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By Jeremy Glaser and Paul A. Larson | 06-12-2012 02:00 PM

The 5 Sources of Moat

Morningstar's Paul Larson breaks down the five ways firms can keep competitors at bay and which ways are more durable over time.

Editor's Note: Since the filming of this video, Morningstar equity analyst Matthew Coffina was named editor of Morningstar StockInvestor.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Finding long-term competitive advantages, or economic moats, has long been a cornerstone of our equity research process. I'm here today with chief equity strategist Paul Larson to see what the sources of these moats are and to hear some new insights that he has on them.

Paul, thanks for joining me today.

Paul Larson: Glad to be here again.

Glaser: Let's start with the source of that economic moat, those competitive advantages. What are some ways that businesses can really put some distance between themselves and their would-be competitors?

Larson: We found five major sources of moats, and those sources are one, the network effect, and this is an effect where when you have customers that start using a network, that network suddenly becomes more valuable for all the other users of the network. Some examples here like eBay. It has the most buyers, and therefore it has the most sellers. And it has the most sellers because it has the most buyers. It's a virtuous circle. A more recent example would be a company like Facebook. When you or I join Facebook, Facebook suddenly becomes more valuable for all of our friends and as more of our friends join Facebook, it's more valuable for us. So, that's a network effect.

Another source of economic moat is customer switching costs, and these are the inconveniences that customers would have when they switch from one product to another. As they say time is money and money is time. It may not cost money to switch from one service provider to another, but if it costs time that's the same thing.

Another source is intangible assets. These are things like patents, basically an explicit monopoly, government licenses that explicitly block competition. Or [this can be a source] if a company has a strong brand that allows it some pricing power for that particular brand.

Another competitive advantage is something that we call efficient scale, and this is a dynamic where you have a limited market that is being efficiently served by one or a very small number of competitors, and some markets are just natural monopolies or natural oligopolies. A great example here are the airport companies like the Mexican airports. Most cities can't support just one major commercial airport, so it doesn't make economic sense to have more than one. If you have it, you benefit.

And the final source of moat is cost advantage, and this is simply when you have a company that can provide a better service at a lower cost than the competition that allows the company to either have a fatter profit margin or the same profit margin as the competitors, but in theory higher volume and higher asset turnover.

Glaser: I know you've done a lot of research into how sustainable some of these sources of advantage are. When you take a look across different types of moats, do some stand out to you as really being kind of a better moat, one that's going to last longer than some of the other reasons?

Larson: Yes. One of the things I recently did is categorize each and every company that has a wide- and narrow-moat rating by their source or sources of economic moat. And what we found is companies that benefit from the intangible assets actually have the best returns on capital by a fairly wide margin relative to the other sources of moat. And digging into why that might potentially be, you have a large exposure to the health-care sector, which basically patents [make up] the moat there. Also you have a larger exposure to the consumer sectors where you have these large relatively stable companies that benefit from brands. The health-care and the consumer companies certainly have high returns on capital, and that contributes to the intangible assets cohort having the absolute highest returns on capital.

Conversely, the source of moat that has the lowest fundamental performance [is found with] the efficient-scale companies, and this makes sense if you think about it intuitively. The efficient-scale dynamic is based on companies having an attractive niche that they have positive economic profits, that they have a moat, but not so profitable and so attractive that they are going to attract new competition into the market. So, it makes sense that the efficient-scale companies would have the lowest returns on capital.

Glaser: Now, when you looked at individual companies and were just looking if they are wide- or narrow-moat, what were some of the differences between wide and narrow? What were some the sources that would have contributed to being one or the other?

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