Morningstar Magazine - December 2017/January 2018 - 32

Spotlight: Abnormal Profitability

EXHIBIT 5

Sources of Strength More of the largest firms have moat sources that generate
higher returns on capital and have stronger fundamental returns.

prevalent moat source, and the key dynamics
supporting it range across several areas,
including patents, brand equity, regulation, and
proprietary technology. Also, firms with an
intangible-asset moat are likely to have another
type of moat, too. (The intangible-asset
moat source has the highest level of crossrepresentation with another source.)

1987

Moat Source of the 100 Largest Firms of 1987 Versus 2017
80%

RETURNS ON INVESTED CAPITAL

HIGHER

60

LOWER

66

60

53

50

Switching Costs Grow in Importance

Switching costs tend to carry high returns on
capital, and this source has been growing over the
decades. Switching costs can manifest in
many ways, but the key element is generally
a one-time inconvenience for a customer to switch
products. Some core elements of the drivers
of profit in this class are the monetary and time
investment to switch, cost of retraining,
razor/blade model, high cost of failure, multiple
customer touch points, and long product
upgrade cycles.
Over the past three decades, the explosive growth
in productivity globally has amplified the
importance of time and expanded the geographic
reach of this moat source. This moat source
is the driver behind Apple AAPL, which has an
outsize impact on the trend in profit gains over the
past few decades and has grown from the
135th largest company by market capitalization
in 1987 to the top spot today. Apple's structural
retention (by limiting the transfer of media

2 U.S. Patent and Trademark Office.

32

Morningstar December/January 2018

40

28
21

20
0

20

17

2

7

Network
Effect

Intangible
Assets

Switching
Costs

Cost
Advantage

Efficient
Scale

Fundamental Returns by Moat Source

TRAILING RETURNS %

We find the increased representation of intangible
assets in line with explosive growth of technology
over the past three decades. A core element
of this moat source has rapidly expanded in size:
Global applications for patents have surged
over four times the level seen in 1987.2 As a key
driver of profits in 2017 that was nonexistent
in 1987, Alphabet is a good example of a new firm
that sources its moat from intangible assets
(as well as network effect). Alphabet's search
algorithms, machine learning, and valuable data
support the moat, leading to the eponymous
term "Google it," which reinforces its brand power
stemming from its perceived best-in-class
search capability.

2017

Number of Firms

103

503

316

352

194

Invested Capital 1-Yr.

11

11

11

10

7

Invested Capital 3-Yr.

12

12

11

11

7

Equity 1-Yr.

18

17

15

15

11

Equity 10-Yr.

18

17

16

16

12

Operating Margin 10-Yr.

20

15

16

15

18

Net Margin 10-Yr.

13

10

11

10

10

Source: Morningstar, collected by applying current moat sources for historical data.

to non-Apple devices) creates an ecosystem that
is hard to leave.
Slight Increase in Cost-Advantage Moats

The cost-advantage moat source has moderately
increased its representation since 1987. Cost
advantages, typically gained through scale, allow
firms to offer lower prices to secure more
volumes or extract higher profits. However, several
factors can create this scale, including buying
power (Wal-Mart WMT), route density (UPS UPS),
manufacturing (Novo Nordisk NVO), low-cost
finance (JPMorgan JPM), research and development (Pfizer PFE), advertising (Nike NKE), and low
occupancy costs (Costco COST).

While representation of this moat source has
increased over the past 30 years, the minor gain,
combined with less dynamic shifts in cost
advantage, appears to have played less of a role in
the growth of profit margins over the past
few decades.
Efficient Scale Falls in Representation

Contrasting the moat source gains over the past
three decades, the lower-return-on-capital
moat source of efficient scale has declined
significantly. Efficient-scale firms serve a market of
limited size that potential competitors have
little incentive to enter because if they were to
do so, returns would fall to the cost of capital.



Table of Contents for the Digital Edition of Morningstar Magazine - December 2017/January 2018

Contents
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Morningstar Magazine - December 2017/January 2018 - Cover2
Morningstar Magazine - December 2017/January 2018 - 1
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