With over 100 equity and credit analysts globally, Morningstar is one of the world’s largest independent sources for stock analysis.
We recently launched equity research in India and have started rolling out Stock Analyst Reports (free registration required) that are consistent with our globally-acclaimed research methodology.
Central to our research insight is our concept of companies having Economic Moats.
What is an economic moat?
The concept of an economic moat can be traced back to legendary investor Warren Buffett, whose annual Berkshire shareholder letters over the years contain many references to him looking to invest in businesses with "economic castles protected by unbreachable 'moats.'"
An economic moat is a long-term competitive advantage that allows a company to earn oversized profits for extended periods of time.
In a 1999 Fortune article, Buffett wrote: "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
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 any industry that allows incumbents to earn high profits attracts competition. These rivals enter the industry to eventually bring down the profits earned by the first mover and all other firms in the same business.
In other words, any monopoly market, unless protected by a sound economic moat, eventually turns to a perfectly competitive market.
Morningstar's approach to moats
So, what are some attributes that can give companies economic moats? Morningstar has defined five key attributes that allow companies to have a moat.
Network Effect: The network effect is one of the most powerful competitive advantages, and it is also one of the easiest to spot. The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service.
For example, in the US, the fact that there are literally millions of people using eBay makes the company's service incredibly valuable and all but impossible for another company to duplicate. For anyone wanting to sell something online via an auction, eBay provides the most potential buyers and is the most attractive. Meanwhile, for buyers, eBay has the widest selection. This advantage feeds on itself, and eBay's strength only increases as more users sign on.
Cost Advantage: Companies that can deliver their goods or services at a low cost, typically due to economies of scale, have a distinct competitive advantage because they can undercut their rivals on price.
Wal-Mart is a great example of a low-cost producer, and its low costs allow it to price its products the most attractively. As a dominant player in retailing, the company's size provides it with enormous scale efficiencies, or operating leverage, that it uses to keep costs low.
Scale allows Wal-Mart to do its own purchasing more efficiently since it has roughly 5,000 large stores worldwide, and it gives the company tremendous bargaining power with its suppliers. Since the company positions itself as a low-cost retailer, it wants to ensure it gives the lowest prices to its customers. This can translate into tough bargaining terms for those firms that want to sell their products on Wal-Mart's shelves. As a result, Wal-Mart is able to offer prices that competitors have a difficult time matching.
Intangible Assets: Some companies have an advantage over competitors because of unique nonphysical, or "intangible," assets. Intangibles are things such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage.
In some cases, whole industries derive huge benefits from intangible assets. Consumer-products manufacturers are one example. They build profits on the power of brands to distinguish their products.
PepsiCo is a world leader in drinks and salty snacks, and the firm boasts a lineup of strong brands, innovative products, and an impressive distribution network. The company's investment in advertising and marketing distinguishes its products on store shelves and allows PepsiCo to command premium prices.
Consumers will pay more for a bag of Frito-Lay chips than for a bag of generic chips. As the value of a brand increases, the manufacturer is also often able to be more demanding in its distribution relationships. To a large degree, brand power creates demand for those chips and secures their placement on store shelves.
Switching Costs: Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. If you've ever taken the time to move all of your account information from one bank to another, you know what a hassle it can be--so there would have to be a really good reason for you to consider switching again.
Companies aim to create high switching costs in order to "lock in" customers. The more customers are locked in, the more likely a company can pass along added costs to them without risking customer loss to a competitor.
Efficient Scale: When a company serves a market limited in size, new competitors may not have an incentive to enter. For instance, for a niche market, the demand would only be large enough to support one dominant firm and thus potential competitors have little incentive to attack.
One final thought about economic moats: It is possible for some companies to have more than one type of moat. For example, many companies that use the network effect also benefit from economies of scale, because these companies tend to grow so large that they dwarf smaller competitors. In general, the more types of economic moat a company has--and the wider those moats are--the better.
Assigning a Moat Rating
For each stock we cover, we assign an Economic Moat rating on three scales: Wide, Narrow and None, depending on whether we think the company will be able to sustain its advantage for two decades, one decade or a few years, respectively.
Assessing a company’s competitive advantage involves understanding what kind of defense, or competitive barrier, the company has been able to build for itself in its industry.
One of the first things we do when we're thinking about the size of a firm's economic moat is look at the company's historical financial performance. Companies that have generated returns on capital higher than their cost of capital for many years running usually have some sort of a moat, especially if their returns on capital have been rising or are fairly stable.
Of course, the past is a highly imperfect predictor of the future, so we look carefully at the source of a company's excess economic profits and analyze how likely it is to continue in the future, before assigning a moat rating.
For example, a competitive advantage created by a hot new technology usually isn't very sustainable, because it won't be too long until someone comes along and invents a better technology. However, any of the above five attributes mentioned earlier can give a company its moat. The longer the advantage remains, the wider a company is said to have an economic moat.
Morningstar has an internal committee that votes on the final recommendation of the analyst before launching an initiating coverage on a new company. The moat ratings are also regularly reviewed to ensure the ratings are in line with changes in the industry/economy.
To read our latest equity research coverage on Indian stocks, click here.
