Seeking competitive advantages and attractive valuations leads to smart investing.
By Michael Holt, Andrew Lane, and Hari Narayan
In a free-market economy, capital seeks the areas of highest return. Whenever a company develops a profitable product or service, it doesn’t take long before competitive forces drive down its economic profits. Only companies with an economic moat—a sustainable competitive advantage that allows a firm to earn above-average returns on capital over a long period of time -- are able to hold competitors at bay.
Warren Buffett devised the economic moat concept. Morningstar has made it the foundation of its stock-investing philosophy and methodology. To us, buying a share of a stock means buying a small piece of a business, and successful investing involves a thorough evaluation of whether a business will stand the test of time.
A firm must have a competitive advantage inherent to its business to possess a moat. To help investors identify companies that have a moat, we assign one of three Morningstar Economic Moat Ratings: none, narrow, or wide. There are two major requirements for firms to earn either a narrow or wide rating: 1) The prospect of earning returns on invested capital above a company’s weighted average cost of capital, and 2) some competitive edge that prevents these returns from quickly deteriorating.
Moats stem from at least one of five sources of competitive advantage—cost advantage, intangible assets, switching costs, efficient scale, and network effect. Of the 200 or so wide-moat companies we cover, 72% benefit from intangible assets, 47% from sustainable cost advantage, 37% from customer switching costs, 20% from network effect, and 12% from efficient scale. (Because firms can achieve a wide moat from multiple sources, the percentages do not add up to 100%.) Great management, size, dominant market share, easily replicable technology or efficiencies, and hot products are advantages to any business, but none of them is a structural advantage that can sustain high returns over a long period of time.
Why Do Moats Matter?
The concept of an economic moat plays a vital role not only in our qualitative assessment of a firm’s long-term investment potential, but also in the actual calculation of our fair value estimates. A company that is likely to compound cash flow internally for many years is worth more today than a company that isn’t. Therefore, when comparing two firms with similar growth rates, returns on capital, and reinvestment needs, the company with a moat has a higher intrinsic value.
High returns on capital will always diminish over time due to competition. For many companies (and their investors), economic profit erosion can be swift and painful. However, a few generate excess returns for many years, and moat analysis gives us a framework for identifying them.
Moreover, if a firm can fall back on a structural competitive advantage, it’s more likely to recover from temporary troubles. Moats provide a margin of safety because if an investor is confident in the moat, it’s easier to average down if he or she initiates a position too early.