The Little Book That Builds Wealth | The Knockout Formula For Finding Great Investments by Pat Dorsey

Brief Summary

Pat Dorsey was the Director for equity research at Morningstar from 2000 to 2011. He now heads Dorsey Asset Management. Dorsey introduces his investment philosophy especially around moats that are durable. A company with a moat adds long-term value because it helps them stay valuable for a longer time. Dorsey categorizes moats into four different types—intangible assets, customer switching cost, network effect and cost advantages. This is an excellent book for anyone interested in value investing around sustainable moats.

Big Ideas

• Buying a share of stock means that you own a really tiny piece of the business.
• The value of a business is equal to all the cash it will generate in the future.
• A business that can profitably generate cash for a long time is worth more today than a business that may be profitable only for a short time.
• Return on capital is the best way to judge a company’s profitability. It measures how good a company is at taking investors’ money and generating a return on it.
• 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.
• 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’re nice to have, but they’re not enough.
• The four sources of structural competitive advantage are intangible assets, customer switching costs, the network effect, and cost advantages. If you can find a company with solid returns on capital and one of these characteristics, you’ve likely found a company with a moat.
• Popular brands aren’t always profitable brands. If a brand doesn’t entice consumers to pay more, it may not create a competitive advantage.
• Patents are wonderful to have, but patent lawyers are not poor. Legal challenges are the biggest risk to a patent moat.
• Regulations can limit competition—isn’t it great when the government does something nice for you? 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.
• Your bank makes a lot of money from switching costs.
• A company benefits from the network effect when the value of its product or service increases with the number of users. Credit cards, online auctions, and some financial exchanges are good examples.
• The network effect is an extremely powerful type of competitive advantage, and it is most often found in businesses based on sharing information or connecting users together. You don’t see it much in businesses that deal in physical goods.
• Cost advantages matter most in industries where price is a big part of the customer’s purchase decision. Thinking about whether a product or service has an easily available substitute will steer you to industries in which cost advantages can create moats.
• Cheaper processes, better locations, and unique resources can all create cost advantages—but keep a close eye on process-based advantages. What one company can invent, another can copy.
• Being a big fish in a small pond is much better than being a bigger fish in a bigger pond. Focus on the fish-to-pond ratio, not the absolute size of the fish.
• Delivering fish more cheaply than anyone else can be pretty profitable. So can delivering other stuff.
• Scale economies have nothing to do with the skin on a fish, but they can create durable competitive advantages.
• Technological change can destroy competitive advantages, but this is a bigger worry for companies that are enabled by technology than it is for companies that sell technology, because the effects can be more unexpected.
• If a company’s customer base becomes more concentrated, or if a competitor has goals other than making money, the moat may be in danger.
• Growth is not always good. It’s better for a company to make lots of money doing what it is good at, and give the excess back to shareholders, than it is to throw the excess profits at a questionable line of business with no moat. Microsoft could get away with it, but most companies can’t.
• 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.
• Bet on the horse, not the jockey. Management matters, but far less than moats.
• 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.
• 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, 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.
• A company’s value is equal to all the cash it will generate in the future. That’s it.
• The four most important factors that affect the valuation of any company are how much cash it will generate (growth), the certainty attached to those estimated cash flows (risk), the amount of investment needed to run the business (return on capital), and the amount of time the company can keep competitors at bay (economic moat).
• Buying stocks with low valuations helps insulate you from the market’s whims, because it ties your future investment returns more tightly to the financial performance of the company.
• The price-to-sales ratio is most useful for companies that are temporarily unprofitable or are posting lower profit margins than they could. If a company with the potential for better margins has a very low price-to-sales ratio, you might have a cheap stock in your sights.
• The price-to-book ratio is most useful for financial services firms, because the book value of these companies more closely reflects the actual tangible value of their business. Be wary of extremely low price-to-book ratios, because they can indicate that the book value may be questionable.
• Always be aware of which “E” is being used for a P/E ratio, because forecasts don’t always come true. The best “E” to use is your own: Look at how the company has performed in good times and bad, think about whether the future will be a lot better or worse than the past, and come up with your own estimate of how much the company could earn in an average year.
• Ratios of price to cash flow can help you spot companies that spit out lots of cash relative to earnings. It is best for companies that get cash up front, but it can overstate profitability for companies with lots of hard assets that depreciate and will need to be replaced someday.
• Yield-based valuations are useful because you can compare the results directly with alternative investments, like bonds.
• 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.
• 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.
• The best investors are always looking for the best places for their money. Selling a modestly undervalued 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.
• Selling a stock when it becomes a huge part of your portfolio can make sense, depending on your risk tolerance.
• Best way to determine a company's profitability is to look at the amount of profit the company is generating relative to the amount of money invested in the business (ROE, ROA, ROIC).
  • Return on assets (ROA) of 7%+ is a good sign of a competitive advantage
  • Return on equity (ROE) of 15%+ a healthy sign
  • Return on invested capital (ROIC) of 15%+ is a healthy sign
• Moat Process:
  • Has the firm historically generated solid ROE, ROA, ROIC?
  • (If step 1 is a yes) Does the firm have one or more of the competitive advantages discussed?
  • (If step 2 is a yes) How strong is the company's competitive advantage? Is it likely to last a long or short time?
    • Short = narrow moat
    • Long = wide moat
• A stock is worth the present value of all the cash it will generate in the future (Free Cash Flow or owner earnings).
• Most important concepts behind valuation
  • Risk: how likely the estimated future FCF will actually materialize
  • Growth: how large those cash flows will likely be
  • ROIC: how much investment will be needed to keep the business going
  • Moat: how long the business can generate excess profits
• Over time, only two things can push a stock's price—the investment return (earnings + dividend) and speculative return (change in P/E ratio)
• Tools for valuation:
  • Price-to-sales (P/S): most useful for companies that have temporarily depressed margins
  • Price-to-book (P/B): compares market price with its book value, useful for financial services companies
  • Be cautious about goodwill as it can distort the value
  • Price-to-earnings (P/E): earnings a decent proxy for value-creating cash flow, look at how company's P/E has fared in good times and bad and think about how company's future looks
  • Price-to-cash-flow (P/CF): shows how much cash is flowing in and out of a business (less manipulated than earnings)
  • Cash return: FCF (cash flow from operations - capex) + net interest expense (interest expense - interest income) / enterprise value (market cap + long-term debt - cash)

Quotes

• Unless a company has an economic moat protecting its business, competition will soon arrive on its doorstep and eat away at its profits. Wall Street is littered with the dead husks of companies that went from hero to zero in a heartbeat.
• Even the best company will hurt your portfolio if you pay too much for it.
• 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
• The best engineer in the world can’t build a 10-story sandcastle.
• I would argue strongly that reading about companies will add infinitely more value to your investment process than will reading about short-term market movements, macroeconomic trends, or interest-rate forecasts. One annual report is worth 10 speeches by a Federal Reserve chairman.
• Once you’ve made these publications part of your investment diet, move on to books about—and by—successful money managers.
• 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 trick is to always stay focused on the future performance of the business, not the past performance of the shares.
• Remember that sometimes the better place for your money may very well be cash.
• If you’ve had a screaming success with an investment and its market value has grown to make up a big chunk of your portfolio, it may make sense to dial down the risk and shrink the position.
• Selling just because a stock price has dropped makes absolutely no sense whatsoever, unless the value of the business has declined as well. Conversely, selling just because a stock has skyrocketed makes no sense, unless the value of the business has not increased in tandem.
• Ask any professional investor what he or she thinks is the hardest part of investing, and most will tell you that knowing when to sell ranks up there near the top—if not right at the top.