Saturday, April 21, 2012

The Little Book That Builds Wealth: Chapter 2

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

This chapter is about some pitfalls investors fall into when trying to identify moats. Not all examples of high market share and strong returns on capital are signs of a moat! Investors must be able to recognize the difference.

For example, Chrysler practically had a license to print money when it came out with the minivan in the 1980s. But there was no structural characteristic that kept competitors from coming out with "me too" products that eroded Chrysler's profits.

Commodity products are another example of this. A supply/demand imbalance can make commodity producers look like "moat" companies for a while, but the lack of moat makes profit margin erosion likely. The author describes the relatively short boom and bust period for the ethanol production industry as an example.

Management effectiveness can also fool investors into believing a company has a moat. But one can't predict how long a manager will stay at the helm. Absent a competitive advantage, a company will revert to being an average performer eventually if it has no moat.

Any time a company does not have a structural advantage, profitability is bound to be eroded. In the next four chapters, Dorsey describes the four categories of competitive advantage that investors should look for to help them find companies with moats.

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