Investing Business Finance

The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments (Summary)

by Pat Dorsey

Why is a company that sells something as simple as a can of Coke or a razor blade a far better long-term investment than the hottest new tech startup? The answer has nothing to do with growth or innovation. It's about an ancient, powerful concept: a castle's moat. The best businesses have an 'economic moat'—a durable competitive advantage that protects them from invaders, allowing them to compound wealth for decades.

Look for One of Four Moats

Truly durable competitive advantages are rare and fall into just four categories: intangible assets (brands, patents), high customer switching costs, the network effect, and cost advantages (process, scale).

Your local bank has a weak moat, as it's easy to move your money. But your company's accounting software provider has a huge moat. The cost and hassle of retraining every employee and migrating decades of data to a new system—the switching costs—are so prohibitively high that you're practically locked in as a customer.

High Profits Attract Armies of Competitors

A company earning high returns on its capital without a strong moat is like a treasure chest left unguarded. Its profits will inevitably be competed away. The key isn't just current profitability, but the ability to sustain it.

In the early 2000s, Krispy Kreme was a stock market darling with huge profits. But its moat was non-existent; anyone can make a donut. Soon, competitors like Dunkin' Donuts and even grocery stores copied their model, and Krispy Kreme's profitability and stock price collapsed.

A Great Company Isn't Always a Great Investment

Identifying a company with a wide moat is only the first step. To earn a superior return, you must buy its stock at a reasonable price. Overpaying for even the best company in the world can lead to mediocre results.

Microsoft in 2000 was an incredible company with an unbreachable moat in operating systems. However, its stock was so expensive during the dot-com bubble that investors who bought at the peak saw their investment go nowhere for more than a decade, even as the business continued to thrive.

The Best CEOs Widen the Moat

Management's primary job is capital allocation—deciding where to reinvest the company's profits. Great managers invest in projects that strengthen and expand the company's existing economic moat, while poor managers destroy value by expanding into areas where they have no competitive advantage.

eBay's acquisition of Skype was a classic example of poor capital allocation. eBay had a powerful network-effect moat in online auctions, but it spent billions on a communications company in a totally unrelated field where it had no advantage. The acquisition was a failure and was eventually written off.

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