- Pat Dorsey's Little Book That Builds Wealth is the ultimate guide to understanding economic moats
- More than a decade from its publishing, investors can learn a lot
Investing is hard. As with other pursuits, it can be helpful to be guided by a few tested rules of thumb. Writers, for example, often rely on George Orwell’s famous six rules. We are told to replace long words when short words will suffice, and to avoid jargon. Some investors may well agree with Orwell’s fourth rule, in particular: “Never use the passive when you can use the active”.
It’s unfair to directly liken Pat Dorsey’s The Little Book That Builds Wealth to a short shopping list of tips. In his book, Mr Dorsey, who runs an eponymous asset management firm in the US, sets out four kinds of ‘economic moat’, as well as identifying mistaken moats and explaining valuation techniques. Much has changed for the companies within this book, such as Microsoft (US:MSFT), since it was first published in 2008. But its simplicity and brevity give it its own edge over other investment tomes.
The coronavirus pandemic has rolled back years of growth and stock market gains, exposing bad companies and separating the weak from the strong. So there’s hardly been a more pressing time for investors to identify companies with wide economic moats.
What is a moat?
The term 'economic moat' was coined by Warren Buffett, who has used the concept in his annual letters to shareholders to explain and justify his investments. Put simply, a moat is a characteristic that helps protect a company from competitors. The wider the moat, the better.
Shares bought in companies with economic moats entitle shareholders to cash flows that are protected from competitors. Companies with competitive advantages, such as robust intellectual property, will find it easier to reinvest future cash flows at a higher rate of return in the long run than those without this edge. By contrast, companies without moats will be vulnerable to competitors.
But, as Mr Dorsey warns, some positive traits in a company can be mistaken for wide economic moats. A good product will not protect returns if the business is unable to prevent it from being imitated or ensure customers cannot easily move to a rival. A revered chief executive will only be able to drum up so much enthusiasm for a stock before competitors expose their company’s lack of genuine moats.
“High returns on capital will always be competed away eventually,” Pat Dorsey accepts. Considering economic moats therefore encourages investors to maintain their discipline, ensuring that they don't get caught up in red-hot stocks that lack sure foundations and adequate competitive shields.
Which companies have moats?
The book cites coverage from Pat Dorsey’s former parish, Morningstar, which breaks out sectors with wide and narrow economic moats. Financial services, utilities and media businesses have a lot of moats, unlike hardware and industrial markets, which are considered more vulnerable to competitors.
Pharmaceutical companies are prime examples of businesses that benefit from ring fencing their intangible assets. In its annual report, GlaxoSmithKline (GSK) emphasises the importance of strong intellectual property protection. “Once IP protection expires, or if challenges to a patent are upheld, generic competitors can rapidly capture a large share of the market,” the company warns.
Given the current climate, it’s perhaps worth noting that there is less importance placed on IP concerning vaccines, owing to the high levels of investment needed to engineer products that can meet regulatory requirements. Biotech shares have oscillated during the pandemic as expectations fluctuate over the potential arrival of a vaccine. But companies will struggle to achieve sufficient scale in a short period and compete with giants like GSK. Unless upstarts can quickly ring fence any potential cure, any stock market excitement is unlikely to last.
Banks, utility and some software companies, meanwhile, are heavily associated with high switching costs. Exit fees, and laborious switching processes, are used to dissuade customers from changing providers. Pat Dorsey highlights Adobe (US:ADBE) as a business that has used switching costs to engineer a moat. The company’s complex software is taught to so many designers that the cost of switching and retraining personnel would be prohibitive. Adobe’s returns on capital employed reached 25 per cent in 2019, up from 10 per cent four years previously.
The value of Adobe’s service arguably increases with the number of people that use it, creating a healthy network that is protected against competition. The same goes for Microsoft and Facebook (US:FB), two technology giants whose core offerings have survived onslaught from competing products that were unable to win over enough users. For example, the value of Microsoft's Office suite means rival Apple (US:AAPL) has not converted consumers en masse from Excel to Numbers. But Facebook’s monthly active user count has steadily increased since its inception, sitting at 2.7bn at the end of this year’s second quarter, according to Statista. Remember Myspace?
Commodities businesses, which might have exclusive access to a particular mine or resource, will be able to exploit this position and extract significant margins from this moat.
How to use The Little Book That Builds Wealth
Pat Dorsey sets out a simple process for applying his framework of economic moats, as shown below.
The book is a simple but effective guide to identifying companies with high returns. As with all guides it is not entirely prescriptive. Pat Dorsey advises his followers to read widely, “one annual report is worth 10 speeches by a Federal Reserve chairman,” he writes.
Investors have had great success with companies such as Tesla (US:TSLA), which have thrived on popular products and management and arguably lack wide economic moats. It can pay to stray from Mr Dorsey’s wisdom from time to time. As George Orwell’s sixth rule of writing goes, wordsmiths should break any of his other standards “sooner than say anything outright barbarous”.
