Sunday, May 6, 2012

The Little Book That Builds Wealth: Chapter 7

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 powerful scale advantage. When considering this advantage, it's important to evaluate a firm's size relative to the competition. Scale advantages occur most when fixed costs (vs variable costs) form a larger part of an industry's cost structure.

To illustrate this advantage, Dorsey describes the trucking industry. The cost of trucks and the salaries of drivers and the fuel required for a particular trip can be seen as fixed costs. The company that has more customers along the route, however, can spread these large fixed costs across higher revenues, thus benefiting from a competitive advantage.

A number of examples are described to illustrate this advantage in action. Darden supplies 650 restaurants with fresh seafood at lower costs because of the number of locations it services; Stericycle collects and disposes of medical waste, and is 15 times larger than its nearest competitor; Sysco, Fastenal, Coke, Pepsi and Diageo all benefit from strong distributor networks that lower costs.

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