The Little Book That Builds Wealth

Text in black are quotes; text in green are my notes. I sometimes write in Spanish.

• FOR MOST PEOPLE, it’s common sense to pay more for something that is more durable. #

• If you can see moats where others don’t, you’ll pay bargain prices for the great companies of tomorrow. Of equal importance, if you can recognize no-moat businesses that are being priced in the market as if they have durable competitive advantages, you’ll avoid stocks with the potential to damage your portfolio. #

• In my experience, the most common “mistaken moats” are great products, strong market share, great execution, and great management. These four traps can lure you into thinking that a company has a moat when the odds are good that it actually doesn’t. #

• Great products, great size, great execution, and great management do not create long-term competitive advantages. They’re nice to have, but they’re not enough. #

• The four sources of structural competitive advantage are intangible assets, customer switching costs, the network effect, and cost advantages. If you can find a company with solid returns on capital and one of these characteristics, you’ve likely found a company with a moat. #

• Look at Sony, for example, which certainly has a well-known brand. Now ask yourself whether you would pay more for a DVD player solely because it has the Sony name on it, if you were comparing it to a DVD player with similar features from Philips Electronics or Samsung or Panasonic. Odds are good that you wouldn’t—at least most people wouldn’t—because features and price generally matter more to consumers when buying electronics than brands do. #

• If a company can charge more for the same product than its peers just by selling it under a brand, that brand very likely constitutes a formidable economic moat. #

• In short, if you can find a company that can price like a monopoly without being regulated like one, you’ve probably found a company with a wide economic moat. #

• 1. Popular brands aren’t always profitable brands. If a brand doesn’t entice consumers to pay more, it may not create a competitive advantage. #

• Although the explicit cost of moving a mutual fund account from Firm A to Firm B is arguably even lower than moving a bank account, most people perceive the benefits as uncertain. They have to convince themselves that the new and less familiar manager will be better than the manager they have been using, which essentially means admitting they made a mistake choosing their current manager in the first place. This is psychologically tough for most people, so assets tend to stay where they are. #

• Switching costs come in many flavors—tight integration with a customer’s business, monetary costs, and retraining costs, to name just a few. #

• The bottom line is that you’re most likely to find the network effect in businesses based on sharing information, or connecting users together, rather than in businesses that deal in rival (physical) goods. As we’ll see later in the chapter, this is not exclusively the case, but it’s a good rule of thumb. #

• In Japan, eBay doesn’t even have a presence—Yahoo! Japan has the vast majority of the country’s online auction market. The reason here is even simpler than you might think: Yahoo! Japan offered auction services five months before eBay did, and so it was able to amass a large group of buyers and sellers quickly. #

• It’s a good question to ask whenever you’re evaluating a company that might benefit from network economics: How might that network open up to other participants? #

• As you can see, the network effect is a pretty powerful competitive advantage. It is not insurmountable, but it’s a tough one for a competitor to crack in most circumstances. This is one moat that is not easy to find, but it’s worth a lot of investigation when you do find it. #

• A company benefits from the network effect when the value of its product or service increases with the number of users. Credit cards, online auctions, and some financial exchanges are good examples. #

• (Technically, commodities are products with no differentiating factor other than price.) #

• 2. Cheaper processes, better locations, and unique resources can all create cost advantages—but keep a close eye on process-based advantages. What one company can invent, another can copy. #

• Large distribution networks are extremely hard to replicate, and are often the source of very wide economic moats. #

• Being a big fish in a small pond is much better than being a bigger fish in a bigger pond. Focus on the fish-to-pond ratio, not the absolute size of the fish. #

• Some kinds of growth can cause moats to erode. In fact, I’d say the single most common self-inflicted wound to competitive advantage occurs when a company pursues growth in areas where it has no moat. #

• Technological change can destroy competitive advantages, but this is a bigger worry for companies that are enabled by technology than it is for companies that sell technology, because the effects can be more unexpected. #

