In his famous book The Little Book that Builds Wealth, famous author Pat Dorsey shares a number of key tips for building wealth over a period of time. He is the founder of Dorsey Asset Management, and was earlier the director of equity research for Morningstar.
He has also written a number of books on investing such as The Five Rules for Successful Stock Investing.
Here we encapsulate some of the learnings he has shared in his books:
1. Above average profits: While picking stocks, Dorsey says that investors should identify businesses that can generate above-average profits for many years to come.
They should wait until the shares of those businesses trade for a value which is less than their intrinsic value, and then buy. Then you should hold those shares until either the business deteriorates, the shares become overvalued, or you find a better investment.
The key thing is that the holding period should be measured in terms of years instead of months.
2. Stock price: It is important to buy undervalued stock relative to earnings potential of company. For this, it is important not to rely on a single valuation metric.
So, if a firm is cyclical then one can use P/S (price/sales) as a fair ratio to measure. Investors can — instead — use price/ book value (P/B) for financial firms with tangible assets. This ratio is not useful for service-oriented firms. P/E (price/ earnings) can be compared to the market, similar firm or firm’s historical P/E.
It should be understood that lowest P/E is not always the best. One should prefer low risk stable firm that produces good FCF (free cash flow) than paying less for a cyclical company that is capital intensive.
3. Economic moat: When a company has an economic moat, it can keep its competition at bay, helping it earn more money for a long time, and becoming more valuable to an investor.
4. Intangible assets: A company can have a number of intangible assets such as brands, patents, or regulatory licenses that allow it to sell products or services that can’t be matched by competitors. This also works as an economic moat around it, thus helping it to give a higher return to shareholders.
5. Overcharging for products: If a company can charge more for the same product than its peers just by selling it under a brand, that brand very likely constitutes a formidable economic moat. Such products include Apple’s iPhone, BMW car, Enfield motorcycles among others.
6. Evaluation of management: Investors should evaluate management through a number of ways. One can check the information relating to compensation and find out whether the pay vary with firms’ performance. It is advisable to avoid companies that give loans to executives, have many related party transactions or give out too many stock options.