Sunday, May 13, 2012

The Little Book That Builds Wealth: Chapter 9

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!

Convinced that you should be investing in moats in order to generate a strong return with low risk? If so, you will need to know how to find companies with moats, and that's what this chapter is about.

The first thing to realize is that not all industries are created equal; some are more conducive to having companies with moats than others. Dorsey cites the asset management industry as one where moats are easy to find, but the auto parts industry as one that is not conducive to moats.

Similarly, Dorsey argues that software firms tend to have moats where hardware firms don't, as software has to be integrated with other pieces of software, leading to high switching costs. Many moats exist in telecom, where favourable regulatory structures (outside the US) or niche markets protect incumbents.

Dorsey goes on to describe the economics (and moat potential) of a number of industries including restaurants, retail, b2b, industrial, utilities and more. Once you think you have found a company with a moat, check its historical returns using ROIC, ROA and ROE to see if the numbers bear out your thesis.

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