A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all. –Buffett (2007)
Many on Wall Street focus on next quarter’s earnings rather than where will earnings be five years from now. They lose perspective on whether the business has or lacks a competitive advantage.
Old School Value
Morningstar Video on Moats
The 5 Sources of Moat
Morningstar’s Paul Larson breaks down the five ways firms can keep competitors at bay and which ways are more durable over time.
Securities mentioned in this video
Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Finding long-term competitive advantages, or economic moats, has long been a cornerstone of our equity research process. I’m here today with chief equity strategist Paul Larson to see what the sources of these moats are and to hear some new insights that he has on them.
Paul, thanks for joining me today.
Paul Larson: Glad to be here again.
Glaser: Let’s start with the source of that economic moat, those competitive advantages. What are some ways that businesses can really put some distance between themselves and their would-be competitors?
Larson: We found five major sources of moats, and those sources are one, the network effect, and this is an effect where when you have customers that start using a network, that network suddenly becomes more valuable for all the other users of the network. Some examples here like eBay. It has the most buyers, and therefore it has the most sellers. And it has the most sellers because it has the most buyers. It’s a virtuous circle. A more recent example would be a company like Facebook. When you or I join Facebook, Facebook suddenly becomes more valuable for all of our friends and as more of our friends join Facebook, it’s more valuable for us. So, that’s a network effect.
Another source of economic moat is customer switching costs, and these are the inconveniences that customers would have when they switch from one product to another. As they say time is money and money is time. It may not cost money to switch from one service provider to another, but if it costs time that’s the same thing.
Another source is intangible assets. These are things like patents, basically an explicit monopoly, government licenses that explicitly block competition. Or [this can be a source] if a company has a strong brand that allows it some pricing power for that particular brand.
Another competitive advantage is something that we call efficient scale, and this is a dynamic where you have a limited market that is being efficiently served by one or a very small number of competitors, and some markets are just natural monopolies or natural oligopolies. A great example here are the airport companies like the Mexican airports. Most cities can’t support just one major commercial airport, so it doesn’t make economic sense to have more than one. If you have it, you benefit.
And the final source of moat is cost advantage, and this is simply when you have a company that can provide a better service at a lower cost than the competition that allows the company to either have a fatter profit margin or the same profit margin as the competitors, but in theory higher volume and higher asset turnover.
Glaser: I know you’ve done a lot of research into how sustainable some of these sources of advantage are. When you take a look across different types of moats, do some stand out to you as really being kind of a better moat, one that’s going to last longer than some of the other reasons?
Larson: Yes. One of the things I recently did is categorize each and every company that has a wide- and narrow-moat rating by their source or sources of economic moat. And what we found is companies that benefit from the intangible assets actually have the best returns on capital by a fairly wide margin relative to the other sources of moat. And digging into why that might potentially be, you have a large exposure to the health-care sector, which basically patents [make up] the moat there. Also you have a larger exposure to the consumer sectors where you have these large relatively stable companies that benefit from brands. The health-care and the consumer companies certainly have high returns on capital, and that contributes to the intangible assets cohort having the absolute highest returns on capital.
Conversely, the source of moat that has the lowest fundamental performance [is found with] the efficient-scale companies, and this makes sense if you think about it intuitively. The efficient-scale dynamic is based on companies having an attractive niche that they have positive economic profits, that they have a moat, but not so profitable and so attractive that they are going to attract new competition into the market. So, it makes sense that the efficient-scale companies would have the lowest returns on capital.
Glaser: Now, when you looked at individual companies and were just looking if they are wide- or narrow-moat, what were some of the differences between wide and narrow? What were some the sources that would have contributed to being one or the other?
Larson: Well, we found that the wide-moat firms are more profitable than the narrow-moat firms. I think, there is zero surprise here because the factors that we’re looking at, such as return on invested capital, return on equity, return of assets, so on and so forth, are the things that we look at when we’re actually assigning the economic moat.
Now, it’s not the absolute level of return on invested capital that we care about when we’re assigning the economic moat rating, it’s actually the duration of the excess profit over the company’s cost of capital. I’ll give you an example, if you have a random fashion retailer that happens to get lucky, hit some fashion trend and has a 50% return on capital for a year or two, we’re not automatically going to say, “Well, gee, that’s a wide-moat firm. They have huge returns on invested capital.” They just got lucky.
But if you look at a company like a railroad or a pipeline, these are companies that don’t have high returns on invested capital. They are actually quite low, around 10%. But the sustainability of that return is exceptionally long, and that’s what we look at when we’re assigning our economic moat rating, the sustainability and not the absolute level.
Glaser: The more of those sources that you have, it seems like it’s easier to kind of extend your benefit over the decades.
Larson: Also, when you have a higher return, if you’re going to have a given variability of earnings over time, if you have a higher return on invested capital to begin with, you have a little bit more of a buffer before you hit that cost of capital than if you have a lower return.
Glaser: You mentioned that some of the wide-moat companies might not have a huge return on capital, but are going to earn that over a long period of time. What about the stability of earnings? How important is that then in determining the moat rating?
Larson: It is relatively important. One of the interesting things that I found in the study looking at the sources of economic moat is that the network-effect companies actually have the least stability in terms of their earnings. What I did is I took a 10-year history of all these network-effect companies and looked at the time series and how the earnings changed over time, and network effect by far had the least stability. Meanwhile, the cost-advantage and also the intangible-asset firms did relatively well.
Glaser: Paul, once investors are kind of armed with these economic moat ratings, what’s the best way to actually invest in them? What’s the best way to really think about actually putting your money behind some of these names?
Larson: Well, I think one of the bottom lines here is that wide-moat firms are fundamentally are better companies than narrow moat firms. Surprise, surprise there. Also companies that have more competitive advantages had better fundamental performance returns on capital than companies that only had a single competitive advantage, all else equal. Also I’d say that for intangible-asset companies, while the moat might not be as identifiable as some of the other sources, the intangible-assets source is relatively attractive. So don’t downplay brands and patents and such.
Glaser: Paul thanks for your thoughts on moats today.
Larson: Thanks for having me.
Glaser: From Morningstar, I’m Jeremy Glaser.