The Little Book that Builds Wealth

In the same way that an apartment building is worth the present value of the rent that will be paid by its tenants, a company is worth the present value of the cash we expect it to generate over its lifetime, less whatever the company has to spend to continue running and expanding its business.

A company with a moat is worth a premium because it will generate profits for a longer stretch of time.

Even if the profits are juicy, competitors will have a hard time moving in to steal market share.

Moats increase the value of the company.

Return on capital is the best way to measure a company’s profitability.

Moats depend less on managerial brilliance.

What stellar management can do for the next couple years isn’t a moat. A moat is the cards that a business already holds, its existing positioning.

Great products rarely make a moat.

Bigger is not necessarily better when it comes to moats.

The biggest company with the most market share might not have a good moat.

Think Kodak, IBM, Netscape.

Size can help create a competitive advantage, but it is unlikely to be the actual advantage itself.

Being more efficient than competitors is not a moat.

Talented CEOs are also a mistaken moat. It is not a sustainable competitive advantage.

Real Moat List

Intangible assets: Brand, Patents, Licenses
High customer switching costs—the products of services the company sells may be hard to give up.
Network effects
Cost advantages or economies of scale—process, location, ownership, vertical integration, or partnerships.

A brand creates a moat only if to increases the customer’s willingness to pay or increases customer captivity.

A well-known brand is not necessarily a moat.

Ask: Does the brand allow the company to charge a premium relative to competing products?

Interesting: both Pharma and Utility companies are heavily regulated by the government.

However Pharma companies can charge whatever they want, and Utility companies have their price checked by the government.

Drug companies are a lot more profitable.

Not in my backyard companies - NIMBYs have a competitive advantage.

Nobody wants a stone quarry or a garbage dump in their backyard, so existing landfills and quarries are extremely valuable. Getting new locations approved is very difficult.

Sticky customers are golden.

Ex. People don’t switch banks very often. The average is 6-7 years. Banks have an above average ROE of 15% because their customers incur a switching cost if they want to move to a new bank.

Ex2. Intuit. Their products Quickbooks and Turbotax have a high switching cost because the small business would lose lots of time switching because they’d have to input all the new data.

The most common switching cost comes from being joined at the hip.

Once a product is integrated into the customer’s day to day life, untangling it will likely be risky or time-consuming.

Think habits. Profit off habits.

Another switching cost is risk.

Given the incredibly low tolerance for failure on a turbine or a jet engine, it doesn’t make sense for GE to try to shave the production cost if it increases the risk of product failure.

The result is that Precision Castparts can earn some pretty fat profit margins on the components it sells.

Many more switching costs -

Designers are taught on adobe programs, so switching would require retraining costs.

High switching costs are usually in companies like Waters Corporation, which makes sophisticated machines for Liquid Chromatography. A firm wanting to switch would need to buy a $100k new LC machine and retrain a small army of technicians. Waters achieves remarkable returns on invested capital north of 30%.

Many consumer oriented firms have low switching costs.

Retailers, restaurants, packaged-goods companies, etc.

It is very hard to have switching costs without economies of scale (think Home Depot and their distribution network) or without a very strong brand (Gucci).

Network effect - businesses who’s value of their product or service increases with the number of users.

Non-Ex. People don’t shop at Walmart because lots of people are there.

Ex. American Express. The more places you can use an Amex card, the greater its network of merchants, the more valuable the card becomes to you.

“Of networks, there will be few.”

Four credit card companies control 85% of the market.

The network effect is much more common in businesses based on information or knowledge transfer than among businesses based on physical capital.

Another network effect emerges from the buyer-seller dynamic.

Buyers are on ebay because sellers are there. And sellers are there because buyers are there.

In a buyer-seller dynamic, you don’t want to charge fees initially and advertise yourself heavily.

Interesting: futures exchanges have maintained very robust profitability.

Companies can have a moat based on cost. Companies can dig moats by having sustainably lower costs than other businesses.

Lowering costs by moving parts of production overseas to low-cost regions of the world like China and India are not sustainable competitive advantages.

The low-cost resources are very likely available to any company that wants them.

Cost advantages step from four sources:

Cheaper Processes (likely to last <7 years)
Better locations (best for heavy and cheap—ex. Garbage. It can only be delivered locally to landfills, to expensive to drive long distances with. Cement plants and quarries are two more examples.)
Unique assets (ex. Ultra Petroleum can sell natural gas at incredibly low cost due to advantageous properties in part of Wyoming. Ex2. Aracruz Cellulose is the lowest cost paper pulp producer in the world. The eucalyptus trees that is uses grow faster in Brazil than anywhere else in the world.)
Greater scale (Absolute size is worth much less than relative size. When two gargantuan firms dominate and industry, like Boeing and Airbus, they are unlikely to have meaningful scale-based cost advantages. Stericycle, 15x bigger than its next competitor, has unrivaled route density, allowing it to make more stops per route and to have more profitable routes.)

Scale-based cost advantages.

Distribution (increases the return on fixed costs.)
Manufacturing (the closer a factory is to 100 percent capacity, the more profitable it is. Also, the easier it is to spread fixed costs like rent and utilities over a larger volume of production. The larger the factory, the easier to specialize by individual tasks and mechanize production.)
Niche markets (Domination of a niche market. Big fishes in small ponds eat everything. Companies can build near monopolies in markets that are only large enough to support one company profitably.)

The best analysis in the world can be rendered moot by unforeseen changes in the competitive landscape.

You must continually monitor the competitive position of the companies in which you have invested.

Some kinds of growth can cause moats to erode.

The single most commonly inflicted wound to a firm’s competitive advantage occurs when a company pursues growth in an area where it has no moat.

If a company that has regularly been able to raise prices starts getting pushback from customers, you’re getting a strong signal that the company’s competitive advantage has weakened.

Some industries are brutally competitive and have awful economics, and creating a competitive advantage requires the managerial equivalent of the Nobel Prize.

Hunt for the right industry and the right firm.

As an investor, you’re free to cast a discerning eye over the entire investment universe.

In tech, software companies have an easier time creating moats than hardware companies.

Companies that provide services to businesses have the highest percentage of wide-moats.

These firms can integrate themselves tightly into their clients business processes which creates high switching costs, giving them pricing power and excellent return on capital.

In service, it’s great to be a niche-dominating firm.

A stock is worth the present value of all the cash it will generate in the future. That’s it.