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Economic Moat

Economic Moat is a proprietary Morningstar data point.

The idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it's this characteristic-think of it as the strength and sustainability of a firm's competitive advantage-that Morningstar is trying to capture with the economic moat rating.

At Morningstar, one of the first things we do when we're thinking about the size of a firm's economic moat is look at the company's historical financial performance. Companies that have generated returns on capital higher than their cost of capital for many years running usually have a moat, especially if their returns on capital have been rising or are fairly stable. Of course, the past is a highly imperfect predictor of the future, so we look carefully at the source of a company's excess economic profits before assigning a moat rating.

For example, a competitive advantage created by a hot new technology usually isn't very sustainable, because it won't be too long until someone comes along and invents a better widget.

Here are some of the attributes that can give companies economic moats:

Huge Market Share

When a firm enjoys economies of scale in areas like manufacturing, sales, and marketing, it can be pretty tough for a competitor to catch up.

Low-Cost Producer

The ability to produce products or services at a lower cost than competitors is an advantage that's especially potent in commodity industries.

Patents, Copyrights, or Governmental Approvals and Licenses

 Some companies generate enormous profits when their products or markets are artificially protected by the government.

Unique Corporate Culture

Although you should be careful of placing too much emphasis on this attribute, since it's such a "soft" method of determining competitive advantage, there's no question it can make a difference.

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.

The Network Effect

 This is a relatively rare, but potentially quite potent, source of competitive advantage, and often applies to the first mover in an emerging technology. Since a network's value increases as more people use it, the company that creates the network can create a massive economic moat.

 

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