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 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. The second, and more durable, method of cost advantage is by having a better location than your competition. 

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. 

Buffett once said of his long-term investment in Coca-Cola, which has been both a market darling and a market demon:

We have had depressions. We have had wars. Sugar prices have gone up and down. A million things have happened. How much more fruitful is it to think about whether the product is likely to sustain itself and its economics than to try to be questioning whether to jump in and out of the stock?

In other words, what he's after is a company with a strong competitive advantage -- a moat that lasts for years.

A nice protective ring of water
Competitive advantages are the sustainable factors or strategies that repel competitors -- just like the ring of water around a medieval castle fended off invaders. The better and more comprehensive this protection, the longer the company can do what it does without worrying about invaders on its turf.

According to Mark Sellers, founder of Sellers Capital, there are four basic characteristics of a strong, deep, and defensible moat. Let's look at them, briefly.

• Economies of scale

Economies of scale enable companies to produce products more cheaply than competitors -- effectively undercutting their prices. Think about Coke and Buffett's comment about sugar prices. Sugar used to be the primary sweetener in Coke. More recently, it's been corn syrup. Coke's global economies of scale let it obtain that ingredient and distribute it at a cost that makes its own product more profitable.

• Intellectual property

But economies of scale aren't the only thing Coke has going for it -- it also has a world-famous brand. You might think brand is just name-recognition, but it goes far beyond that. In fact, behavioral studies have shown that if people know they are drinking a Coke, they say it tastes better than if they receive the same drink in a blind taste test. That's powerful!

Intellectual property goes beyond brands, though, to include things like patents and trademarks. 

• Network effect

When the value of a product or service increases when more people use it, that's called a network effect. 

• High switching costs

Excerpts from an article on moat.