Morningstar Advisor - April/May 2012 - (Page 14)

Know-How How to Find Economic Moats By Paul Larson Moats give firms a leg up on the competition. Here’s how to spot them. When researching companies and stocks at Morningstar, we focus on analyzing sustainable competitive advantages—economic moats—and understanding the source of each company’s edge. But how do we know if a company has a moat? advantageous location can also give a company a cost edge, and this leg-up can be sustainable given the difficulty of duplication. Companies that enjoy economies of scale have lower average costs than their competitors with smaller capacities. Finally, access to a unique asset can yield a sustainable cost advantage. Switching Costs a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital. This especially makes sense when entry into a market requires a lot of capital. To cover its entry costs, a new entrant would want a sufficient share of the market, but if the opportunity is limited, a fight for market share would cause prices to fall, hurting all players. 1 Look for Qualitative Attributes After assigning moat ratings to every company in our equity research coverage universe, we found that the firms with competitive advantages benefit from one or more of these: Intangible Assets The intangible-asset category includes brands, patents, and regulatory licenses. A brand creates an economic moat around a company’s profits if it increases the customer’s willingness to pay or increases customer captivity. Patents explicitly allow companies to generate excess profits while rivals are legally barred from competing. Regulatory licenses create a moat if they make it difficult or even impossible for competitors to enter the market. Cost Advantages Switching costs are the expenses—whether in time or money—a customer would incur to change from one producer or provider to another. Customers facing high switching costs often won’t switch even if a competitor is offering a lower price or a better-performing product or service. The improvement in performance or price must be large enough to offset the cost of switching. High switching costs are especially prevalent and powerful when there is a high cost of failure or the cost of the specific product or service is low relative to the customer’s total operating costs. Network Effect 2 Look for Evidence in Financials Companies that have a competitive advantage should, all else equal, have better profitability than competitors. This means having greater profit margins and/or asset turns that translate to higher returns on assets and equity. But where the rubber really hits the road is with a company’s return on invested capital. We want to see projected ROICs above the firm’s cost of capital for at least 15 years (for a narrow moat) or 20 years (for a wide moat). It is the expected persistence of the competitive advantage that matters most, not necessarily the absolute level of current profitability. For instance, we would tend to assign a wide moat rating to a pipeline company with a modest but very long-lived ROIC near 10%, but we will hold back on a fashion retailer on a hot streak with flash-in-pan ROICs near 30%. By focusing on economic moats we can find the companies that should compound in intrinsic value for years to come. K Paul Larson is Morningstar’s chief equities strategist and editor of Morningstar StockInvestor. Companies can dig economic moats around their businesses by having intrinsically lower costs than their competitors. A favorable cost position can stem from process advantages, a superior location, scale, or access to a unique asset. Process advantages are interesting, but we only award economic moat ratings to companies with this edge if the process can’t be easily replicated. An The network effect is the most potent source of a sustainable competitive advantage, but it’s also rarer than most. The network effect occurs when the value of a particular good or service increases for both new and existing users as more customers use that good or service. The network effect is a virtuous cycle, allowing strong companies to get even stronger. Efficient Scale The efficient-scale category is relatively new to our framework. This describes a dynamic in which a market of limited size is effectively served by one or a handful of companies. The incumbents generate economic profits, but 14 Morningstar Advisor April/May 2012

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

Morningstar Advisor - April/May 2012