Demystifying Economic Moats
In the foreword to The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments, Joe Mansueto, founder and CEO of Morningstar, Inc., a leading investment research firm, says he discovered the concept of economic moats from Warren Buffett in the 1980s and based the company’s approach to stock investing on it. Now, Pat Dorsey, director of stock analysis at Morningstar, shares how he and his team of analysts locate businesses with moats, such as whether they have the potential to generate above-average profits over time.
From Long-Ago Castles to Long-Term Profits
Dorsey explains that economic moats protect companies from competition the way moats protected castles from attack, which helps them earn money over time and recover from marketing mistakes, thereby offering greater value to investors than moatless firms. He cites the case of Coca-Cola’s expensive flops with New Coke and C2, which would have drowned a company without a moat.
Companies with economic moats exhibit one or more of the following structural advantages, according to Dorsey: intangible assets (brands, patents, regulatory licenses); high customer switching costs; network economics; and cost advantages from location, processes, scale or some asset. Each of the characteristics is discussed in detail with plenty of real-life, mostly well-known examples that aid in clarifying Dorsey’s logic.
The book also identifies traits that might be mistaken for moats. Great products, strong market share, great execution and great management, says Dorsey, do not make an enduring moat. They all can disappear quickly. For example, ethanol was touted as a good investment by Wall Street just two years ago. But when U.S. refineries switched to the new gasoline standard, many producers entered the commodity ethanol market, which ended up tanking operating margins for everyone involved. Management, although widely hyped, is another poor indicator of economic durability. CEOs come and go, and it’s hard to accurately judge results before the fall when investing decisions must be made in order to build wealth.
To show readers exactly how to find stocks with moat protection, Dorsey provides a three-step process that seems simple enough. Just answer a few questions about the value of a company, because, he writes, “The best business in the world will be a bad investment if purchased at an unattractive price.” The four most important considerations of a firm’s future value are growth (how much cash it will generate), risk (certainty of its estimated cash flow), return on capital (investment needed to run the business) and the existence of an economic moat (the length of time competitors can be stalled). The typical value measurements used by investors fail to identify economic moats, Dorsey contends. To support his theory, he explains various valuation tools and notes the pitfalls and strengths of each.
Finding an investment with a wide moat at a good price requires in-depth analysis before a company becomes a good buy. Dorsey recommends regularly reading the business press and articles by successful money managers. The Little Book That Builds Wealth abounds with processes, tools and examples. It even gives guidelines on when to sell. Anyone who can find the time, discipline and patience to conduct the considerable research described in this “little” book could select high-performing, long-range investments.