The Little Book that Builds Wealth – Pat Dorsey

What does it mean for a company to have a moat? What are the key drivers to valuation? Pat Dorsey will use examples to shed light on these, and more questions.

“All of the information is in the past, but all of the value is in the future”

Beating the Odds

  • Small minority of companies that enjoy high return on capital
  • They do this by creating competitive advantages or economic moats
  • Without moats, competition destroy returns

Moats Basics

  • Structural + sustainable qualities that are inherent to business (not hot products, cool tech, or largest market share)
  • Generally manifest in pricing power (companies that can’t raise prices is unlikely to have a strong moat)
  • Moats add intrinsic value: firm that can compound cash flow for many years is worth more than a firm which can’t

Moats Criteria’s

  • Intangible Assets (Brand, Patents, Licenses/Approvals) => results are price premiums or lower marketing costs
  • Switching Costs: Does the cost of switching to a competing product or service outweigh the benefits (integration with cx business, sell on-going service relationships, provide product with high benefit/cost ratio)
  • Network Effect: provide a service that increase in value as the numbers of users expands. Not about the number of connections, the how often are those connections used.
  • Cost Advantages: Process, scale or niche

Moats in a Global Context

  • Local differences (e.g., Foreign countries cannot own Canadian Banks)
  • Minimum Efficient Scale
  • Cultural preferences create barrier to entry

Widening the Moat: Brands

  • Can delivery a consistent or aspirational experience
  • Consistently lowers search cost and drive loyalty
  • Aspiration increases willingness to pay, so create scarcity and exclusivity

Managers

  • Managers only matter in the context of the moat. Level of managerial skill is inversely related to the quality of the business (bad business => better have a great manager, great business => genius not needed
  • Good managers look for ways to widen moats (Amazon focus on customer experience)
  • Bad managers invest capital outside a company’s moat, lowering overall ROIC

Valuing Moats

  • Ability to reinvest tons of cash at a high incremental ROIC = a very valuable moat
  • If firm has limited ability to reinvest, moat adds little to intrinsic value
  • Overestimating moats means paying for value creation that never materialize
  • Underestimating moats means paying a large opportunity cost
  • Quantitative data is efficiently priced
  • Qualitative insight is less efficiently priced

Other Notes

  • Capitalism seeks the highest return possible => high profits attract competition
  • Most business with high returns will see returns decrease overtime
  • Conducted research looking back 50 years on businesses that had return on capital > cost of capital for 15 years+
  • Do a value map to see where the money is made to see where to invest
  • When looking at emerging companies look at: Opportunity (how big can this company get), Variable Cost, Fixed Cost