Fri, 8 Feb 2013
Morningstar recently upgraded several companies' moat ratings, and global equity research director Heather Brilliant explains why.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Our team of equity analysts spends a lot of time thinking about competitive advantages, or economic moats. I am here with Heather Brilliant; she is the director of global equity research. We're going to look at some companies that have recently been upgraded to wide moat and some of the factors behind those moves.
Heather, thanks for talking with me.
Heather Brilliant: Thanks for having me, Jeremy.
Glaser: Let's start with a little bit of an overview of the concept of economic moats. A lot of people are probably familiar with it, but how do companies kind of carve out these competitive advantages?
Brilliant: Well, we think there are five primary ways that a company can earn an economic moat. The first is intangible assets. That would be anything like patents or licenses that might be granted by the government. Also, that includes brands. So that's a very important part of the whole intellectual property side of things.
The second would be a cost advantage. If someone can produce something cheaper and charge the same price, obviously they can earn excess returns through doing that, and so that's a very powerful advantage you see in companies like Compass Minerals, which has a lower-cost asset when it comes to both potash and rock salt than any other competitor out there.
A third type of competitive advantage is the network effect; the network effect is hard to find but can be very powerful. Facebook is a great example and also one of our new wide-moat companies. We really believe that Facebook benefits from a network effect, because the more users it has, the more valuable it is to those users.
And fourth would be what I would call customer switching costs. We're seeing a lot of developments around customer switching costs. It seems that companies that can really develop that relationship with customers that makes it more difficult for them to go to a competitor, the better duration and depth of moat they have been able to earn.
And finally, efficient scale is the fifth type of competitive advantage. And efficient scale, really, some people think it means economies of scale, but it actually has nothing to do with that. It refers to a situation where the market is not large enough to support another competitor entering. So, for example, if you have a company like Lockheed Martin, it benefits from efficient scale because it manufactures F-35s for the U.S. government, and if another player were to come in and do that, it would not be economical for either player. Now of course Lockheed also benefits from some other advantages, but I think just within that that one market you can kind of get the idea.
Glaser: All of these seem kind of longstanding--you don't build the network effect overnight. What causes you to rethink a company's economic moat and why have we seen so many new moats over the last couple of months?
Brilliant: There is really a couple of different ways that we try to keep our moat ratings fresh. The first is that an analyst at any time can pitch to our moat committee a change in the moat. So, if he or she is seeing developments that lead them to believe that it's time to take a fresh look, they can bring it before the committee at any point.
The second is that we have been instituting a new process where we are going through all of the companies that we cover and looking at the moat ratings, and making sure they make sense within the industry that the company is positioned in and within our overall framework. I think that review process has really led to us realizing we had some companies in narrow moat that upon further reflection, and then in some cases given new information, really we believe should be wide moat.
Glaser: Let's take a look at some those new wide moats, then. You mentioned customer switching costs was an emerging area for moats. What are some companies that have been able to build those switching costs in?
Brilliant: Sure. I think, customer switching costs is the biggest area, or the biggest theme I guess you could say, across all of these companies that are newly wide moat. Cerner comes to mind as a company that has been very strong in the health-care IT trend that's been going on recently, and so Cerner has been able to really get embedded within different health-care providers. It makes it very hard for them to switch because first of all, it was hard enough to get them to initiate doing health-care IT in the first place, and then to switch to another provider really is cost-prohibitive for most doctor's offices, medical service professionals, et cetera. And so you really have seen Cerner build a very strong economic moat from that.
Glaser: Are there any other that have gotten a wide moat due to maybe an event, merger, acquisition, something like that?
Brilliant: Yeah, I guess I'd put a couple of health-care companies in that category, both Express Scripts and Baxter. Both of these companies have recently done deals that have led to a serious increase in our assessment of their economic moat. Baxter, for example, now has a very dominant position within the dialysis market through its acquisition of Gambro. And Express Scripts, of course, had a very large merger with Medco that gave it a dominant position and really a low-cost advantage within the pharmacy benefit space.
Glaser: Efficient scale is one of the newer sources of moat we've identified. Do you have any examples of companies that are taking advantage of that?
Brilliant: Yeah, we recently upgraded the moat for Praxair, which is an industrial gas company. The interesting thing about it is that it's very well positioned to serve the customers that it has--meaning that if it has a plant or a facility in a given area, it's basically the only provider of industrial gas in that area. It has a near monopoly within a given area. And part of the reason for that is that if another competitor were to come in and put another industrial gas plant in that area, it would no longer be economical for either player. So just the mere presence of Praxair, already in the market, kind of keeps other competitors at bay.
Also, industrial gas is a very critical part of most of the customers' processes with which Praxair works, but it's also a very small component. So it's not an area where you're likely to see a whole lot of nickel and diming by the customer. So, Praxair really benefits from both of those angles.
Glaser: Now, among these new wide moats, do any of them look attractively priced today or do you have to really pay up to get this kind of quality?
Brilliant: Generally speaking, wide moats look pretty reasonably priced, I would say--or I should say pretty fairly priced. So we're not seeing a whole lot of tremendous opportunities. That said, I just mentioned Express Scripts; that is one that we do see trading at a pretty meaningful discount. It's a 4-star stock right now, and we think it's worth about $73 per share. So, there is some decent upside there.
Glaser: Heather, thanks for your thoughts today.
Brilliant: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.