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What Makes a Moat?

In an excerpt from their new book, Morningstar's Heather Brilliant and Elizabeth Collins explore how to identify a moat and how intangible assets can help a firm carve out a sustainable competitive advantage.

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Identifying economic moats, or structural barriers that protect companies from competition, is the cornerstone of Morningstar's equity analysis. Similar to the way castles are protected by moats, companies with economic moats are great businesses that can fend off competition and earn high returns on capital for many years. Morningstar's new book, Why Moats Matter: The Morningstar Approach to Stock Investing, helps investors find superior businesses and determine when to buy them to maximize returns over the long term.

During the next three days Morningstar.com will be presenting excerpts from the book on what makes a moat and how to identify the five sources of moat. Part 1 is below.

To determine a company's economic moat rating, we start by asking two questions:

  1. Are the company's returns on invested capital, or ROIC, likely to exceed its weighted average cost of capital, or WACC, in the future? (1)
  2. Does the company appear to have at least one of the five sources of sustainable competitive advantage (intangible assets, cost advantage, switching costs, network effect, or efficient scale)?

In this regard, our moat methodology considers both quantitative and qualitative factors--the ROIC-WACC spread, also referred to as economic profits, and the moat sources, respectively. A firm generates economic profits when its earnings exceed not only accounting costs but also investors' opportunity costs. A firm can generate positive net income, or positive accounting profits, without posting economic profits if it doesn't reward equity investors for putting their money in the business.

The process of answering these fundamental questions about future economic profits and sustainable competitive advantages includes carefully researching the company and its industry. At Morningstar, our process includes analyzing the company's financial statements, talking to its managers, visiting the firm's operations when relevant, and reading industry publications. This fundamental analysis is a key component of understanding the outlook for a company's future profitability and competitive forces. If we think ROICs are likely to exceed WACC in the future, and the company appears to have any of the five sources of competitive advantage, it's possible that the firm does indeed have a narrow or wide economic moat. But the investigation doesn't stop there. We next assess the company's ability to generate positive economic profits 10 to 20 years into the future. In free-market economies, rivals will eventually encroach on any excess profits earned by companies without protective moats--time and capital requirements aren't effective barriers to entry when we have a long-term time horizon. Some companies may generate positive ROIC-WACC spreads today and for a few years into the future. But if their competitive advantages aren't sustainable enough, competitors will begin to eat into excess profits over time.

Therefore, for a company to earn our narrow economic moat rating, we must find evidence that at least one source of competitive advantage exists and that economic profits will be positive for at least 10 years. If we think economic profits will endure for at least 20 years, the firm earns our wide moat rating. We believe sustainability is much more important than the magnitude of economic profits when assessing economic moats. In other words, a highly certain 20-year stream of modest economic profits is much more moat-worthy than a few years of extraordinarily high returns on invested capital. The 10- and 20-year benchmarks are somewhat arbitrary, but the idea is to focus on the long-term cash generation potential of the underlying business and put some parameters around approximately how long we expect excess returns to last. It's also important to note that we're considering economic profits in a normalized, or "midcycle," environment. If we expect a company to generate robust ROICs only during peak industry conditions, then it's not a candidate for our narrow or wide moat ratings. On the flip side, if a company isn't earning economic (or even accounting) profits today because it's in the depths of an industry trough or because extraordinary one-time factors are at play, it's not precluded from earning a narrow or wide moat rating.

Note that our moat-rating methodology is absolute, not relative. We're simply looking for companies that have 1) sustainable competitive advantages and 2) a likelihood of generating positive economic profits for a decade or more. Narrow and wide moat ratings are not reserved for only the best companies in a given industry, and some industries may lack any companies with sustainable competitive advantages at all. To ensure we apply our methodology consistently across our broad coverage universe, and given the central importance of the economic moat rating to the Morningstar equity research methodology, a committee of 15 senior members of the Morningstar research team oversees all of the individual company ratings. Because the committee members represent each of the major sectors, this approach provides context for an individual company's rating, and we can avoid common pitfalls such as thinking that only the finest company in an industry deserves a wide moat, or that "best-in-industry" status automatically equates to a sustainable competitive advantage.

