Wednesday, May 22, 2013

The Best Way to Build Wealth

Here's another great read from "The Little Book..." series. The Little Book that Builds Wealth by Pat Dorsey is a book about finding great companies to invest in. He takes an important lesson taught by Warren Buffett which is to look for companies with economic moats. Moats used to be water ways built around castles to protect it from incoming invaders, an economic moat is similar only that it guards a company's earning from competing companies.

What does a company with a wide economic moat look like? Pat Dorsey explains the four common traits of a great economic moat:

1) Intangible assets - these are strong brands that entice customers to pay more. This also includes patents that a company may own. 

2) Cost advantages - some companies have important cost advantages based on scales of operations, proximity to resources or well-engineered processes.

3) Customer switching costs - some companies make it difficult for customers to switch to a competing company's product because switching is expensive and/or time consuming

4) Network economics - the more people who use this product the more valuable it becomes. For example Microsoft Office becomes more valuable as more people use it and share files even if there are free word processing and spreadsheet software available.

One of the easiest ways to tell if a company has a strong economic is by looking at it's long-term (10 year) average return on equity. This value tells an investor how efficiently a company utilizes invested capital to generate more earnings. If the return on equity is in the double digits year after year, it's a good sign that it has a strong economic moat and probably has one or more of the traits listed above.

Happy hunting!