Morningstar Advisor - Winter 2008 - (Page 31) enjoyed by stone-aggregate companies like Cemex CX and Vulcan VMC are enabling them to raise prices even amid a downturn in the construction industry. (Gravel is cheap but heavy, which means that whichever quarry is closest to the customer tends to have a large transportation cost advantage.) The switching costs of moving a bank account help banks to earn fat returns on equity, because most consumers choose to pay high fees rather than incur the hassle of moving their checking account. And the network effect enables companies as diverse as eBay EBAY, the Chicago Mercantile Exchange CME, and Western Union WU to enjoy very high returns on capital. Our equity research process incorporates moats in two ways. First, we publish an economic moat rating—wide, narrow, none—on every company that we cover, and our analyses are always careful to discuss why we think a company does—or doesn’t—enjoy a competitive advantage. We think this information helps investors sort potential core holdings from investments that may still be attractive, but which are of lower quality. Second, moats are part of our valuation process, which means we can estimate how much a competitive advantage adds to a company’s intrinsic value. A company with a moat can compound capital for a longer period of time than a company without a moat, so it’s reasonable to assign a higher fair value estimate to the company that enjoys a competitive advantage. For a company to earn a wide moat, we must be very confident in its ability to generate returns on capital in excess of its cost of capital MorningstarAdvisor.com 31 http://MorningstarAdvisor.com
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