Sunday, April 15, 2012

The Little Book That Builds Wealth: Chapter 1

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!

In the opening chapter, justification is presented for why the identification of moats is important. Just as a longer lasting appliance is more valuable than one that breaks down soon after purchase, so too is a company with a moat more valuable than one without.

Companies with moats generate economic profits (as measured by returns on capital or excess returns on capital) for longer stretches than those without moats. For example, consider tow companies with identical financials, but where one has a moat and the other doesn't. The company without the moat will see their financials erode over time as competition challenges their market position, whereas the company with the moat will keep on earning strong returns.

Investors must therefore learn to recognize and understand moats so they can avoid the erosion of capital that can occur when investing in a company that sees its financials deteriorate because it has no moat.

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