Sunday, April 22, 2012

The Little Book That Builds Wealth: Chapter 3

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!

Intangible assets are the first of the four sources of competitive advantage that Dorsey argues investors should look for. Such assets include items such as brands, patents and regulatory licenses that can't be physically touched, but that are valuable nevertheless. But this is a challenging category to understand and excel in. Brands can lose their luster, patents expire and can be challenged, and government licenses can be revoked at any time.

First, it's important to realize that a brand only creates a moat if it increases the customer's willingness to pay or increases captivity. After all, brands are expensive to maintain (requiring investments in marketing etc). Sony is an example of a brand without a moat, as most buyers compare their electronics purchases on price and features. But Tiffany is an example of a firm with a brand, as Tiffany can sell the exact same rock as another jeweler, but for a significantly higher price.

Patents also confer an advantage, but the sustainability of a competitive advantage based on patents is hard to predict. A firm that is successful based only on a few patents faces a high risk that competitors will challenge those patents, and/or the company will suffer when the patents expire. The only time patents represent a truly sustainable advantage is when the firm has a proven ability to innovate and constantly build upon its patent portfolio.

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