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Pat Dorsey

The Little Book that Builds Wealth

Summary

Pat Dorsey, the Director of Equity Research at Morningstar, describes why companies with moats (long-term competitive advantages) are the best companies to invest in. Morningstar uses this idea of intrinsic value and moats to rate their stocks on a 1 to 5 star basis (5 being the most undervalued stock and best investment)

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Key Takeaways
  1. Dorsey discusses in detail what gives a company a moat, how to identify them, which metrics you should consider and some examples of investing mistakes. A company with a moat adds value because it helps them stay valuable for a longer time
  2. You must have a long-term mindset, be patient, do your homework, be analytical and a little bit lucky and then you have a good shot of getting a healthy return on your investment with less risk
  3. Want to look for companies where their competitors would have a very difficult time replicating or competing with them
  4. List of what makes a company with a moat includes:
    1. A company with intangible assets, like brands, patents, regulatory licenses that can't be matched by competitors
      • Popular brands are not necessarily profitable brands
    2. Products or services that a company sells may be hard for customers to give up which creates customer switching costs that gives the firm pricing power
      • Be nervous when companies that used to be able to raise prices easily begin receiving pushback from customers
    3. A company with network economics, which is a very powerful type of economic moat which can lock competitors out for a long time
      • The value of the company's product or service increases with the number of users
      • Need to operate in a closed network and must ask "how might this network open up to other participants?"
    4. Cost advantages, stemming from process, location, scale or access to a unique asset, which allows them to offer goods or services at a lower cost than competitors
      • Scale is one of the most important cost advantages to consider - distribution, manufacturing and niche markets
  5. Outlines a 4 step process to find companies with moats:
    1. Identify businesses that can generate above-average profits for many years
    2. Wait until the shares of those businesses trade for less than their intrinsic value, then buy
    3. Hold those shares until either the business deteriorates, the shares become overvalued or you find a better investment. This holding period should be measured by years, not months
    4. Repeat as necessary
  6. Companies with moats are more resilient and are less likely to leave you with drastic, permanent capital loss
  7. Identifying companies with moats helps you define your "circle of competence."
  8. Don't fall for false moats - great products, strong market share, great execution and great management. All of these things are not very enduring
  9. If you can find a company that can price like a monopoly without being regulated like on, you've probably found a company with a wide economic moat
  10. The absolute size of a company matters much less than its size relative to its rivals
  11. Broadly speaking, the higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be
  12. Be very mindful of when a company loses its moat. Disruptive technologies can hurt moats of businesses that are enable by technology even more than businesses that sell technology. Also, watch out for a consolidation of a once-fragmented group of customers
  13. Be weary of companies that pursue growth in areas where they have no moat
  14. Companies that provide services to businesses have more moats than most because they are often able to integrate themselves into their customer's business processes, creating high switching costs
  15. 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)
  16. ROA of 7%+ is a good sign of a competitive advantage
  17. ROE of 15%+ a healthy sign
  18. Moat Process:
    1. Has the firm historically generated solid ROE, ROA, ROIC?
    2. (If step 1 a Yes) Does the firm have one or more of the competitive advantages discussed?
    3. (If step 2 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
  19. You don't need to know the precise value of a company before buying. All you need to know is that the current price is lower than the most likely value of the business
  20. A stock is worth the present value of all the cash it will generate in the future. That's it
    1. Free Cash Flows (FCF, owner earnings) a great representation
  21. Most important concepts behind valuation
    1. Risk - how likely the estimated future FCF will actually materialize
    2. Growth - how large those cash flows will likely be
    3. ROIC - how much investment will be needed to keep the business going
    4. Moat - how long the business can generate excess profits
  22. Over time, only two things can push a stock's price - the investment return (earnings + dividend) and speculative return (change in P/E ratio)
  23. Metrics
    1. P/S - most useful for companies that have temporarily depressed margins
    2. P/B - compares market price with its book value, useful for financial services companies
      1. Be cautious about goodwill as it can distort the value
    3. 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
    4. P/CF - shows how much cash is flowing in and out of a business (less manipulated than earnings)
    5. Cash return - FCF (CF from operations - capex) + net interest expense (interest expense - interest income) / Enterprise Value (market cap + long-term debt - cash)
  24. Must ask yourself a couple questions before selling:
    1. Did I make a mistake?
    2. Has the company changed for the worse?
    3. Is there a better place for my money?
    4. Has the stock become too large a portion of my portfolio?
  25. Be cautious or at least mindful of when you anchor on a price
    1. Write down why you bought a stock and roughly what you expect to happen with the company's financial results (increasing sales, profit margins up/down...)
    2. If company does worse, look at what you wrote down and if something has changed, selling is likely your best option regardless of whether you've made or lost money
  26. Recommends keeping 5-10% in cash in case something really juicy comes up
  27. Sometimes the best place for your money is in cash
  28. Trick is to always stay focused on the future performance of the business, not the past performance of the shares
  29. Never stop learning - read annual reports, earnings calls, books, shareholder letters...
What I got out of it
  1. Dorsey does an amazing job of showing why companies with moats are better long-term investments. You don't need to even understand investing to understand that a company with a long-term competitive advantage has a better chance of making more money in the future. It takes a lot of patience, reading and eventually guts when the time comes to pounce. You can find a full list of "wide-moat" companies on Morningstar

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