Moat Sources
Now we're ready to dig into the moat sources one by one. For each of the five sources we provide lists of critical questions that you can ask yourself when determining whether a particular company has a narrow or wide economic moat. If you've read even a handful of 10-K annual reports, you know that most companies present a list of competitive advantages that sound moat-worthy, such as patents, brands, cost advantages, and strong customer relationships. The questions we have assembled are designed to help ferret out whether a company truly benefits from one of the moat sources. Further, in our years of reading 10-Ks, we've found it rare for companies to explicitly mention advantages such as switching costs, network effect, or efficient scale. So, finding companies with these sources requires an extra level of analysis, and these key questions are meant to help you uncover companies with these powerful sources. For each source, we provide a few examples, so you can see how these play out in the real world.

Intangible Assets
Intangible assets is a broad category that includes brands, patents, and regulatory licenses.

Brands
A brand creates an economic moat around a company's profits if it increases the customer's willingness to pay or increases customer captivity. A moat-worthy brand manifests itself as pricing power or repeat business that translates into sustainable economic profits.

Walt Disney (DIS) is a good example of a company that has built a moat based on the intangible asset of brand. In fact, strong brands support robust and sustainable economic profits at both of Walt Disney's key businesses: cable networks and Disney-branded businesses (parks, filmed entertainment, and consumer products). On the cable side of the business, strong networks like ESPN earn rich subscriber fees and profits. These profits allow the company to spend on long-term programming rights with the major professional sports leagues and college athletic conferences, which reinforces ESPN's position as the leader in its category. The strength of this brand has allowed the company to expand the franchise and has resulted in several sister channels and the most popular website dedicated to sports content. In the Disney-branded businesses, the company exploits strong characters and franchises across multiple platforms. Disney has been creating high-quality family entertainment for decades and has become a brand that children seek and parents trust. Disney's theme parks and resorts are difficult for competitors to replicate, especially considering the tie-ins with its other business lines. A Disney character franchise typically starts with a theatrical release, but can be further exploited through DVD sales, licensing to television networks, sequels, merchandising, and theme park attractions. Each new successful franchise becomes a valuable addition to Disney's large library of content, which can be monetized for decades.

Starbucks (SBUX) remains the dominant player in specialty coffee, and its brand commands premium pricing for what is truly a commodity. Coffee is a globally fungible commodity (in other words, it is easily replaced by another identical product) that is traded on liquid exchanges with complete price transparency. Still, Starbucks' customers are willing to fork over extra dollars for a cup with a green mermaid, thanks to the experience Starbucks has created as part of its brand. As a result, we expect Starbucks to generate handsome economic profits in the coming decades, with ROICs in excess of 20% over the long term.

Bayerische Motoren Werke AG BMW earns our narrow moat rating, thanks to the strength and global recognition of its brands, its technological leadership in powertrain, its ability to command premium pricing from consumers that regularly rate its vehicles as some of the best to own, and its ability to consistently generate excess returns. Even though the venerable Rolls-Royce and BMW brand names command premium pricing, consumers can easily switch to other brands, like Bentley or Audi, and a seemingly bulletproof brand image can tarnish quickly. However, thanks to an ingrained culture that obsesses over the details that the company's customers demand, we think BMW will continue to successfully manage its brand images--ranging from premium-priced BMW motorcycles and Cooper MINI passenger cars, to luxury BMW passenger cars and crossovers, to ultraluxury Rolls-Royce cars--leading to economic value creation for investors. The company's returns exceeded its cost of capital in 10 of the past 11 years, an outstanding performance for an automotive manufacturer and a phenomenon that we expect will endure.

Key Questions: Brands

  1. How do you quantify the strength of the brand? What is the pricing power that the brand conveys? What is the premium that the company can charge relative to competitors? High name recognition doesn't always translate into pricing power. Just think of airlines such as United or American--you're probably very aware of these brands, but that doesn't mean you're willing to pay more for a United or American ticket. Most likely you'll make your purchasing decision based solely on cost after factoring in class, mileage credits, and baggage fees, and we see this reflected in the poor returns these airlines generate. As a result, most airlines lack sustainable competitive advantages.
  2. Is the premium offset by higher costs? Some companies do indeed charge higher prices than their competitors, but that merely reflects a higher cost of production. For a brand to be moat-worthy, it must confer pricing power that at least offsets any difference in costs.
  3. How do the company's margins compare with competitors that don't have strong brands? If you don't have specific data on prices and costs, you can look at a company's profit margins relative to its peers for signs of pricing power.
  4. What gives you confidence that the brand strength, the premium pricing, and the higher operating margins are sustainable for 10-20 years? Brands come and go, and sustainability is the most important factor when determining economic moats. After all, history is littered with examples of well-recognized brands that didn't lead to sustainable returns, such as Crocs (CROX),  Nokia (NOK), and Palm. Although it's hard to predict which brands will remain powerful decades into the future, companies that continuously plow money into innovation and marketing are more likely to have powerful brands in the future. Further, lifelong brands arguably have more longevity potential than companies with high-turnover client bases. For example, once a consumer develops a taste for, say,  Coca-Cola (KO) over  Pepsi (PEP), that's a preference that will likely hold, and Coca-Cola can rely on having the same customer for decades. However, new parents deciding on infant formula develop a brand preference that lasts only during the early childrearing years, and therefore formula companies such as Mead Johnson must constantly acquire cohorts of new parents.