• Growth is not always good. It’s better for a company to make lots of money doing what it is good at, and give the excess back to shareholders, than it is to throw the excess profits at a questionable line of business with no moat. Microsoft could get away with it, but most companies can’t. #

• So, how do we measure return on capital? The three most common ways are return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC). Each gives us the same information, but in a slightly different way. #

• Very broadly speaking, a nonfinancial company that can consistently generate an ROA of 7 percent or so likely has some kind of competitive advantage over its peers. #

• Again, as a very broad rule of thumb, you might use 15 percent as a reasonable cutoff—companies that can consistently crank out ROEs of 15 percent or better are more likely than not to have economic moats. #

• It’s easier to create a competitive advantage in some industries than it is in others. Life is not fair. #

• However, it’s very rare for managerial decisions to have a bigger impact on a company’s long-run competitive advantage than that company’s structural characteristics. #

• As he often does, Warren Buffett summed this dynamic up best when he said, “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” #

• It’s inherent in human nature to want to tell stories and see patterns that may not actually exist—we feel better when we can identify a cause for every effect that we observe, and identifying the causal agent as a single person is infinitely more satisfying than blaming a “lack of competitive advantage.” The truth of the matter, though, is that CEOs have a hard time either creating a competitive advantage where it doesn’t exist or damaging a competitive advantage that is very strong to begin with. #

• Management matters, but within boundaries set by companies’ structural competitive advantages. No CEO operates in a vacuum, and while great managers can add to the value of a business, management by itself is not a sustainable competitive advantage. #

• Bet on the horse, not the jockey. Management matters, but far less than moats. #

• The point is that unless a company has some kind of economic moat, predicting how much shareholder value it will create in the future is pretty much a crapshoot, regardless of what the historical track record looks like. Looking at the numbers is a start, but it’s only a start. Thinking carefully about the strength of the company’s competitive advantage, and how it will (or won’t) be able to keep the competition at bay, is a critical next step. #

• What Is a Company Worth, Anyway? It’s a simple question, so here’s a simple answer: A stock is worth the present value of all the cash it will generate in the future. That’s it. #

• concepts that underpin the valuation of any company: the likelihood that those estimated future cash flows will actually materialize (risk), how large those cash flows will likely be (growth), how much investment will be needed to keep the business ticking along (return on capital), and how long the business can generate excess profits (economic moat). Keep these four factors in mind when using price multiples or any other valuation tool, and you’re certain to make better investing decisions. #

• Over long stretches of time, there are just two things that push a stock up or down: The investment return, driven by earnings growth and dividends, and the speculative return, driven by changes in the price-earnings (P/E) ratio. Think of the investment return as reflecting a company’s financial performance, and the speculative return as reflecting the exuberance or pessimism of other investors. #

• A company’s value is equal to all the cash it will generate in the future. That’s it. #

• The four most important factors that affect the valuation of any company are how much cash it will generate (growth), the certainty attached to those estimated cash flows (risk), the amount of investment needed to run the business (return on capital), and the amount of time the company can keep competitors at bay (economic moat). #

• So, don’t use price-to-sales ratios to compare companies in different industries, or you’ll wind up thinking that the lowest-margin companies are all great bargains, while the high-margin ones are too expensive. #

• Life is full of trade-offs. #

• Always remember the four drivers of valuation: risk, return on capital, competitive advantage, and growth. All else being equal, you should pay less for riskier stocks, more for companies with high returns on capital, more for companies with strong competitive advantages, and more for companies with higher growth prospects. #

• Be patient. Wonderful businesses do not trade at great prices very often, but as Warren Buffett has said, “There are no called strikes in investing.” Have a watch list of wonderful businesses that you would love to own at the right price, wait for that price, and then pounce. #

• Not making money beats losing money any day of the week. #

• as economist John Maynard Keynes once said, “When the facts change, I change my mind.” #

• If the fundamentals of a company change permanently—not temporarily—for the worse, you may want to sell. #

• I would argue strongly that reading about companies will add infinitely more value to your investment process than will reading about short-term market movements, macroeconomic trends, or interest-rate forecasts. #