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This weekend I read The Little Book that Builds Wealth, by Morningstar's Director of Equity Research, Pat Dorsey. This is a wonderful companion to The Little Book that Beats the Market, and combining the principles in the two should lead to finding outstanding investment opportunities. In this article, I recap the main points of Dorsey's new book, and then provide some ways we can apply it's wisdom to better select stocks in the Magic Formula screen.

The Little Book that Builds Wealth is all about one principle - determining a company's economic moat. This is an important concept, as a moat protects a company's profits from competition and allows the company to earn exceptional returns on capital over long periods of time. Businesses that earn high returns on capital invariably attract lots of competition. Companies with no moat can see their profit margins and sales growth dwindle as competitors capture more and more of their market share. On the other hand, wide moat companies have advantages that make it very difficult or uneconomical for competitors to try and compete with them. The concept of a moat has been one of the keys behind the success of the world's most recognized investor, Warren Buffett.

Dorsey lays out 4 main ways a company can establish an economic moat (or durable competitive advantage, as Buffett would say). The first method is by intangible assets. Examples of this are a strong brand that allows a business to charge more for comparable items, patent protection on products like drug formulations and technologies, and regulatory licenses that are particularly hard to obtain.

The second method is by having high switching costs - the "sticky" customer advantage. Here, Dorsey presents banks and widely adopted software vendors as having high switching costs. Who wants to go through the hassle of transferring an account or training an entire staff on a new piece of software?

The third form of a moat is created by the network effect, where the value of a business increases with each node on the network. This very powerful advantage is well illustrated by credit card processors. The more places that accept Mastercard (MA), the more people will want to use it, and the more new places sprout up that want to accept it. eBay (EBAY) is another good example - sellers go there because that is where the buyers are, and buyers go there because, you guessed it, that's where the sellers are!

The last way to create a moat is through cost advantages. There are a number of ways companies can accomplish this. One way (although the least durable) is by simply having a better business model than your competition. Both Dell (DELL) and Southwest Airlines (LUV) are provided as examples, where business structure allowed these two companies to under price the competition. The second, and more durable, method of cost advantage is by having a better location than your competition. An example here is aggregate (gravel and stone) providers, where ownership of a quarry close to construction is a huge advantage, as these products are heavy and expensive to ship long distances. Quarries also have little potential for competition, as public resistance is a huge barrier to opening a new quarry. This is also known as the "Not In My Back Yard", or NIMBY, effect.

Nearly as useful as the discussion of what constitutes a moat is the explanation of what DOES NOT constitute a moat. How many times have you seen a company recommended because of a great new product or a successful manager that is hired to turn the company around? These are not durable advantages. As Dorsey points out, Krispy Kreme (KKD) and Palm (PALM) both had great products, but great products are easily copied and have a limited life span. Alan Mullaly was considered a great manager at Boeing (BA), but Boeing is a much more attractive business than Ford (F). So far, he hasn't had much success turning around the troubled automaker.

So, how does all of this relate to this site's purpose of finding the best opportunities in the Magic Formula screen? Joel Greenblatt summarizes the Magic Formula screen as "buying great companies at great prices". The "great companies" part of this is based on a return on capital variant - return on tangible capital, to be specific. However, the screen uses a TRAILING twelve month return on tangible capital. Often, this figure screens a company that has enjoyed short term success due to unsustainable factors such as a popular product or temporarily high commodity prices. Certainly, we don't want to buy a Magic Formula stock just to see it's return on capital plummet... which will surely be reflected in a plummeting stock price.

Put another way, there are two ways a stock can drop out of the Magic Formula screen. One, the stock price can rise to a point where the earnings yield figure is no longer high enough to place the stock in the screen. Second, the return on tangible capital can drop to a point where it is no longer high enough, even with a cheap price, to earn a position. So, the company either ceases to be sold at a great price, or it ceases to be a great company (as far as a mechanical screen is concerned). Clearly, we would prefer our stocks to drop out due to price appreciation. This ensures us of a profitable stock pick, while a drop in return on capital will likely lead to a losing pick.

This is where The Little Book that Builds Wealth comes in. Companies with wide moats, by definition, can maintain high returns on capital for long periods of time. By using Dorsey's 4 points in analyzing Magic Formula stocks, we can find stocks that are likely to maintain their high returns on capital. This leaves price appreciation as the more likely means of exiting the Magic Formula screen - exactly the scenario we desire as investors.

In essence, combining the precepts of the two "Little Books" has been the goal of MagicDiligence all along. Combining the moat analysis of The Little Book that Builds Wealth with the quality + undervalued universe created by the methods of The Little Book that Beats the Market, I'm confident most investors will pick stocks that outperform the market over a reasonable period of time. Both books are highly recommended as the foundation of a value based investment strategy.

Steve owns no position in any stocks discussed in this article.

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