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By Jeremy Glaser and Heather Brilliant, CFA | 01-29-2013 11:00 AM

Taking Another Look at Economic Moats

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.

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