you buy a company’s stock, you should have a specific reason for doing so.
When that reason changes or goes away, that’s the time to sell. Better yet, that specific reason should have nothing whatsoever to do with what other people are doing in terms of buying and selling – if your reason for investing still exists, you shouldn’t sell it just because the herd is panicking because of a down market.
Homework, homework, homework!
Moat-based investing isn’t for people who don’t want to put in the time to do some homework. Basically, if you buy a company’s stock, you should have a specific reason for doing so.
When that reason changes or goes away, that’s the time to sell. Better yet, that specific reason should have nothing whatsoever to do with what other people are doing in terms of buying and selling – if your reason for investing still exists, you shouldn’t sell it just because the herd is panicking because of a down market.
Buy or Don’t Buy
Much like the other entries in the Little Books series, The Little Book That Builds Wealth is a strong introduction to a particular investment strategy.
Dorsey’s style is perhaps not as fancy as others, but he still gets the point across.
If you’ve ever wanted a good introduction into the model of investing that Warren Buffett uses, this is a very good place to start.
Dorsey lays it out in a very approachable way and offers up enough concrete examples that anyone can actually see the principles at work.
Dorsey lays it out in a very approachable way and offers up enough concrete examples that anyone can actually see the principles at work.
Conclusion
Finding an investment with a wide moat at a good price requires in-depth analysis before a company becomes a good buy. Dorsey recommends regularly reading the business press and articles by successful money managers. The Little Book That Builds Wealth abounds with processes, tools and examples. It even gives guidelines on when to sell. Anyone who can find the time, discipline and patience to conduct the considerable research described in this “little” book could select high-performing, long-range investments.
Shuchi.P.Nahar
Shuchi.P.Nahar
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