Table of Contents
Little Book Big Profits Series
Title Page
Copyright Page
Foreword
Acknowledgments
Introduction
Chapter One - Economic Moats
Moats Matter for Lots of Reasons
Chapter Two - Mistaken Moats
Moat . . . or Trap?
These Moats Are the Real Deal
Chapter Three - Intangible Assets
Popular Brands Are Profitable Brands, Right?
Patent Lawyers Drive Nice Cars
A Little Help from the Man
One Moat Down, Three to Go
Chapter Four - Switching Costs
Joined at the Hip
Switching Costs Are Everywhere
Chapter Five - The Network Effect
Networks in Action
Chapter Six - Cost Advantages
A Better Mousetrap
Location, Location, Location
It’s Mine, All Mine
It’s Cheap, But Does It Last?
Chapter Seven - The Size Advantage
The Value of the Van
Bigger Can Be Better
Big Fishes in Small Ponds Make Big Money
Chapter Eight - Eroding Moats
Getting Zapped
Industrial Earthquakes
The Bad Kind of Growth
No, I Won’t Pay
I’ve Lost My Moat, and I Can’t Get Up
Chapter Nine - Finding Moats
Looking for Moats in All the Right Places
Measuring a Company’s Profitability
Go Where the Money Is
Chapter Ten - The Big Boss
The Celebrity CEO Complex
Chapter Eleven - Where the Rubber Meets the Road
Hunting for Moats
Chapter Twelve - What’s a Moat Worth?
What Is a Company Worth, Anyway?
Invest, Don’t Speculate
Chapter Thirteen - Tools for Valuation
Hitting the Books
The Multiple That Is Everywhere
Less Popular, but More Useful
Say Yes to Yield
Chapter Fourteen - When to Sell
Sell for the Right Reasons
Conclusion
Little Book Big Profits Series
In the Little Book Big Profits series, the brightest icons in the financial world write on topics that range from tried-and-true investment strategies to tomorrow’s new trends. Each book offers a unique perspective on investing, allowing the reader to pick and choose from the very best in investment advice today.
Books in the Little Book Big Profits series include:
The Little Book That Beats the Market, where Joel Greenblatt, founder and managing partner at Gotham Capital, reveals a “magic formula” that is easy to use and makes buying good companies at bargain prices automatic, enabling you to successfully beat the market and professional managers by a wide margin.
The Little Book of Value Investing, where Christopher Browne, managing director of Tweedy, Browne Company, LLC, the oldest value investing firm on Wall Street, simply and succinctly explains how value investing, one of the most effective investment strategies ever created, works, and shows you how it can be applied globally.
The Little Book of Common Sense Investing, where Vanguard Group founder John C. Bogle shares his own time-tested philosophies, lessons, and personal anecdotes to explain why outperforming the market is an investor illusion, and how the simplest of investment strategies—indexing—can deliver the greatest return to the greatest number of investors.
The Little Book That Makes You Rich, where Louis Navellier, financial analyst and editor of investment newsletters since 1980, offers readers a fundamental understanding of how to get rich using the best in growth investing strategies. Filled with in-depth insights and practical advice, The Little Book That Makes You Rich outlines an effective approach to building true wealth in today’s markets.
The Little Book That Builds Wealth, where Pat Dorsey, director of stock research for leading independent investment research provider Morningstar, Inc., guides the reader in understanding “economic moats,” learning how to measure them against one another, and selecting the best companies for the very best returns.
Foreword
WHEN I STARTED Morningstar in 1984, my goal was to help individuals invest in mutual funds. Back then, a few financial publications carried performance data, and that was about it. By providing institutional-quality information at affordable prices, I thought we could meet a growing need.
But I also had another goal. I wanted to build a business with an “economic moat.” Warren Buffett coined this term, which refers to the sustainable advantages that protect a company against competitors—the way a moat protects a castle. I discovered Buffett in the early 1980s and studied Berkshire Hathaway’s annual reports. There Buffett explains the moat concept, and I thought I could use this insight to help build a business. Economic moats made so much sense to me that the concept is the foundation for our company and for our stock analysis.
I saw a clear market need when I started Morningstar, but I also wanted a business with the potential for a moat. Why spend time, money, and energy only to watch competitors take away our customers?
The business I envisioned would be hard for a competitor to replicate. I wanted Morningstar’s economic moat to include a trusted brand, large financial databases, proprietary analytics, a sizable and knowledgeable analyst staff, and a large and loyal customer base. With my background in investing, a growing market need, and a business model that had wide-moat potential, I embarked on my journey.
Over the past 23 years, Morningstar has achieved considerable success. The company now has revenues of more than $400 million, with above-average profitability. We’ve worked hard to make our moat broader and deeper, and we keep these goals in mind whenever we make new investments in our business.