Patents
Sometimes patents are a source of sustainable competitive advantage for a company, although not all patents lead to narrow or wide economic moat ratings. If patents protect a company's main products, and there are no viable alternatives, then the company may have pricing power for a sustained period while other industry players are legally barred from competing.

Like other highly successful pharmaceutical companies, Sanofi (SNY) benefits from patent protection that keeps competitors at bay for several years while the company charges prices that enable returns on invested capital significantly above its cost of capital. Also, Sanofi's unique entrenched position in the insulin market further reduces the threat of generic competition even after patents expire thanks to the high up-front costs needed to achieve the economies of scale for low-cost insulin production. Sanofi's existing product line boasts several top-tier drugs, including long-acting insulin Lantus. The drug's ability to work well for an entire day sets Lantus apart from other insulins. Given the complexity in marketing and manufacturing insulin, we don't expect major generic competition following the drug's 2015 patent loss. The company's leadership in the insulin and rare-disease biologic markets exposes Sanofi to less-pronounced generic threats; we believe eventual generic competition will not destroy branded sales to the same extent that we see with generic small molecules, given the marketing and manufacturing complexity associated with biologic drugs. Further, Sanofi has compiled a robust group of late-stage pipeline products that complement its existing lineup and should help mitigate patent losses.

A patent portfolio worth mentioning belongs to iRobot (IRBT), maker of Roomba (the robotic vacuum cleaner) as well as military and police robots. The company has a perceived product advantage that is backed by strong patent protection. Outside Korea, where players such as Samsung and LG have found success with their own high-end products, iRobot has not faced meaningful competition in its home robot division, even as the company has sold more than 6 million Roombas worldwide. We attribute this success to a continued strong patent portfolio; the only competing products have been too expensive, of lower quality, or poorly managed, preventing them from denting iRobot's competitive position.

Having created the agricultural biotechnology market where it now competes, Monsanto (MON) has a wide economic moat. The company's portfolio of patented traits--seed characteristics that improve farmers' profitability--forms the basis of its moat, much in the same way patent-protected drugs form the moat foundation for a pharmaceutical firm. Monsanto's proprietary seeds use the traits it develops, but the firm also licenses traits for use by others. This strategy has led to dominant market share, and Monsanto enjoys premium pricing for its patented traits. Monsanto uses the cash flows generated from its current product lineup to invest in research and development for next-generation offerings. The company consistently pours 10% of sales into R&D each year. Monsanto is also a very attractive partner for agricultural biotech companies without their own extensive seed platforms. Further, the company owns an industry-leading germplasm (a seed bank for conventional and molecular hybrid breeding) and a global breeding operation that are difficult to replicate. Signs of Monsanto's dominance in genetically modified, or GM, seeds are readily apparent, including rivals' accusations of controlling an unfair monopoly and the fact that some competitors choose to license the firm's technology instead of going head-to-head with Monsanto. For example, Syngenta (SYT) and  DuPont (DD) have chosen to license Roundup Ready 2 Yield for their second-generation soybean offerings instead of investing the dollars to develop their own platforms. We think Monsanto will earn returns on invested capital above the firm's cost of capital for quite some time.

