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By Matthew Coffina, CFA | 12-09-2014 03:00 PM

Opportunities in Internet Stocks

Focused on sustainable competitive advantages and sensitive to valuation, Morningstar StockInvestor's Matt Coffina sees potential in a handful of Internet stocks today.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. There's usually no shortage of excitement around the latest Internet startup, but how do you know which firms are here to last and which firms will be more of a flash in the pan? I'm here with Matt Coffina--he's editor of Morningstar StockInvestor newsletter--to discuss how he thinks about investing in Internet companies. Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's first talk about how Internet companies build economic moats--build sustainable competitive advantages. What do you think are the biggest factors that can keep an Internet company at the top of the game?

Coffina: Within Morningstar's economic-moat framework, there are really three of the five sources of moat that are at play with Internet companies. The most common is the network effect. This occurs when a service becomes more valuable to both new and existing users as more people use the service. You could think of, for example, eBay (EBAY). The more sellers there are on eBay, the easier it is to find things you want to buy. The more buyers there are, the easier it is to sell things. So, more buyers attract sellers and vice versa.

The second source of moat would be intangible assets. I think branding and consumer habits are actually quite important on the Internet. Originally, people gravitated to Google (GOOGL), for example, because I think the search results loaded faster and they gave higher-quality search results. But nowadays, I think most people just go to Google out of habit. I doubt many people are switching back and forth between Bing and Google on a regular basis to decide who has the best-quality search results at any given moment.

So, that branding really becomes an important factor. And in a lot of ways, a company like Google is almost more of a consumer-products company, at least as far as its source of competitive advantage, than it is a technology company.

And lastly, switching costs: These are relatively rarer on the Internet. But I think switching costs do exist. For example, you can think of building your professional network on LinkedIn (LNKD) or uploading years' worth of photos on Facebook (FB). In switching to a competing social network, you would lose a lot of that content and those connections, which makes people, I think, very hesitant to switch.

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