20 Small Companies with Great Profits

When you think of companies with strong competitive advantages, you may first think of the brand-name giants. These might include brands like  Sony (SNE),  Coca-Cola (KO),  Ford (F),  Starbucks (SBUX),  Nike (NKE), Mercedes (owned by  DaimlerChrysler ), and  Hewlett-Packard (HPQ)--all of which typically land near the top of the lists of  most-recognized brands. You wouldn't be completely wrong to associate big, well-known companies with competitive advantages, but of the companies I just mentioned, only one (Coca-Cola) gets a wide moat rating from Morningstar. Several are no-moat companies.

As a refresher, by moat we mean the size of a company's competitive advantage. If a company has a wide moat, we think it can earn returns on capital above its cost of capital for up to 20 years into the future. That's quite a feat. Typically, those kind of excess returns disappear quickly as competitors pile into the market to capture the excess profits. Whether a company has a strong brand or not is, in itself, immaterial to our decision about the moat. 

Columbia professor Bruce Greenwald emphasizes this last point in his new book Competition Demystified, and his thinking echoes our own. Brands help differentiate a company's products from those of rivals. But a differentiated product alone is no advantage. It may simply be the price of admission to compete in a given industry. And size, too, doesn't necessarily imply strength. Many companies get large by diversifying out of their core strengths, either by launching new products, acquiring other companies, or expanding into markets where they lack the economies of scale that swelled profitability at home.

So what is the relationship, if any, between size and moat? The table below breaks out the distribution of Morningstar's moat ratings by company size. The table shows that as the revenue of a company becomes smaller, it's less likely to earn a wide moat rating. Of 51 firms with revenues greater than $50 billion, 25.5% have wide moats, in our opinion. Contrast that with the 5.8% of companies with revenues of less than $2 billion.

Moat Distribution by Revenue
Revenues	# of Firms	% Wide Moat	% Narrow Moat	% No Moat
>$50 billion	51	25.5%	37.3%	37.3%
$20B to $50B	113	22.1%	46.0%	31.9%
$10B to $20B	151	11.9%	49.0%	39.1%
$5B to $10B	193	11.4%	53.4%	34.7%
$2B to $5B	323	9.3%	48.0%	42.7%
<$2 billion	765	5.8%	47.1%	47.1%
Data as of 10-03-05

But the table also demonstrates that a firm doesn't have to be big to earn a wide moat rating. A surprisingly high number of small firms have carved out sustainable competitive advantages. The group of companies on our coverage list with revenues of less than $2 billion totals 762, and the 5.8% of those firms with wide moats is still a healthy number. And notice that the percentage of "narrow" moats for the smallest category is the same as all the other categories except the very largest. (Narrow-moat companies are those that we think can earn excess returns on capital, but we're just not sure that they can do it for 20 years.) So there are actually a good number of small firms with some kind of a moat, either wide or narrow. 

As our coverage list has expanded into smaller-cap names, we've been pleasantly surprised at the number of quality wide-moat companies. The table below shows the 20 smallest firms--as measured by revenues--that earn a wide moat rating from Morningstar. For context, of the 155 companies that earn Morningstar's wide moat rating, the median revenue figure is $5 billion. The biggest company in the table below, asset manager  Blackrock (BLK), took in $881 million in revenue over the trailing 12-month period. The smallest,  TC Pipelines , took in just $54 million, which is half of Microsoft's daily sales.

The 20 Smallest Wide-Moat Companies
Company	Trailing 12-Month Revenues	Industry
Blackrock (BLK)	$881 million	Money Management
Federated Investors (FII)	$840 million	Money Management
Chicago Merc. Exchange (CME)	$834 million	Securities
DeVry (DV)	$781 million	Education
SET Investments (SEIC)	$732 million	Business Support
Eaton Vance	$729 million	Money Management
Brown & Brown (BRO)	$722 million	Insurance (general)
Getty Images	$679 million	Business Support
Northern Border Partners	$614 million	Pipelines
Stericycle (SRCL)	$565 million	Waste Management
Nuveen Investments	$539 million	Money Management
Jack Henry & Associates (JKHY)	$536 million	Consulting
Buckeye Partners	$379 million	Pipelines
Forward Air (FWRD)	$297 million	Land Transport
ARM Holdings PLC ADR	$278 million	Semiconductor
Gamco Investors (GBL)	$253 million	Money Management
Macrovision	$204 million	Business Applications
Strayer Education (STRA)	$202 million	Education
W.P. Stewart & Company (WPL)	$152 million	Money Management
TC Pipelines LP	$54 million	Pipelines
Data as of 10-03-05.

The table highlights a couple of industries in which size is no prerequisite for earning a moat. Three pipeline firms are on the list; it's certainly a business in which you don't have to be big to be extremely profitable. Morningstar StockInvestor Editor Paul Larson bought tiny TC Pipelines LP for his newsletter's Hare Portfolio in August. According to analyst Michael Cumming, we love the pipeline business because "rights of way do not come easily, and regulators do not give their approval to new systems or expansions unless there is a demonstrated economic need." Although none of our portfolios owns DeVry, we do like the for-profit education sector, owning  Apollo Group  in the Hare Portfolio and  Strayer Education (STRA) in the GrowthInvestor newsletter's Growth Portfolio.

The table might also be called "Why Money Management Is the Best Industry Ever." The economics of asset management are incredible, and the fact that six money-management firms made the table demonstrates that size isn't a hurdle. Once you cover fixed costs--the portfolio managers and analysts, the risk-management software, the plush offices--revenue flows right to the bottom line. And as long as you stay within shouting distance of the benchmarks, assets tend to be sticky.

The Next Frontier: Emerging Moats
We've only recently begun to explore the concept of an "emerging moat" company--mainly in our GrowthInvestor newsletter, edited by my colleague Mike Trigg. By "emerging moat" we mean a firm that, in our opinion, has the potential to capture excess economic profits by building a sustainable competitive advantage. It just hasn't done so yet, and therefore doesn't earn a wide moat rating. Most of these companies are naturally quite small. If you haven't built a moat by the time you have $5 billion or $10 billion in sales, you're not going to build one.

Great examples of emerging-moat companies are  Blue Nile , the online diamond retailer, and  Given Imaging , a maker of cameras you can swallow. (I'm not kidding. To quote from our Analyst Report: “Using Israeli missile technology, Given scientists have created a miniature wireless video camera that a patient can swallow. Over the course of eight hours, this tiny battery-powered camera takes pictures of the inside of the gastrointestinal tract and transmits the images to a data recorder worn around the waist.”) Blue Nile's annual revenues are less than $200 million, but the company is growing at a 25% clip. Given Imaging is even smaller, with revenues of less than $100 million.

We're the first to admit that we'll get some of these emerging-moat companies wrong. Some will turn out to be also-rans, just as susceptible to the chilly winds of competition as your typical company. But we also think that small companies, which can focus on exploiting competitive advantages without the distractions of size, offer an incredibly exciting hunting ground.