In developing an economic moat rating for a company, the analysts at Morningstar use six criteria, according to the book, “Why Moats Matter: The Morningstar Approach to Stock Investing.”
Lead authors Heather Brilliant and Elizabeth Collins, along with the rest of team behind the book, said they begin with two questions:
- Are returns on invested capital likely to be greater than the weighted average cost of capital in the future?
- Does the company under consideration have one or more of the five sources of competitive advantage and are they sustainable?
Each of the six criteria are discussed in some depth in this chapter.
The first criterion, the spread between ROIC and WACC, is obviously measurable and, thus, is a quantitative factor. For example, this screenshot excerpted from the summary page for Coca-Cola (KO, Financial) at GuruFocus shows the beverage maker has a return on invested capital that is more than four times as much as its weighted average cost of capital:
To assess whether a company can sustain a spread, the Morningstar analysts go through financial statements, talk to management and read industry publications. If they think it will be sustainable for at least 10 years, they award the company a “narrow” moat rating. If profits are expected to last for at least 20 years, they award a “wide” moat rating. When this book was published in 2014, only about 200 companies worldwide were able to boast a “wide” rating.
Next, the analysts turn to their five qualitative criteria:
Intangible assets
This criterion takes in a lot of ground, including brands, patents and regulatory protections. Regarding brands, this involves a customer’s willingness to pay a premium for a product or service. It is important the premium is not offset by higher costs, that brand strength is not mistaken for high name recognition, that margins are stronger than those of competitors and there is some rationale for believing this brand power will last for at least a decade. Examples include Walt Disney (DIS, Financial), Starbucks (SBUX, Financial) and Bayerische Motoren Werke (BMW, Financial).
Patents have good moat potential because they can block the development of alternatives. In considering patents, key issues include the expiration schedule of a company’s portfolio, the diversity of the patent portfolio, the strength of the patent pipeline, competitor plans after products lose their patent protection and potential substitutes. Examples of companies with patent-based moats include pharmaceutical companies such as Sanofi (SNY, Financial), iRobot (IRBT, Financial), the maker of Roomba vacuum cleaners, and Monsanto (MON, Financial).
Cost advantage
There are many sources of cost advantage, including location, economies of scale and access to unique assets. Not all cost advantages can be defended over the long term, however, so analysts have important questions. Does the company have some unique edge from economies of scale that give it a lasting advantage? What about economies of scope, in which costs can be spread across a wide range of products? How do its transportation costs compare with those of competitors? Is there a unique production process that cannot be replicated easily? Examples of such companies include managed care organizations and railroads.
Switching costs
Sometimes, a competitor may offer lower prices or even a better product, but if the costs of switching to a new provider are too high, the customer will remain loyal. That’s especially true in cases where there is a high cost of failure from switching or the gain from switching is relatively small. Some examples of companies with switching cost moats are Apple (AAPL, Financial) with its unique operating system, BlackRock (BLK, Financial), the asset management firm with a highly diverse product portfolio, and Rockwell Automation (ROK, Financial) with its Logix automation control platform.
Network effect
A social media service such as Facebook (FB, Financial) provides more value to its users when more people sign up, so the network effect is called a “virtuous cycle that allows strong companies to become even stronger.” When considering a moat based on the network effect, investors and analysts should have a clear and logical explanation for the advantage, knowledge of how a company monetizes its network and awareness of how much value needs to be shared with suppliers and customers. For example, the authors cited online travel services Expedia (EXPE, Financial) and Priceline (a subsidiary of Booking Holdings (BKNG)), as well as Core Labs (CLB), an industry consortium that supplies analytical tools for studying oilfield reservoirs.
Efficient scale
This refers to situations in which one or a few providers serve a limited market and have protection because potential competitors could not profitably enter it. Any analysis of an efficient scale moat would need to know the limits of the market and its capacity, the cost of entering the market and the experience of potential competitors that tried and failed to enter the market. Examples include pipelines and Mexican airports (which also have government regulation on their side). In 1998, the Mexican government decided to privatize the country’s major airports and subsequently sold monopolistic concessions for 50 years.
Summing up, earning even a narrow moat rating at Morningstar is a challenge for companies because they must pass at least one quantitative hurdle and satisfy at least one of the five qualitative criteria. A company that seems likely to hold its competitive advantage for at least 10 years will get a narrow rating, and a company that is assessed as holding an advantage for at least 20 years receives a wide rating. Anything less than 10 years gets no rating.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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