Moats, however, are also the basis of Morningstar’s approach to stock investing. We believe investors should focus their long-term investments on companies with wide economic moats. These companies can earn excess returns for extended periods—above-average gains that should be recognized over time in share prices. There’s another plus: You can hold these stocks longer, and that reduces trading costs. So wide-moat companies are great candidates for anyone’s core portfolio.
Many people invest by reacting: “My brother-in-law recommended it” or “I read about it in Money.” It’s also easy to get distracted by daily price gyrations and pundits who pontificate about short-term market swings. Far better to a have a conceptual anchor to help you evaluate stocks and build a rational portfolio. That’s where moats are invaluable.
While Buffett developed the moat concept, we’ve taken the idea one step further. We’ve identified the most common attributes of moats, such as high switching costs and economies of scale, and provided a full analysis of these attributes. Although investing remains an art, we’ve attempted to make identifying companies with moats more of a science.
Moats are a crucial element in Morningstar’s stock ratings. We have more than 100 stock analysts covering 2,000 publicly traded companies across 100 industries. Two main factors determine our ratings: (1) a stock’s discount from our estimated fair value, and (2) the size of a company’s moat. Each analyst builds a detailed discounted cash flow model to arrive at a company’s fair value. The analyst then assigns a moat rating—Wide, Narrow, or None—based on the techniques that you’ll learn about in this book. The larger the discount to fair value and the larger the moat, the higher the Morningstar stock rating.
We’re seeking companies with moats, but we want to buy them at a significant discount to fair value. This is what the best investors do—legends like Buffett, Bill Nygren at Oakmark Funds, and Mason Hawkins at Longleaf Funds. Morningstar, though, consistently applies this methodology across a broad spectrum of companies.
This broad coverage gives us a unique perspective on the qualities that can give companies a sustainable competitive advantage. Our stock analysts regularly debate moats with their peers and defend their moat ratings to our senior staff. Moats are an important part of the culture at Morningstar and a central theme in our analyst reports.
In this book, Pat Dorsey, who heads up our stock research at Morningstar, takes our collective experience and shares it with you. He gives you an inside look at the thought process we use in evaluating companies at Morningstar.
Pat has been instrumental in the development of our stock research and our economic moat ratings. He is sharp, well-informed, and experienced. We’re also fortunate that Pat is a top-notch communicator—both in writing and speaking (you’ll often see him on television). As you’re about to find out, Pat has a rare ability to explain investing in a clear and entertaining way.
In the pages that follow, Pat explains why we think making investment decisions based on companies’ economic moats is such a smart long-term approach—and, most important, how you can use this approach to build wealth over time. You’ll learn how to identify companies with moats and gain tools for determining how much a stock is worth, all in a very accessible and engaging way.
Throughout the book, you’ll learn about the economic power of moats by studying how specific companies with wide moats have generated above-average profits over many years—whereas businesses lacking moats have often failed to create value for shareholders over time.
Haywood Kelly, our chief of securities analysis, and Catherine Odelbo, president of our Individual Investor business, have also played a central role in developing Morningstar’s stock research. Our entire stock analyst staff also deserves much credit for doing high-quality moat analysis on a daily basis.
This book is short. But if you read it carefully, I believe you’ll develop a solid foundation for making smart investment decisions. I wish you well in your investments and hope you enjoy our Little Book.
—JOE MANSUETO
FOUNDER, CHAIRMAN, AND CEO, MORNINGSTAR, INC.
Acknowledgments
ANY BOOK IS A TEAM effort, and this one is no exception.
I am very lucky to work with a group of extremely talented analysts, without whom I would know far less about investing than I do. The contributions of Morningstar’s Equity Analyst staff improved this book considerably, especially when it came to making sure I had just the right example to illustrate a particular point. It’s a blast to have such sharp colleagues—they make it fun to come in to work every day.
Special thanks go to Haywood Kelly, Morningstar’s chief of securities analysis, for valuable editorial feedback—and for hiring me at Morningstar many years ago. I’m also grateful to director of stock analysis Heather Brilliant for quickly and seamlessly shouldering my managerial duties while I completed this book. Last but not least, Chris Cantore turned ideas into graphics, Karen Wallace tightened my prose, and Maureen Dahlen and Sara Mersinger kept the project on track. Thanks to all four.
Credit is also due to Catherine Odelbo, president of securities analysis, for her leadership of Morningstar’s equity research efforts, and of course to Morningstar founder Joe Mansueto for building a world-class firm that always puts investors first. Thanks, Joe.
No one, however, deserves more gratitude than my wife Katherine, whose love and support are my most precious assets. Along with little Ben and Alice, our twins, she brings happiness to each day.
