The Little Book That Builds Wealth - The Knockout Formula for Finding Great Investments by Pat Dorsey

Published On: 02-Jan-2019

The Little Book That Builds Wealth - The Knockout Formula for Finding Great Investments by Pat Dorsey
Comments by Swati Kulkarni
January 2019

Porter’s five forces framework gave me perspective to analyze the competitive intensity and profitability trends of any business, in my initial years. I preferred companies that build sustainable competitive advantages (entry barriers) to fend against competitors – “companies with Economic Moats” as Mr. Buffet terms it. “The Little Book That Builds Wealth” by Mr. Pat Dorsey provides interesting insights on evaluation of economic moats. He describes in a lucid style on how to identify companies with moats that continue to generate above average profits, Return on Capital Employed (RoCE) and cash flows helping investors in them compound wealth for many years. 

Key insights from the book are:

Moats must provide either pricing power or cost advantage useful in defending high RoCE.

For companies with strong past returns, find out the existence (if any) and durability of moat to get comfort on continuity of that trend. 

Investment returns have two parts: one that reflects financial performance and another that reflects exuberance or pessimism of investors (speculative part). One can forecast the former part only; therefore buying a wide moat business in times of pessimism (at lower valuation) will be a great opportunity eventually.

Four factors that affect valuation are

1.   Risk to future Cash Flows estimates

2.   Growth in Cash Flows

3.   RoCE

4.   Durability of Moat

Higher the Risk lower the Valuation; higher the factors in 2 to 4, more the Valuation.

It is easier to create moat in certain industries v/s in highly competitive industries. The fourth best player in structurally attractive industries may have a wide moat than the number one player in the latter.

Differentiating durable competitive advantage from a temporary advantage reduces chances of permanent capital impairment. Growth in intrinsic value protects investment returns even for purchases at higher valuation.

Understanding of moat gives an insight on whether the business is going through a problem which is temporary or terminal. I can relate this to an opportunity in corporate banks with strong liability franchise and capital adequacy v/s that in wholesale funded, capital starved banks, the former is more likely to see improvement in return ratios.    

Mistaken moats discussion clarifies that market share, size, brand, and management competencies matter less than moats. Bet on the horse than on the jockey.

Intangible sources of moat:  for e.g. brand is a moat if consumer is willing to pay more for it, being on top recall is not enough. Patents can be moat if the company has a track record of innovation and diverse patented products. For e.g. A pharmaceutical company targeting US generic market, with a diverse product pipeline of approved An abbreviated new drug applications (ANDAs) should be more valuable than the one with a couple of ANDAs.

Switching costs as moat improves clients’ stickiness. I can relate this to Bloomberg, which is able to charge more as users are reluctant to spend time to learn a new system.

The ‘network effect’ builds a wide moat for a services company as users increase. Consider one of India’s reputed stock exchange’s F&O volume growth, as more buyers and sellers used the exchange, liquidity increased, strengthening the moat further.   

Cost efficiency is a solid moat in industries lacking pricing power. Companies’ with lower cost of production are more resilient and enjoy supernormal profits when supply shrinks. The source of cost competitiveness should be durable like sourcing / location advantage and the threat of substitution should be lower. Consider best operating efficiencies as a moat for Airline Company. Economies of scale are more valuable in business with higher fixed cost.

As competitive landscape can change fast, if the moat is likely to erode one must act early. Disruptions have severe consequences and can make wide moat non-existent. Famous example is what digital photography did to Kodak.

Consolidation is akin to industrial earthquake. Sharp shifts in bargaining powers follow it. Recent example is the pricing pressure we see in US Generic market post consolidation in distribution.

Entry of irrational competitor can severely damage the profitability of the business, aren’t we noticing that in Indian Telecom space with drastic drop in Revenue and EBITDA pool.

Company’s decision to invest in non-core areas in a quest to grow size may be an early sign of erosion of moat.

 
 

Author Bio

Swati Kulkarni
Ms. Swati Kulkarni is Executive Vice President and Fund Manager – Equity at UTI AMC Ltd. After her graduation in Commerce, she went on to earn her Masters in Financial Management from Narsee Monjee Institute of Management Studies from University of Mumbai, where she also distinguished herself as a rank holder. Ms. Swati holds CFA charter conferred by CFA Institute, USA. She is also a Certified Associate of Indian Institute of Bankers (CAIIB - UTI). Swati has professional experience of 27 years of which for the last 26 years she has been with UTI AMC. She has been designated as Fund Manager since 2004. Earlier she was part of the Fund Management team involved in analyzing companies across sectors, while assisting the Fund Managers. She has handled Mutual Fund Research, Market Research, Product Reviews and Quantitative Analysis as part of the Research and Planning team at UTI. Her previous assignment with Reliance Industries Ltd was in the Financial Planning Cell. Swati was recognized among the top three India's Best Fund Managers in Equity category by Outlook Money in 2010.