The Little Book That Builds Wealth

The Little Book That Builds Wealth PDF ( The Knockout Formula for Finding Great Investments) reveals why competitive advantages, or economic moats, are such strong indicators of great long-term investments and examines four of their most common sources: intangible assets, cost advantages, customer-switching costs, and network economics. Along the way, he skillfully outlines this proven approach and reveals how you can effectively apply it to your own investment endeavors.

Language: English

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Introduction

In The Little Book That Builds Wealth, author Pat Dorsey―the Director of Equity Research for leading independent investment research provider Morningstar, Inc.―reveals why competitive advantages, or economic moats, are such strong indicators of great long-term investments and examines four of their most common sources: intangible assets, cost advantages, customer-switching costs, and network economics. Along the way, he skillfully outlines this proven approach and reveals how you can effectively apply it to your own investment endeavors.

Foreword

WHEN I STARTED Morningstar in 1984, my goal was to help individuals invest in mutual funds. Back then, a few financial publications carried performance data, and that was about it. By providing institutional-quality information at affordable prices, I thought we could meet a growing need.
But I also had another goal. I wanted to build a business with an “economic moat.” Warren Buffett coined this term, which refers to the sustainable advantages that protect a company against competitors—the way a moat protects a castle.
I discovered Buffett in the early 1980s and studied Berkshire Hathaway’s annual reports. There Buffett explains the moat concept, and I thought I could use this insight to help build a business. Economic moats made so much sense to me that the concept is the foundation for our company and for our stock analysis.

I saw a clear market need when I started Morningstar, but I also wanted a business with the potential for a moat. Why spend time, money, and energy only to watch competitors take away our customers?

The business I envisioned would be hard for a competitor to replicate. I wanted Morningstar’s economic moat to include a trusted brand, large financial databases, proprietary analytics, a sizable and knowledgeable analyst staff, and a large and loyal customer base. With my background in investing, a growing market need, and a business model that had wide-moat potential, I embarked on my journey.

Over the past 23 years, Morningstar has achieved considerable success. The company now has revenues of more than $400 million, with above-average profitability. We’ve worked hard to make our moat broader and deeper, and we keep these goals in mind whenever we make new investments in our business.

Moats, however, are also the basis of Morningstar’s approach to stock investing. We believe investors should focus their long-term investments on companies with wide economic moats. These companies can earn excess returns for extended periods—above-average gains that should be recognized over time in share prices. There’s another plus: You can hold these stocks longer, and that reduces trading costs. So wide-moat companies are great candidates for anyone’s core portfolio.

Many people invest by reacting: “My brother-in-law recommended it” or “I read about it in Money.” It’s also easy to get distracted by daily price gyrations and pundits who pontificate about short-term market swings. Far better to a have a conceptual anchor to help you evaluate stocks and build a rational portfolio. That’s where moats are invaluable.

While Buffett developed the moat concept, we’ve taken the idea one step further. We’ve identified the most common attributes of moats, such as high switching costs and economies of scale, and provided a full analysis of these attributes. Although investing remains an art, we’ve attempted to make identifying companies with moats more of a science.

Moats are a crucial element in Morningstar’s stock ratings. We have more than 100 stock analysts covering 2,000 publicly traded companies across 100 industries. Two main factors determine our ratings: (1) a stock’s discount from our estimated fair value, and (2) the size of a company’s moat. Each analyst builds a detailed discounted cash flow model to arrive at a company’s fair value. The analyst then assigns a moat rating—Wide, Narrow, or None— based on the techniques that you’ll learn about in this book. The larger the discount to fair value and the larger the moat, the higher the Morningstar stock rating.

We’re seeking companies with moats, but we want to buy them at a significant discount to fair value. This is what the best investors do—legends like Buffett, Bill Nygren at Oakmark Funds, and Mason Hawkins at Longleaf Funds.

Morningstar, though, consistently applies this methodology across a broad spectrum of companies.
This broad coverage gives us a unique perspective on the qualities that can give companies a sustainable competitive advantage. Our stock analysts regularly debate moats with their peers and defend their moat ratings to our senior staff.