Introduction
The Game Plan
THERE ARE LOTS OF WAYS to make money in the stock market. You can play the Wall Street game, keep a sharp eye on trends, and try to guess which companies will beat earnings estimates each quarter, but you’ll face quite a lot of competition. You can buy strong stocks with bullish chart patterns or superfast growth, but you’ll run the risk that no buyers will emerge to take the shares off your hands at a higher price. You can buy dirt-cheap stocks with little regard for the quality of the underlying business, but you’ll have to balance the outsize returns in the stocks that bounce back with the losses in those that fade from existence.
Or you can simply buy wonderful companies at reasonable prices, and let those companies compound cash over long periods of time. Surprisingly, there aren’t all that many money managers who follow this strategy, even though it’s the one used by some of the world’s most successful investors. (Warren Buffett is the best-known.)
The game plan you need to follow to implement this strategy is simple:
1. Identify businesses that can generate above-average profits for many years.
2. Wait until the shares of those businesses trade for less than their intrinsic value, and then buy.
3. Hold those shares until either the business deteriorates, the shares become overvalued, or you find a better investment. This holding period should be measured in years, not months.
4. Repeat as necessary.
This Little Book is largely about the first step—finding wonderful businesses with long-term potential. If you can do this, you’ll already be ahead of most investors. Later in the book, I’ll give you some tips on valuing stocks, as well as some guidance on when you want to sell a stock and move on to the next opportunity.
Why is it so important to find businesses that can crank out high profits for many years? To answer this question, step back and think about the purpose of a company, which is to take investors’ money and generate a return on it. Companies are really just big machines that take in capital, invest it in products or services, and either create more capital (good businesses) or spit out less capital than they took in (bad businesses). A company that can generate high returns on its capital for many years will compound wealth at a very prodigious clip.1
Companies that can do this are not common, however, because high returns on capital attract competitors like bees to honey. That’s how capitalism works, after all—money seeks the areas of highest expected return, which means that competition quickly arrives at the doorstep of a company with fat profits.
So in general, returns on capital are what we call “mean-reverting.” In other words, companies with high returns see them dwindle as competition moves in, and companies with low returns see them improve as either they move into new lines of business or their competitors leave the playing field.
But some companies are able to withstand the relentless onslaught of competition for long periods of time, and these are the wealth-compounding machines that can form the bedrock of your portfolio. For example, think about companies like Anheuser-Busch, Oracle, and Johnson & Johnson—they’re all extremely profitable and have faced intense competitive threats for many years, yet they still crank out very high returns on capital. Maybe they just got lucky, or (more likely) maybe those firms have some special characteristics that most companies lack.
How can you identify companies like these—ones that not only are great today, but are likely to stay great for many years into the future? You ask a deceptively simple question about the companies in which you plan to invest: “What prevents a smart, well-financed competitor from moving in on this company’s turf?”
To answer this question, look for specific structural characteristics called competitive advantages or economic moats. Just as moats around medieval castles kept the opposition at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies. If you can identify companies that have moats and you can purchase their shares at reasonable prices, you’ll build a portfolio of wonderful businesses that will greatly improve your odds of doing well in the stock market.
So, what is it about moats that makes them so special? That’s the subject of Chapter 1. In Chapter 2, I show you how to watch out for false positives—company characteristics that are commonly thought to confer competitive advantage, but actually are not all that reliable. Then we’ll spend several chapters digging into the sources of economic moats. These are the traits that endow companies with truly sustainable competitive advantages, so we’ll spend a fair amount of time understanding them.
That’s the first half of this book. Once we’ve established a foundation for understanding economic moats, I’ll show you how to recognize moats that are eroding, the key role that industry structure plays in creating competitive advantage, and how management can create (and destroy) moats. A chapter of case studies follows that applies competitive analysis to some well-known companies. I’ll also give an overview of valuation, because even a wide-moat company will be a poor investment if you pay too much for its shares.
Chapter One
Economic Moats
What’s an Economic Moat, and
How Will It Help You Pick
Great Stocks?
FOR MOST PEOPLE, it’s common sense to pay more for something that is more durable. From kitchen appliances to cars to houses, items that will last longer are typically able to command higher prices, because the higher up-front cost will be offset by a few more years of use. Hondas cost more than Kias, contractor-quality tools cost more than those from a corner hardware store, and so forth.
The same concept applies to the stock market. Durable companies—that is, companies that have strong competitive advantages—are more valuable than companies that are at risk of going from hero to zero in a matter of months because they never had much of an advantage over their competition. This is the biggest reason that economic moats should matter to you as an investor: Companies with moats are more valuable than companies without moats. So, if you can identify which companies have economic moats, you’ll pay up for only the companies that are really worth it.
To understand why moats increase the value of companies, let’s think about what determines the value of a stock. Each share of a company gives the investor a (very) small ownership interest in that firm. Just as an apartment building is worth the present value of the rent that will be paid by its tenants, less maintenance expenses, a company is worth the present value2 of the cash we expect it to generate over its lifetime, less whatever the company needs to spend on maintaining and expanding its business.
