How we use Moats in Equity Analysis

At Morningstar, the concept of economic moats is a cornerstone of our stock-investment philosophy. Successful long-term investing involves more than just identifying solid businesses, or finding businesses that are growing rapidly, or buying cheap stocks. We believe that successful investing also involves evaluating whether a business will stand the test of time.

To define, an economic moat is a long-term competitive advantage that allows a company to earn oversized profits over time. Quite simply, companies with a wide moat will create value for themselves and their shareholders over the long haul.

Castles and Moats

The concept of an economic moat can be traced back to legendary investor Warren Buffett who looked to invest in businesses with "economic castles protected by unbreachable moats."

Moats are important to investors because any time a company develops a useful product or service, it isn't long before other firms try to capitalize on that opportunity by producing a similar--if not better--product. Basic economic theory says that in a perfectly competitive market, rivals will eventually eat up any excess profits earned by a successful business. In other words, competition makes it difficult for most firms to generate strong growth and margins over an extended period of time.

Investors especially run into trouble when they underestimate the effects of competition by assuming that a company's prospects are more sustainable than they really are. Palm, which pioneered the personal digital assistant, or PDA, is a great example. In the late 1990s, the Palm Pilot became an exceptionally popular organizational gadget, and investors quickly caught on to this trend by bidding up Palm's market value to around $30 billion in the fall of 2000. But it didn't take long for rivals like Handspring, Sony and Hewlett-Packard to introduce their own versions of the PDA, thus taking market share from Palm and eroding its margins. By 2003, Palm's market cap stood at around $350 million. Investors at the time clearly underestimated Palm's competition.

The problem with Palm was that although the firm had built an impressive castle with nifty new technology, it couldn't build a sufficient moat to defend that castle from its rivals. That’s why investors should look for firms that have a sustainable competitive advantage--not just an interesting new product, but a unique asset that can truly stand the test of time.

Sustainable competitive advantages can take many forms, and some companies are better at developing them than others. But more than anything, the principle of sustainability is key to evaluating a company's economic moat. A company with a wide economic moat is one best suited to prevent a competitor from taking market share or eroding its margins. Here are some moats to help you get the picture.

• The Network Effect

This is a potentially quite potent source of competitive advantage, and often applies to the first mover in an emerging technology.

The network effect is an effect where the value of a given network grows exponentially with each node of the network that's added. The value of that good or service increases for both new and existing users as more people use that good or service. Since a network's value increases as more people use it, the company that creates the network can create a massive economic moat.

Equity strategist Paul Larson illustrates it with examples. When you look at the payment networks--like Visa and MasterCard--those credit card payments are accepted because those are the cards that consumers have in our wallets. And why do we carry around those particular cards in our wallets? Well, that's what's accepted as payment. It’s a virtuous network. Every person that takes out another Visa credit card is adding to that network and making it more likely that the merchants are going to sign up for Visa.

Why is everyone on Facebook? Because that's where everyone else is. And the value of Facebook grows as more people join. As more customers join the network, it makes that network more valuable for other customers.

This is a relatively rare source of competitive advantage but is also the most powerful. The companies that have this advantage tend to have relatively high levels of profitability.

• High Customer-Switching Costs

If you can make it tough for your customers to use a competitor, it's usually easy to keep ratcheting prices up just a bit year after year-which can lead to big profits.

Switching is a barrier to entry that involves an expense a customer incurs to change over from one product or service to another. If not an expense, it could be a one-time inconvenience.

Buyers in these cases often need a big improvement in either price or performance to make the switch to another product worthwhile.

It may not cost a customer money to switch from one provider to another. In fact, they may actually save money by switching. But if it's going to cost them time to switch, that may increase inertia and keep them with an existing provider, and allow that provider some pricing power.

The typical example is bank deposit accounts. Those deposits tend not to turn over a whole lot simply because it costs customers time to actually switch banks.

• Low-Cost Producer

Firms that can figure out ways to provide a good or service at a relatively low cost have an advantage because they can undercut their rivals on price. This means that you can either charge the same price as the other competitors out there, and reap a higher profit margin, or you can charge slightly lower prices and maybe try and gain some share from competitors.

One way to get a cost advantage would be economies of scale. A bigger company can typically source things cheaper and have lower overhead costs. On the other hand, Larson says that a basic materials company may have an inherently low cost. He gives the example of a company mining a certain geology that has much lower cost than geologies elsewhere around the world. This is an inherent cost advantage, something structural to the business, and could be a source of economic moat.

• Intangible Assets

Intangible assets generally refer to the intellectual property that firms use to prevent other companies from duplicating a good or service. Patents are the most common economic moat in this category. This gives a company basically a legalized monopoly. In certain situations, especially in the pharmaceutical industry, if you have a best-in-class drug, and you have legalized monopoly, that gives you enormous pricing power.

A strong brand name can also be an economic moat. Larson points out that a brand for a random consumer-electronics, say a DVD player, is not going to confer a company pricing power. But a brand like a Coke or a Tiffany allows them to charge that little bit of a premium that could certainly be a source of economic moat.

Copyrights, governmental approvals and licenses also fall in this category. Some companies generate enormous profits when their products or markets are artificially protected by the government. For instance, a permit for a landfill or a casino license in an area where there are a limited number of casinos provide a competitive advantage.

• Efficient Scale

Larson compares it to a game of musical chairs, where all the chairs are already taken. When you have a company that's providing a service to a limited market, and there's a relatively small number of competitors supplying to that market, it may not make sense for a new competitor to enter the market, because that new competitor would destroy the returns for all the players involved.

Some markets are just natural monopolies. Larson cites International Speedway, which owns NASCAR race tracks. Chicago has a NASCAR racetrack, and the Chicago market can support exactly one NASCAR racetrack. So no one would want to build another racetrack in the market when there's already a player there. It just wouldn't make sense.

Measuring Moats 

Evaluating economic moats is a qualitative process and tough to pin down. At Morningstar, we classify moats as either wide, narrow, or none. To determine which bucket a company fits into, we spend a lot of time getting to know the industries we cover, combing through financial statements and talking to management. Before we'll classify a company's moat as wide, we want to see evidence of competitive advantages, such as large market share or above-average returns on capital over an extended period of time.

The text for this article has been extracted from a conversation between Morningstar's U.S. editor Jason Stipp and equity strategist Paul Larson, and an analyst's explanation in How Morningstar Measures Moats.  To check the term in the Investing Glossary, click here.