Key Questions: Patents

  1. What is the expiration schedule for the company's patent portfolio? Because a narrow or wide economic moat rating depends on a company's ability to produce economic profits for a decade or more, patents that expire within the next several years certainly don't confer a moat by themselves.
  2. How diverse is the company's patent portfolio? A company with a wider breadth of patented products is more likely to have a narrow or wide moat because the diversity leads to higher chances that the company will generate economic profits for a decade or more. A company with a history of successful research and development investment in its patent portfolio is more likely to maintain a patent-related competitive advantage than one without such a track record.
  3. What is the market potential of patentable products in the pipeline and the probability of their success? Since we need to assess a company's economic-profit-generating potential 10–20 years in the future, we need to analyze the earning potential of products that haven't even come to market yet.
  4. Once products come off patent, how easy will it be for competitors to enter the market? Sometimes, even when a product comes off patent, competitors will hesitate to enter the market because of the difficulty involved in replicating the offering. For example, generic pressure for biologic drug manufacturers isn't as severe as for traditional pharmaceuticals because of manufacturing difficulties and the costs of clinical trials and product marketing.
  5. What are the potential substitutes for the patented product? Even a patented product won't garner moat-worthy pricing power if effective substitutes are readily available. In markets where patents can more easily be innovated around, such as in the technology or industrials sectors, patents become a less important driver of moats.
  6. How strong is intellectual property protection in the relevant markets? If patents don't actually keep competitors at bay because of lax intellectual property protections in the markets a company serves, then pricing power is diminished and patents alone are unlikely to convey a sustainable competitive advantage.

Regulations
Government regulations are another intangible asset that can lead to sustainable competitive advantages if the rules make it difficult or even impossible for competitors to enter the market. Regulations are especially favorable if a company can operate like a monopoly but isn't regulated like one with regard to pricing.

Grupo Televisa (TV) is a good example of a company with a wide economic moat that stems from favorable government regulation. The company generates half of its operating income from its television broadcasting business, where through a licensing arrangement with the Mexican government, Televisa owns and operates many of the leading television networks in the country. If advertisers want to reach Mexican viewers en masse, Televisa is essentially the only way to go. Building on this sustainable competitive advantage in broadcasting, Televisa has amassed a programming empire, and added ownership stakes in cable and satellite TV distribution that give Televisa more than half of Mexico's pay TV market.

Casino operators with Asian facilities, such as Las Vegas Sands (LVS) and Wynn Resorts (WYNN), benefit from regulatory barriers to entry, giving Asian casino operators much wider economic moats than their U.S. counterparts. The China market is an oligopoly, with only six licenses granted, and legalized gambling limited to the tiny, densely populated region of Macau; Singapore is a duopoly, with only two licenses. It is extremely unlikely that the Chinese central government will authorize casinos in another province of China, as this would require a change to the Chinese constitution, and Beijing doesn't want gambling to bring societal ills to other provinces in mainland China. Advertising casinos in mainland China is illegal, and Beijing has cracked down hard on illegal gambling. Casino licensing in Macau is quite different than in the United States, in that the companies that receive licenses to operate in Macau are able to open more than one casino, with the limitation that new casinos require government approval and licensed operators must pay an additional fee to the government for each new casino. In the U.S., license holders generally do not have the right to open multiple casinos, and a new license is required for each new casino.

Key Questions: Regulations

  1. Are there offsets to the favorable regulation, such as price controls or service mandates? Regulatory barriers to entry aren't moat-worthy if they come with the burden of price controls or service mandates that prevent economic profit generation. For example, even though Aéroports de Paris (ADP) has a geographic monopoly on airports serving the number-one tourist destination in the world, the government-regulated rates that ADP can charge for certain services have been too low to allow for economic profit generation.
  2. If regulatory barriers to entry are the key argument, consider the threat of substitutes. If a company provides a good or service in a particular country and is shielded from competition within the country, consider whether potential customers can meet their needs with goods or services provided by companies from other countries.
  3. What is the most likely outcome for future regulations? Even if government regulations result in distorted market conditions that differ materially from what would prevail in a more lax regime, we need to base our expectations for future economic profits on the regulatory environment that will most likely prevail.
  4. How material are the risks of adverse regulatory changes? Our narrow and wide moat ratings require a high degree of confidence in future economic profits. If there's a material chance that regulations will change in a way that depresses future economic profits, this could prevent a company from obtaining our narrow or wide moat rating, depending on the probability and impact of any regulatory change.

Note: (1) At Morningstar, we calculate ROIC as earnings before interest (EBI) divided by invested capital, where EBI is operating income (excluding charges) plus amortization less cash taxes and invested capital is operating assets less operating liabilities. WACC is defined as (cost of debt) × (weight of debt) + (cost of equity) × (weight of equity).

Excerpted with permission of the publisher John Wiley & Sons, Inc. from Why Moats Matter: The Morningstar Approach to Stock Investing. Copyright (c) 2014 by Morningstar. This book and ebook is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.

Heather Brilliant does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.