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By Morningstar.com | 03-25-2014 10:00 AM

Why Moats Matter

An economic moat provides a gauge of a company's competitive advantages and overall strength, and it is a highly valuable tool for investors of all levels.

Note: This video is being re-featured as part of Morningstar's December 2014 Guide to Better Investment Picking special report. This video originally appeared in March 2014.

Narrator: What do moats have to do with successful investing? No, we're not suggesting you go out and buy a medieval castle. We're suggesting finding companies that have carved a moat around their business that keeps competitors at bay. We believe these economic moats are one of the keys to investing success. Over the next few minutes, we'll explore how to identify an economic moat, take a deep dive into two wide-moat firms and see what makes them tick, and talk to practitioners about how they have been using this strategy successfully for years.

Individual investors may assume that the deck is stacked against them compared with sophisticated institutions. They see these large investors piling money into private equity deals, getting in on the ground floor on the next hot IPO, and spending sums of money to speed up already fast high-frequency trading systems. But the truth is individuals and others with a long-term time horizon can actually have some distinct advantages over those that are more focused on the near term. Instead of being worried about what is going to happen next quarter or even next year, individuals just like some of the most successful investors of all time, can truly take a long-term view of the world, and this different view gives them a distinct perspective.

Heather Brilliant: We really like to think like owners of the businesses that we're investing in, and I would liken this really to way that Warren Buffett thinks about investing. Buffett has had a lot of influence on our philosophy over the years, but generally speaking we really like to think about buying a stock as owning a piece of the underlying business.

Narrator: The stock market gives you a chance to own great businesses from Johnson & Johnson to Amazon to McDonald's and, yes, even to Berkshire Hathaway. But how do you identify firms that are truly going to be able to withstand competition for years to come. At Morningstar, we've developed a framework to help investors find these companies, figure out the best time to buy them, and help investors build wealth over time.

Brilliant: We're really looking for a couple of factors when we're trying to find businesses that have an economic moat. The first is that we look at a qualitative list of different factors or sources of moat that we've identified over our research over the past decade or so. The other is really on the quantitative side; we're looking for literally a calculation of return on invested capital to exceed the cost of capital in the future. We have found over our decade-plus of experience in studying moats that companies with wide moats literally have lower risk than companies with no moats. They have a structural advantage to their business itself that helps them compete effectively against other companies in their industry and all of those things really help set them up for establishing a very long track record of strong cash flow generation.

Matt Coffina: You take a company like Coca-Cola, people enjoy Coca-Cola's products about as much now as they did 20 years ago or 50 years ago even, and we're pretty confident that people are going to still enjoy Coca-Cola products just as much 20 years from now, maybe even 50 years from now. When you think about a company that wouldn't have an economic moat, let's take Crocs for example. Crocs was a very hot product a couple of years ago and very trendy for a while, but the company never had an economic moat. It was just a fashion that quickly went out of fashion. And that's the kind of company that's much harder to predict how much sales they can generate in the short run and what people are really going to think of that product over the long run, versus something that's has a lot more history and is a lot more engrained in our society like Coca-Cola.

Narrator: Over years of studying companies, we at Morningstar have identified five major sources of competitive advantage or economic moat: intangible assets, customer switching costs, cost advantage, the network effect, and efficient scale.

Intangible assets include brands, patents, or government licenses that explicitly keep competitors away from that same business.

Brilliant: We see that for example with companies like Tiffany where customers are willing to pay 25% to 30% more for a Tiffany diamond than one available on any Jeweler's Row in America.

Elizabeth Collins: We see these in health  care, for example, where a company develops a drug and then they have really a protected monopoly for the period of the patents that matter. And competitors are legally barred from entering the market.

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