This weekend I read The little book that generates wealth, by Morningstar’s Director of Equity Research, Pat Dorsey. This is a wonderful companion for The little book that beats the market, and the combination of the principles in the two should lead to finding exceptional investment opportunities. In this article, I summarize the main points of Dorsey’s new book, and then provide some ways we can apply his wisdom to better select actions on the Magic Formula screen.

The little book that generates wealth It has to do with a principle: determining the economic moat of a company. 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. Companies that earn high returns on capital invariably attract a lot of competition. Moatless companies may see their profit margins and sales growth decline as competitors increasingly capture their market share. On the other hand, wide moat companies have advantages that make it very difficult or uneconomical for competitors to try to compete with them. The moat concept has been one of the keys to the success of the world’s most renowned investor, Warren Buffett.

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

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

The third form of moat is created by the network effect, where the value of a business increases with each node in the network. This 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 will come up that want to accept it. eBay (EBAY) is another good example: sellers go there because the buyers are there, 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 several ways that companies can achieve this. One way (albeit the least sustainable) is simply to have a better business model than the competition. Both Dell (DELL) and Southwest Airlines (LUV) are provided as examples, where the business structure allowed these two companies to price lower than the competition. The second and more enduring method of cost advantage is having a better location than the competition. An example here is aggregate (gravel and stone) suppliers, where owning a quarry close to construction is a great advantage, as these products are heavy and expensive to transport over long distances. Quarries also have little potential for competition, as public resistance is a major barrier to opening a new quarry. This is also known as the “Not In My Back Yard” or NIMBY effect.

Almost 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 who is hired to turn the company around? These are not lasting advantages. As Dorsey points out, Krispy Kreme (KKD) and Palm (PALM) had great products, but great products are easily copied and have a limited shelf life. Alan Mullaly was considered a great manager at Boeing (BA), but Boeing is a much more attractive business than Ford (F). So far, it hasn’t been very successful in turning around the troubled automaker.

So how does all of this relate to this site’s purpose of finding the best opportunities on the Magic Formula screen? Joel Greenblatt summarizes the Magic Formula screen as “buying big companies at big prices.” The “large company” part of this is based on a variant of return on capital: return on tangible capital, to be specific. However, the screen uses a TRAILING twelve-month return on tangible capital. Often this figure assesses a company that has enjoyed short-term success due to unsustainable factors, such as a popular product or temporarily high commodity prices. We certainly don’t want to buy a Magic Formula stock only to see its return on equity plummet…which is sure to be reflected in a stock price plummet.

Put another way, there are two ways an action can go off the Magic Formula screen. One, the stock price can rise to a point where the earnings yield figure is no longer high enough to put the stock on the screen. Second, the return on tangible equity can drop to a point where it is no longer high enough, even at a low price, to win a position. So, the company either stops selling at a very good price, or it stops being a great company (as far as mechanical screens are concerned). Clearly, we would prefer our stock to drop due to price appreciation. This assures us of a profitable stock pick, while a drop in return on equity will likely lead to a losing pick.

this is where The little book that generates wealth comes in. Companies with wide moats, by definition, can sustain high returns on capital for long periods of time. By using Dorsey’s 4-point Magic Formula stock analysis, we can find stocks that are likely to maintain their high returns on capital. This leaves price appreciation as the most likely means of exiting the magic formula screen, exactly the scenario we want as investors.

Combining the moat analysis of The little book that generates wealth with the quality + undervalued universe created by the methods of The little book that beats the market, I’m sure most investors will choose 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.