Moats are an important part of the culture at Morningstar and a central theme in our analyst reports.

In this book, Pat Dorsey, who heads up our stock research at Morningstar, takes our collective experience and shares it with you. He gives you an inside look at the thought process we use in evaluating companies at Morningstar.

Pat has been instrumental in the development of our stock research and our economic moat ratings. He is sharp, well-informed, and experienced. We’re also fortunate that Pat is a top-notch communicator—both in writing and speaking (you’ll often see him on television). As you’re about to find out, Pat has a rare ability to explain investing in a clear and entertaining way.

In the pages that follow, Pat explains why we think making investment decisions based on companies’ economic moats is such a smart long-term approach—and, most important, how you can use this approach to build wealth over time. You’ll learn how to identify companies with moats and gain tools for determining how much a stock is worth, all in a very accessible and engaging way.

Throughout the book, you’ll learn about the economic power of moats by studying how specific companies with wide moats have generated above-average profits over many years—whereas businesses lacking moats have often failed to create value for shareholders over time. Haywood Kelly, our chief of securities analysis, and Catherine Odelbo, president of our Individual Investor business, have also played a central role in developing Morningstar’s stock research. Our entire stock analyst staff also deserves much credit for doing high-quality moat analysis on a daily basis.

This book is short. But if you read it carefully, I believe you’ll develop a solid foundation for making smart investment decisions. I wish you well in your investments and hope you enjoy our Little Book.

—JOE MANSUETO FOUNDER, CHAIRMAN, AND CEO, MORNINGSTAR, INC.

Table of Contents- The Little Book That Builds Wealth PDF

Introduction
The Game Plan 1
Chapter One
Economic Moats 7
Chapter Two
Mistaken Moats 15
Chapter Three
Intangible Assets 29
Chapter Four
Switching Costs 43
Chapter Five
The Network Effect 57
Chapter Six
Cost Advantages 75
Chapter Seven
The Size Advantage 91
Chapter Eight
Eroding Moats 103
Chapter Nine
Finding Moats 115
Chapter Ten
The Big Boss 133
Chapter Eleven
Where the Rubber Meets the Road 143
Chapter Twelve
What’s a Moat Worth? 159
Chapter Thirteen
Tools for Valuation 171
Chapter Fourteen
When to Sell 187
Conclusion
More than Numbers 197

Reviews

The Little Book That Builds Wealth provides a sensible framework for identifying companies that can sustain high returns on capital. Pat Dorsey tells the reader how to look for durable competitive advantage in choosing equities. His four sources of structural competitive advantage: (1) intangible assets; (2) switching costs; (3) network effect; and (4) cost advantage are particularly valuable in selecting long-term equity commitments.
–Louis A. Simpson, President and Chief Executive Officer, Capital Operations, GEICO Corporation

Pat Dorsey provides a practical framework for integrating the realities of a changing future into today’s investment decisions. A little art and a little science–key ingredients to successful long-term investing.
–Larry D. Coats, Chief Executive Officer, Oak Value Capital Management, Inc.

Spend two evenings reading Pat Dorsey’s The Little Book and you’ll cast away all the techniques that failed for you in the past. This is the definitive text on how to identify strong-performing businesses for your portfolio and, more importantly, how to avoid thousands of investments that won’t stand the test of time. It’s must reading for every investor.
–Timothy P. Vick, Senior Portfolio Manager, The Sanibel Captiva Trust Co., and author of How to Pick Stocks Like Warren Buffett

About the author

Pat Dorsey, CFA, is Director of Equity Research at Morningstar, Inc. He played an integral part in the development of the Morningstar Rating for stocks, as well as Morningstar’s economic moat ratings. Dorsey is also the author of The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market (Wiley). He holds a master’s degree in political science from Northwestern University and a bachelor’s degree in government from Wesleyan University. Please visit www.findingmoats.com.

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