Dorsey quickly points out to the reader what is not a moat- great products, size, great execution, and great management. Dorsey notes that these aspects are nice to have but they are in no shape or form a moat.
Dorsey outlines five different types of moats: intangible assets, customer switching costs, the network effect, cost advantages, and size. Let us briefly discuss each of these four characteristics.
Intangibles assets are described as the type of Government regulation that creates a moat but does not impede on a company’s abilities with its business practices i.e. regulating price increases. Another example are the credit agencies which are at a huge advantage since bonds have to be rated. They have no limits on how much they charge (although we all know how that ended).
Customer switching costs are companies that make it tough for customers to switch to a competitor. Examples of switching costs include tight integration with a customer’s business, retraining costs, or financial services companies which people are very hesitant to switch (because they do not want to pull out with a loss, and it is a huge annoyance to switch something like checking accounts).
Pat Dorsey describes the networking effect as a company that will increase its monopoly by gaining more customers. For example the more users EBAY gets the more of a moat it builds. This is because when anyone wants to sell or buy something easily they can get a lot more items than by searching on some online auction site with only several hundred members. Dorsey also describes a similar effect with credit card companies. Since Visa is accepted so many places the more users that sign up the more of a moat it will build. No one is going to get a no name credit card that is only accepted in five percent of the country.
Dorsey describes cost advantages as companies that have lower costs. Dorsey states that cost advantages matters most in industry where price is the most important factor this is especially true in commodity based business where sometimes the only factor is price. Companies that are located closer to customers will have large advantages over competitors if shipping is a large expense.
Finally, Dorsey gets into size advantages which include large distribution networks to give the company an edge over competitors who have smaller networks. For example the reason UPS has much higher returns on capital than FedEx is because UPS earns more of its revenue from door to door deliveries. FedEX earns a lot of its revenue from overnight letter services. Dorsey states that a dense delivery network provides much better returns on capital than from door to door delivery of packages. To demonstrate a delivery van that is only half full will still likely earn a profit, however a half-full cargo plane with time-sensitive packages will not.
While Dorsey obviously comes with a different definition of a moat than others and offers a valuable perspective, a more advanced investor might want to skip this book and go straight to Bruce Greenwald’sCompetition Demystified, or Michael Porter’sCompetitive Strategy. Both these books offer a much more detailed analysis of what a moat is. However, to get a quick read (you can read the whole book in less than two hours) on what really is a moat this is the perfect book. In addition, a more advanced reader might consider this book as it does mention some ideas not included in Greenwald’s or Porter’s writings.
For example, Dorsey does add a few chapters at the end. In one chapter he talks about companies with eroding moats, and how changing technology can quickly destroy a company’s moat even if the company is not a technology company. I found this chapter to be very informative.
Dorsey provides the reader a quick way to determine whether the moat is being eroded; if the company can no longer raise prices as easily as it used to. Therefore if I had to chose from all three books for a beginner I would pick Dorsey’s hands down, but even a more advanced investor can gain some knowledge from this book.
To purchase the book on amazon.com click on the following link-The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments (Little Books. Big Profits)
Disclosure: I receive free books from book publishers asking me to review them. In addition I sometimes request specific books that look interesting. I try to review the books that I think will be the most interesting. I have a material connection because I received a free copy of this book from the publisher. In addition I receive a small commission if you click on the above link and buy the book (or anything else) from Amazon.com It does not cost you a penny more. So I get a commission, Amazon gets a sale, and you get your book so it is a win for everyone.
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