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Investing Specialists

The Next Game-Changers

We think these trends will shape the business landscape, and company moat ratings, in years to come.

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A version of this article originally appeared in the May issue of Morningstar StockInvestor.

Economic moats are dynamic entities that are constantly shifting. As investors, it's crucial to know whether the competitive advantages of our firms are getting stronger, weaker, or not changing much. Below are some of the larger trends we are observing that will change the landscape in the coming years. How these trends play out will determine whether or not dozens of companies we follow hang on to their moats as well as which companies will eventually graduate to wide moat.

Fragmentation of Media
It was only a generation ago that media companies of all stripes had some of the widest moats. In any given city, there might be one or two newspapers, as well as a handful of television and radio stations, and that was about it. The companies that held the appropriate licenses controlled the dissemination of information. It was almost impossible to start and maintain a business without paying the relatively steep price of the few toll-keepers that managed information exchange.

As an example of just how concentrated media was a few decades ago, back in the 1950s, it was common for more than half the televisions in the country to be tuned to the typical "I Love Lucy" show. But today, the world has totally changed, and it will likely only continue to get worse for the existing media companies. It's safe to say that the shared media experiences of the past are mostly gone.

The number of options for receiving information via any given medium has exploded. We've gone from three major television networks to hundreds of available cable channels. In radio, in recent years we've gone from a couple dozen stations in any given market to hundreds because of high-definition and satellite services. Each additional channel slices the existing pie into pieces that are that much smaller.

Not only are we seeing a proliferation of options over media that have existed for some time, but we are also seeing an explosion of alternatives. For instance, I no longer receive physical newspapers; I just read everything online, a far superior format in terms of scope and speed. Plus, why watch "reality television" when Web sites Facebook and YouTube can provide just as much entertainment? My kids and their friends (as good an indication as any of what the future will bring) still watch small amounts of TV, but it is a tiny fraction of the amount I watched growing up in the pre-Internet era. They much prefer (as do I) to spend their downtime in front of a computer instead of sitting on a couch in front of the TV.

The losers from the trend are the media companies themselves, including conglomerates  Disney (DIS) and  General Electric (GE). In a nutshell, these companies control something that was once scarce but is now plentiful. There is a big silver lining, however, as there is a group benefiting from this trend. Namely, the consumer products firms with strong brands, such as  Coca-Cola (KO) and  Procter & Gamble (PG). In the golden age of media, it was relatively easy to reach a broad audience to launch a new product. Today, attaining critical mass for a new national brand is much more difficult, as there is no easy way to advertise to a majority of the population. As media fragments further, the incumbent brands simply become that much more entrenched.

Not only is the way we receive media fragmenting exponentially, but the information and entertainment we consume is moving to the digital realm. Examples best tell the story here. Physical newspapers are closing by the day, as people migrate online to receive the news. Audio CD sales continue to plunge (now at roughly half the peak reached in 2000), while download services such as  Apple's (AAPL) iTunes continue to explode in popularity. Or, consider the high growth rates of  Netflix (NFLX), while  Blockbuster (BBI) is nearing bankruptcy. (And even the traditional Netflix mail service is likely to be supplanted by downloads.)

In a nutshell, in the future, if something is able to be delivered and consumed electronically, it probably will because this method of distribution is much less expensive. After all, the value in any given media is not in the cardboard and plastic, but rather in the information itself. Apple and  Amazon's (AMZN) gain will be at the expense of physical retailers such as  Best Buy (BBY) and  Barnes & Noble (BKS).


Cloud Computing
It's not just music and movies that are likely to be delivered via the Internet in coming years, but software, too. The days of buying a physical cardboard box full of software and manuals are numbered.

Consider "cloud computing" (which is sometimes called "software as a service"). Basically, instead of having all your software and files installed on your computer, in a cloud computing world, you would just fire up a Web browser and use services provided remotely from central locations. In the current way of doing things, I buy  Microsoft (MSFT) Word, install it on my machine, use it, and store my files on my local hard drive. But on the bleeding edge of technology, I could just fire up a Web browser, visit the Web site of a word processing service (such as the current  Google (GOOG) Docs), and save my documents on the service's central computers. It's cheaper, and the documents are automatically backed up and available from anywhere.