So, let’s compare two companies, both growing at about the same clip, and both employing about the same amount of capital to generate the same amount of cash. One company has an economic moat, so it should be able to reinvest those cash flows at a high rate of return for a decade or more. The other company does not have a moat, which means that returns on capital will likely plummet as soon as competitors move in.
The company with the moat is worth more today because it will generate economic profits for a longer stretch of time. When you buy shares of the company with the moat, you’re buying a stream of cash flows that is protected from competition for many years. It’s like paying more for a car that you can drive for a decade versus a clunker that’s likely to conk out in a few years.
In Exhibit 1.1, time is on the horizontal axis, and returns on invested capital are on the vertical axis. You can see that returns on capital for the company on the left side—the one with the economic moat—take a long time to slowly slide downward, because the firm is able to keep competitors at bay for a longer time. The no-moat company on the right is subject to much more intense competition, so its returns on capital decline much faster. The dark area is the aggregate economic value generated by each company, and you can see how much larger it is for the company that has a moat.
EXHIBIT 1.1 Company with an Economic Moat versus a Company without a Moat
So, a big reason that moats should matter to you as an investor is that they increase the value of companies. Identifying moats will give you a big leg up on picking which companies to buy, and also on deciding what price to pay for them.
Moats Matter for Lots of Reasons
Why else should moats be a core part of your stock-picking process?
Thinking about moats can protect your investment capital in a number of ways. For one thing, it enforces investment discipline, making it less likely that you will overpay for a hot company with a shaky competitive advantage. High returns on capital will always be competed away eventually, and for most companies—and their investors—the regression is fast and painful.
Think of all the once-hot teen retailers whose brands are now deader than a hoop skirt, or the fast-growing technology firms whose competitive advantage disappeared overnight when another firm launched a better widget into the market. It’s easy to get caught up in fat profit margins and fast growth, but the duration of those fat profits is what really matters. Moats give us a framework for separating the here-today-and-gone-tomorrow stocks from the companies with real sticking power.
Also, if you are right about the moat, your odds of permanent capital impairment—that is, irrevocably losing a ton of money on your investment—decline considerably. Companies with moats are more likely to reliably increase their intrinsic value over time, so if you wind up buying their shares at a valuation that (in hindsight) is somewhat high, the growth in intrinsic value will protect your investment returns. Companies without moats are more likely to suffer sharp, sudden decreases in their intrinsic value when they hit competitive speed bumps, and that means you’ll want to pay less for their shares.
Companies with moats also have greater resilience, because firms that can fall back on a structural competitive advantage are more likely to recover from temporary troubles. Think about Coca-Cola’s disastrous launches of New Coke years ago, and C2 more recently—they were both complete flops that cost the company a lot of money, but because Coca-Cola could fall back on its core brand, neither mistake killed the company.
Coke also was very slow to recognize the shift in consumer preferences toward noncarbonated beverages such as water and juice, and this was a big reason behind the firm’s anemic growth over the past several years. But because Coke controls its distribution channel, it managed to recover somewhat by launching Dasani water and pushing other newly acquired noncarbonated brands through that channel.
Or look back to McDonald’s troubles in the early part of this decade. Quick-service restaurants are an incredibly competitive business, so you’d think that a firm that let customer service degrade and failed to stay in touch with changing consumer tastes would have been complete toast. And in fact, that’s the way the business press largely portrayed Mickey D’s in 2002 and 2003. Yet McDonald’s iconic brand and massive scale enabled it to retool and bounce back in a way that a no-moat restaurant chain could not have done.
This resiliency of companies with moats is a huge psychological backstop for an investor who is looking to buy wonderful companies at reasonable prices, because high-quality firms become good values only when something goes awry. But if you analyze a company’s moat prior to it becoming cheap—that is, before the headlines change from glowing to groaning—you’ll have more insight into whether the firm’s troubles are temporary or terminal.
Finally, moats can help you define what is called a “circle of competence.” Most investors do better if they limit their investing to an area they know well—financialservices firms, for example, or tech stocks—rather than trying to cast too broad a net. Instead of becoming an expert in a set of industries, why not become an expert in firms with competitive advantages, regardless of what business they are in? You’ll limit a vast and unworkable investment universe to a smaller one composed of high-quality firms that you can understand well.
You’re in luck, because that’s exactly what I want to do for you with this book: make you an expert at recognizing economic moats. 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.
The Bottom Line
1. Buying a share of stock means that you own a tiny—okay, really tiny—piece of the business.
2. The value of a business is equal to all the cash it will generate in the future.
3. A business that can profitably generate cash for a long time is worth more today than a business that may be profitable only for a short time.
4. Return on capital is the best way to judge a company’s profitability. It measures how good a company is at taking investors’ money and generating a return on it.