Morningstar Magazine - December 2017/January 2018 - 33

Efficient-scale markets tend to exhibit one
or more of the following characteristics: mature
demand, excess capacity, commodity products,
inelastic demand, high sunk costs, significant entry
barriers, and credible deterrence.
This moat source had a higher level of
representation 30 years ago, led by utilities and
railroads, which tend to carry lower returns
on capital. In fact, all 10 of the utilities that ranked
among the largest companies in 1987 fell out
of the top 100 by 2017. Additionally, the less
portable sedentary nature of utilities and railroads
has limited these firms' ability to expand
profits outside of their home countries, limiting the
profit gains relative to firms with more easily
deliverable goods and services. As the global profit
potential expanded over the decades, several
historically large efficient-scale firms have
had less opportunity to move into new markets
relative to firms with more fungible goods
and services.
Factors Driving Moats

Several factors have likely driven increased
representation of moats among the largest firms
over the past three decades, including globalization and technology shifts in industrialization.
Increased globalization has opened more market
opportunity for all companies, but companies
with moats should gain the most from this market
expansion, while gains from no-moat firms
may spike initially but should be whittled away
by competition. Further, firms with a networkeffect moat source hold the potential to strengthen
the moat with more players coming into
the markets.
When thinking about geographies, nowhere is the
recent rapid growth more apparent than in
China. Aided by decades of massive productivity
gains and major market investments, many
Chinese firms have emerged with moats. Chinese
firms Tencent, Alibaba, China Mobile CHL, China
Construction Bank, Agricultural Bank of China,
Bank of China, and China Merchants Bank all now
rank in the largest 100 firms and have moats
to support excess returns.

Beyond the global growth, the current phase of
industrialization also supports more moats.
As industrialization has moved from mechanical
and mass production to information technology, we have seen an expansion in moats,
especially in intangible assets and switching costs.
Further, as we move into the next phase of
industrialization focused on networking and the
exchange of data between machines and humans,3
we expect more growth in profits supported
by network effects. Several of the largest
companies, including wide-moat firms with strong
network effects Alphabet, Facebook, Amazon.com
AMZN, Alibaba, and Tencent, didn't exist 30
years ago and now represent more than 10% of
the market capitalization of the top 100 firms.
Regulatory Outlook

While mergers and acquisitions are driving
monopolistic concerns and sparking risks for
increased antitrust actions to break up dominant
market-leading companies, we don't expect a
major shift in the regulatory outlook for the current
market leaders. However, the risks from
governments are different around the world,
with higher risks in Europe, where the focus is
on fostering opportunities for all companies
to compete.
In the United States, as long as consumers
are receiving high-quality products and
services at fair pricing, the government appears
less likely to demand breakups of leading
companies like Alphabet and Facebook. Barring
egregious pricing or political influence
by market-leading firms, we don't expect a
significant political reaction similar to the major
antitrust actions driven by the robber baron
era of the 19th century. However, while we don't
expect aggressive antitrust actions, we
might need to revise this assumption in the coming
years: As discussed in the Policy column
this issue (Page 18), Democrats have unveiled
a plan to revamp the antitrust framework.
Despite the potential for antitrust actions, the
increased representation of moats among
the leading firms should help mitigate these
potential headwinds.

Steady Outlook for Moats

Productivity and efficiency gains are available to
all firms, but those with economic moats
are able to capture a disproportionate share of
the benefits. Where no moats exist, such as in
many areas of consumer electronics, intense rivalry
among firms drives the gains through to the
customers. However, firms with moats can retain
higher returns, and the growing representation of firms with moats will likely have a positive
impact on overall profitability.
Importantly, moats are driven by the durability of
excess returns relative to the cost of capital.
Therefore, even if profit levels fall from their current
high levels, companies could still gain excess
returns, albeit at a lower level. Very likely,
increased costs and competitive pressures will
weigh on current high profit margins, but
we expect the higher concentration of firms
with moats will help defend against the
potential upcoming headwinds. Within highly
competitive markets, those firms with economic
moats should be best positioned to protect
excess returns. K
Damien Conover is director of equity strategy with
Morningstar Research Services.
Michael Holt is head of global equity research with
Morningstar Research Services.
William Fitzsimmons, an associate equity analyst with
Morningstar Research Services, contributed to this article.
Note
The Morningstar Equity Research team recently released a
five-part Economic Moat Source Series. Each report
provides background on the five moat sources: network
effect, intangible assets, switching costs, cost advantage,
and efficient scale.

3 Franz Haniel and Co., 2015 Annual Report.

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