Sunday, April 29, 2012

The Little Book That Builds Wealth: Chapter 5

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 the network effect. Some products or services increase with the number of users. It's a simple concept, but rare and powerful. Dorsey argues that only 2 companies in the Dow 30 benefit from network effects, but this advantage propels them to high returns on capital.

Dorsey introduces the concept of nonrival goods; that is, goods that can be used by more than one person at a time. For example, you can only use one tractor at a time, but you can use a Windows program at the same time as someone else. It is these kinds of goods/services that enable network effects.

Again a number of examples are offered to illustrate this advantage. American Express has millions of merchants supporting its card-paying system, which encourages more card holders, which encourages more merchants to become Amex customers. Microsoft's Windows and Office user bases make it difficult for a competing program, even if it offers better features, to compete. Who wants to produce document files and PC programs that Office and Windows users can't use? eBay, several exchanges, and Western Union are also examined for their network effects and their vulnerabilities.

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