How to Find Companies with Wide Moats
You need to look at the numbers, and at the business.
What gives a company a wide economic moat? I get this question all the time, and it bears some discussion, since analyzing moats and thinking about competitive advantage is at the core of what we do at Morningstar.
People often think that analyzing moats is as simple as looking for strong historical profitability. Ah, if only it were that easy. In truth, history is an imperfect guide, since the value a company will create for shareholders is dependent on how well it fends off competition in the future. High returns on capital attract competitors, and those great historical numbers will fade fast if a firm doesn't have a strong competitive advantage. Oftentimes, that competitive advantage isn't obvious--you have to do some digging into the firm's business model to figure it out.
Let me walk you through four types of companies to show you how quantitative analysis meshes with more subjective, qualitative analysis in deciding the strength of a company's competitive advantage.
First, the "no-brainer" firms, with strong historical returns on capital and a business model chock-full of "moaty" characteristics. These are the firms whose businesses approach that lovely nirvana of minimal capital investment, and lots of cash generation. Think about Moody's (MCO) or eBay (EBAY)--great profitability metrics in the past, and competitive positions strong enough to make it likely that they'll be just as profitable in the future. Moody's is protected by a strong brand and government regulations, and eBay has a massive liquidity pool of buyers and sellers that would be very hard to replicate.
Firms with Less-Obvious Advantages
Second, there are firms that have posted great historical metrics, but which have less-obvious competitive advantages. Expeditors International (EXPD) and Weight Watchers (WTW) are good examples of this. Both have tremendous records of generating gobs of free cash flow and kicking out high returns on capital, but neither freight forwarding nor weight-loss management seem like intuitively wide-moat businesses.
If you dig into the two firms, however, you discover that Expeditors has a global network of offices and an incentive-based company culture that would be very tough to replicate. As for Weight Watchers, there's a strong brand and a flexible approach to weight loss--essentially, the firm is little more than an organized support group, since it can modify its content based on the latest scientific findings. It would be tough for a rival to compete with such an all-encompassing approach to weight loss. As you can see, the moats for Expeditors and Weight Watchers are more subtle than those for Moody's or eBay, but they're definitely evident once you do some qualitative analysis of the firms' business models.
Third, we have what I call the flash-in-the-pan firms, which have fabulous historical returns on capital, but that fail to build significant moats around their businesses. Lots of technology firms fall into this category--remember Borland (Quattro Pro), 3dfx (graphics chips), or all the firms that made pagers back in the day? All were very profitable businesses that were also very susceptible to competition or technological change.
Most retailers also fall into this category, since most retail "concepts" either get copied or go out of style. My current favorite example of this phenomenon is Garmin (GRMN), which is a leader in global positioning devices--for aircraft and for personal use. It's a solid, high-growth business with 40%-plus returns on capital, but we think it has at best a narrow economic moat. There's just not much stopping a bigger competitor from investing some capital, building a better mousetrap, and eating away at Garmin's profits.
Finally, there are the really tough calls--companies that have not yet posted great returns on capital, but that seem to have lots of wide-moat characteristics. I'd point to document-storage firm Iron Mountain (IRM) as a great example. Operating margins are solid in the mid- to high teens, but the firm has been plowing so much capital into its business that returns on invested capital are pretty mediocre in the mid-single digits. Moreover, it's only started generating free cash flow again recently, after a long dry spell in the 1990s when it was investing heavily.
However, when you consider that customers have to pay a fee equivalent to nearly a year's rent if they want to remove a box, some switching costs become evident. A competitor would have to offer some big discounts to overcome this cost, and since document-storage facilities become profitable only after they're 50% full, that would-be competitor would have to be willing to lose money for quite some time--a substantial barrier to entry. Also, since storage costs are a miniscule part of most companies' budgets, Iron Mountain has pricing power--gross margins have been steadily rising for almost a decade. Finally, it costs a lot less to maintain a storage warehouse than it does to build a new one, so free cash flow should improve considerably once Iron Mountain moves out of its growth phase.
All these sound like pretty moaty characteristics to me, but assuming that Iron Mountain has a wide economic moat is still a bit of a leap of faith, since it hasn't yet put up the numbers.
That's the point, though--investing is a mix of quantitative and qualitative analysis. Usually, the first tells you where a company has been, and the second helps you think about where it might be going.
Pat Dorsey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.