Allow me a short analogy using electricity. Think of how the world would look if each of us had our personal electricity generator in our backyards. Although silly and inefficient, this is essentially what we have with computers today. Eventually, it looks as though the computing world will move to the electricity model, where power is generated efficiently at a handful of central locations and then distributed via a robust transmission system.

Another emerging example of this trend comes from console gaming. A new firm named OnLive will soon be offering a service that--according to early reviews--will offer games comparable to what is available today from Microsoft's Xbox or  Sony's (SNE) PlayStation. But with OnLive, there is no big box under the television or physical games required, just a controller and a simple device that connects to the Internet.

The winners are the companies that can provide the large central servers such an infrastructure would require. This means numerous firms, such as  IBM (IBM),  Oracle (ORCL),  Cisco (CSCO), and Google, could see their moats widen a tad and/or their growth rates tick up. Those with narrowing moats are those that benefit from the old way of doing things.  Dell (DELL) does a great job selling powerful desktop boxes, but the amount of computing power sitting on a desktop is becoming much less relevant. Moreover, Microsoft has a stranglehold on desktop software, but once software becomes provided as a service, the desktop loses relevance. (We still think Microsoft has a wide moat as it will no doubt be a major player in cloud computing, but its moat is definitely narrowing from its previous "superwide" status.)

Cloud computing is perhaps the most revolutionary trend in this article, as opposed to the other trends that are more evolutionary. Simply put, software is no longer married to hardware. Or, just think of it as the trend toward having the majority of computing power no longer distributed on millions of desktop boxes, but rather provided by central servers in thousands of locations and distributed via the Internet.

Health-Care Reform
Health-care spending growth has outpaced overall economic growth for several decades now, and this is not a sustainable situation. This means we will have to limit care (no more "all you can eat" health care), or we will have to reduce the cost of care, or both. Reform could potentially take several paths, and in the most drastic scenarios, nearly every health-care company we follow would have its moat destroyed. But we think milder, incremental changes are most likely to occur.

One thing that seems to be obviously coming down the pike (because it was mentioned in President Obama's budget) are generic versions of biologic drugs. Biologics are drugs composed of proteins that tend to be quite large chemically (thousands of atoms) and made via biological processes. These differ from most pharmaceuticals, which are small molecules with only a couple dozen atoms, easily manufactured in bulk. Whenever a biologic drug goes off-patent in the United States, the drugs essentially maintain a monopoly because a biologic drug's form and function depend on its manufacturing method. Much like how a wine from France tastes different than a wine from Ohio; the differences are subtle but important. With biologics, creating a precisely exact copy of a drug is nearly impossible, so at the moment, a generic manufacturer cannot simply say "me too" concerning the safety and efficacy studies. Right now, there is no meaningful approval pathway for generic biologics.

But that is changing. In order to generate greater competition (and lower prices) the government wants to create relatively easy pathways for generic biologics to make it to market by relaxing and streamlining testing restrictions. Should this happen, the losers would be those companies currently selling biologics, such as  Amgen (AMGN) and  Johnson & Johnson (JNJ). Winners would be generic manufacturers, such as the Sandoz unit at  Novartis (NVS). (This trend could move the needle a lot at Amgen, but not so much at J&J and Novartis, given their diversity of operations.) Either way, the broader trend is that the government will be doing everything in its power to lower its costs (reduced pricing power in the industry across the board), offset mildly by an increase in volumes as the currently uninsured receive more care.

As you can see, some companies will see the competitive advantages weaken a tad over time, while others will get stronger. It's simply the way of the world to have comers and goers. We've got eyes on the changes and are incorporating all the shifts in the landscape into our ratings and analyses.

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Paul Larson has a position in the following securities mentioned above: AMGN, DELL, JNJ, MSFT, NVS, PG. Find out about Morningstar’s editorial policies.