How Morningstar Measures 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 capitalise 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. The tech sector provides plenty of case studies to back this up. Palm, which pioneered the personal digital assistant (PDA), is a great example. In the late 1990s, the Palm Pilot became an exceptionally popular organisational gadget, and investors quickly caught on to this trend by bidding up Palm's market value to around $30 billion in autumn 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. Today Palm's market cap sits 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 we think 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.

Wider, Deeper, and More Alligators
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. Harvard University professor Michael Porter outlined many of these qualities in his book Competitive Strategy. Below, we briefly review some of the main types of moats we look for.

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. Dell is a textbook example of a low-cost producer because its large size allows it to negotiate favourable component costs, and its direct-sales distribution system allows it to sell PCs more efficiently than rivals who use resellers.

High switching costs: Porter defines switching costs as a barrier to entry that involves the one-time inconvenience or expense a buyer incurs to change over from one product or service to another. Buyers in these cases often need a big improvement in either price or performance to make the switch to another product worthwhile. Medical-device companies Biomet and Stryker benefit from high switching costs because, for example, a surgeon would have have to forgo the comfort and familiarity of doing procedures with one artificial joint product. And because the surgeon would have to be trained to use competing products, he or she would also have to contend with lost time and money resulting from not performing as many surgical procedures.

The network effect: 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. It can also occur when other firms design products that complement an existing product, thereby enhancing that product's value. For example, the fact that there are literally millions of people using eBay is the thing that both makes eBay's service incredibly valuable and makes it all but impossible for another company to duplicate its service.

Intangible assets: Intangible assets generally refer to the intellectual property that firms use to prevent other companies from duplicating a good or service. Of course, patents are the most common economic moat in this category. In techland, Qualcomm's CDMA patents give it a strong moat in the mobile phone industry. Patents are also critical for drugmakers like Merck and Johnson & Johnson. A strong brand name can also be an economic moat--just consider consumer-product companies like Coca-Cola and Gillette.

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.

It's not easy for a company to meet our wide-moat criteria. Of the approximately 550 companies to which we assign moat ratings, less than 20% of them are currently classified as wide-moat. And given that we make an effort to cover wide-moat stocks, that percentage would be far lower if we were rating all publicly-traded companies.

We're sticklers about this because not only must a company's historical financials have to demonstrate a moat, but we also have to be confident that its competitive advantages are sustainable well into the future. Again, Buffett said it best in a 1999 Fortune article: "The key to investing is...determining the competitive advantage of any given company and, above all, the durability of that advantage."