Vikash Anand's Reviews > The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments

The Little Book that Builds Wealth by Pat Dorsey is one of the crispiest and finest book to understand the field of investing. The book is little but the value offered is immense.

The book succinctly deals with the concept of moat/competitive advantage. For long term investments it is important to focus on companies with wonderful business with long term potential. The book offers deep understanding of the concept of moat/competitive advantage. It’s important to understand the attributes of moat i.e. high switching cost, economy of scale, network effect etc.

A company at a very fundamental level is just a big machine that takes investors capital as input and generate return on it by investing into products or services. A company that creates more capital out of investors capital is a good business i.e. a wealth compounding machine, whereas a company that spit out less capital than they took in are bad business. A company that can generate high returns on its capital for many years is an awesome business, and will create tremendous wealth. But to generate high return on capital for many years, the business/company must have big moat.

It’s also important to understand the impact of competition on business. A business/company that generates high returns on capital attracts high competition. Only a business with significant competitive advantage can survive the competitors and create value for its shareholders.

To create wealth through investing, it’s important to identify companies that have moats/sustainable competitive advantage and purchase their shares at reasonable price. Generally, companies with long term sustainable competitive advantage are more valuable.

The competitive advantage can be in the form of structural characteristics of a business that would be very hard for a competitor to replicate. The sources of structural competitive advantage can be intangible assets, high customer switching cost, the network effect, and cost advantage due to process, location, scale or access to a unique asset.

Companies that makes it tough for customers to switch to competitors through high switching cost can charge better margin and maintain high return on capital.

Brands cost money to build and sustain, and if that investment does not generate a return through better pricing power or repeat purchase, then it’s not a competitive advantage.

A regulatory approval/license that limits competition or a set of patents and history of innovation is a company with sound moat.

Companies that benefits from network effect i.e. when the value of the products or services increases with the number of users create powerful competitive advantage by capturing almost the entire market.

Technological disruption and innovation will also play crucial role for long term sustainability of business. Kodak for decades printed money, but the disruption in the form of digital photography resulted into creative destruction of the entire business model. Newspaper business used to generate enormous revenue in the past through advertisement, but the advent and mass usage of internet has disrupted the entire business model.

The competitive advantage due to structural competitive dynamics of a business have a bigger impact on a company’s long term competitive advantage as compared to competence of the management.

Identifying a sound business with economic moats is one part of successful investing, the other part involves price to be paid to purchase the business. Therefore, valuation is also critical. The factors that needs to be taken into account for valuation are risk, return on capital, competitive advantage and growth. If everything is equal, one should pay less for riskier stocks, more for companies with strong competitive advantage and more for companies with higher growth prospects.

The conceptual framework of investment return and speculative return given in the book is also a very powerful one. A stock might go from $10 to $15 per share because earnings have increased from $1 per share to $1.5 per share, or because even though earnings stayed flat at $1 per share, the PE ratio increased from 10 to 15. In the first case the return is driven by investment return whereas in the second case, it is driven by speculation. A company with significant moat will have higher potential in terms of investment return as compared to speculative return. The difference and understanding of investment return and speculative return will result into better decision to sell stocks at appropriate time.

The Little Book that Builds Wealth by Pat Dorsey is an insightful book. It is a must read for anyone interested in understanding the field of investment.