A company with a very profitable business is like a castle that is constantly under attack by competitors. Without a strong defense, competitors will soon imitate the company’s products, charge lower prices, steal market share, and erode profit margins to the point where the business is merely average, at best.
Economic moats are what keep competitors at bay. An economic moat is a sustainable competitive advantage that allows a company to earn excess returns on capital for a long period of time.
Morningstar analysts assign every company in our coverage universe an economic moat rating: either wide, narrow, or none. Here are the 5 sources of economic moats.
1. The network effect
The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. This is a potentially quite potent source of competitive advantage, and often applies to the first mover in an emerging technology.
Millions of buyers and sellers on eBay give the company an advantage over other online marketplaces. The more sellers there are on eBay, the more likely buyers are to find what they’re looking for at a decent price. The more buyers there are, the easier it is to sell things.
Alternatively, look at a payment network like Visa. A visa card payment is accepted because it is the card that consumers have in their wallets. And why do they carry around those particular cards? Well, that's what's accepted as payment. It’s a virtuous network. Every person that takes out another Visa credit card is adding to that network and making it more likely that the merchants are going to sign up for Visa.
Why is everyone on Facebook? Because that's where everyone else is. And the value of Facebook grows as more people join. As more customers join the network, it makes that network more valuable for other customers.
As is evident, the network effect is an effect where the value of a given network grows exponentially with each node of the network that's added. The value of that good or service increases for both new and existing users as more people use that good or service. Since a network's value increases as more people use it, the company that creates the network can create a massive economic moat.
This is a relatively rare source of competitive advantage but is also the most powerful. The companies that have this advantage tend to have relatively high levels of profitability.
2. Intangible assets
Intangible assets generally refer to the intellectual property that firms use to prevent other companies from duplicating a good or service. Patents are the most common economic moat in this category since it gives a company a legalised monopoly. In certain situations, especially in the pharmaceutical industry, if you have a best-in-class drug, and you have legalised monopoly, that gives you enormous pricing power. When patents expire, generic competition can quickly push the prices of drugs down by a huge margin.
A strong brand name can also be an economic moat. Morningstar’s equity strategist Paul Larson points out that a brand for a random consumer-electronics, say a DVD player, is not going to confer a company pricing power. But a brand like a Coke or a Tiffany allows them to charge that little bit of a premium that could certainly be a source of economic moat.
Copyrights, regulatory licenses, and governmental approvals also fall in this category. Some companies generate enormous profits when their products or markets are artificially protected by the government. For instance, a permit for a landfill or a casino license in an area where there are a limited number of casinos provide a competitive advantage.
3. Efficient scale
When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. Larson compares it to a game of musical chairs, where all the chairs are already taken. When you have a company that's providing a service to a limited market, and there's a relatively small number of competitors supplying to that market, it may not make sense for a new competitor to enter the market, because that new competitor would destroy the returns for all the players involved.
Some markets are just natural monopolies such as International Speedway, which owns NASCAR race tracks. Chicago has a NASCAR racetrack, and the Chicago market can support exactly one NASCAR racetrack. So no one would want to build another racetrack in the market when there's already a player there. It just wouldn't make sense.
The Sydney Airport stock is a case in point. The company develops and maintains the airport infrastructure and leases terminal space to airlines and retailers at the airport at Sydney, Australia. Sydney Airport’s regional monopoly, encompassing Australia's most populous city, creates a narrow economic moat.
Midstream energy companies such as Enterprise Products Partners, a Fortune 500 company, enjoy a natural geographic monopoly. It would be too expensive to build a second set of pipes to serve the same routes; if a competitor tried this, it would cause returns for all participants to fall well below the cost of capital.
4. Low-cost producer
Firms that can figure out ways to provide a good or service at a relatively low cost have an advantage because they can undercut their rivals on price. This means that you can either charge the same price as the other competitors out there, and reap a higher profit margin, or you can charge slightly lower prices and maybe try and gain some share from competitors.
One way to get a cost advantage would be economies of scale. A bigger company can typically source things cheaper and have lower overhead costs. On the other hand, a basic materials company may have an inherently low cost. For instance, a company mining a certain geology may have a lower cost than geologies elsewhere around the world. This is an inherent cost advantage, something structural to the business, and could be a source of economic moat.
For instance, we believe Coal India Ltd enjoys a narrow moat, reflecting the significant cost advantage afforded by vast and relatively shallow open-cut coal mines.
5. High customer-switching costs
If you can make it tough for your customers to use a competitor, it's usually easy to keep ratcheting prices up just a bit year after year-which can lead to big profits.
Switching is a barrier to entry that involves an expense a customer incurs to change over from one product or service to another. If not an expense, it could be a one-time inconvenience.
Buyers in these cases often need a big improvement in either price or performance to make the switch to another product worthwhile.
It may not cost a customer money to switch from one provider to another. In fact, they may actually save money by switching. But if it's going to cost them time to switch, that may increase inertia and keep them with an existing provider, and allow that provider some pricing power.
The typical example is bank deposit accounts. Those deposits tend not to turn over a whole lot simply because it costs customers time to actually switch banks.
Architects, engineers, and designers spend entire careers mastering Autodesk’s software packages, creating very high switching costs.
When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power.
