An Introduction to Economic Moats

How does Morningstar decide whether a company has a wide, narrow, or nonexistent economic moat?

That's a simple question with a lengthy answer. After all, next to valuing businesses, analyzing economic moats is what we spend the most time on here at Morningstar--and not all decisions are as clear cut as  Microsoft (MSFT) (with a very wide moat) or  Ford (F) (with an utterly nonexistent moat.) So here's your primer on how we do it, from the kinds of data we look at to how we weigh various factors, along with some examples of moat ratings that might seem odd without knowing our underlying logic. (Special note: During Morningstar.com's Premium Stock Research Week--through Oct. 30--you are invited to view all of Morningstar.com's Stock Analyst Reports, including our moat ratings, free of charge. Click here for more information.)

What Is an Economic Moat, Anyway?
We begin with the premise that all highly profitable firms attract competitors, and only firms that are able to keep competition at bay will earn above-normal profits for a long time. An economic moat--or competitive advantage--allows a company to fend off competitors and earn sustainable excess economic profits. We look at return on invested capital (ROIC) relative to the company's cost of capital to determine profitability, because ROIC shows us the cash return on the capital invested in the business. We think that ROIC is the best measure of a firm's true economic profitability.

Of course, we have to examine ROIC relative to a firm's cost of capital because money isn't free--those who have capital charge companies for the right to use it, and they charge some companies more than others. A firm that operates pipelines or sells beer has a low cost of capital because it has a stable business, so investors don't ask for much in the way of returns. A small semiconductor or biotech firm would have a very high cost of capital because it's entirely possible that investors might not get their money back, so they ask for a high return to compensate for the higher risk. For example, an ROIC of 14% would be spectacular for a pipeline company relative to its 8% cost of capital, but would barely clear the bar for a small tech or biotech firm.

How Does Morningstar Assign Moat Ratings?
The first step is called "show me the money." We look at whether ROIC has exceeded the firm's cost of capital in the past, and then ask whether it's likely to do so in the future. If the answer is "no" on both counts, then the firm has no moat, no matter how attractive it might sound on the surface. Moats should show up in the numbers--unless there's a convincing reason why the future will be different than the past, a firm that has not demonstrated the ability to earn decent returns on capital doesn't have a moat.

The second step is identifying a competitive advantage, since even companies that have posted strong returns on capital in the past might not have a moat if there's no identifiable reason why those high returns will continue. If we didn't think about why high ROICs will stay high, we'd just be driving while looking into the rearview mirror, which is rarely a good idea. Think about retailers and restaurant chains--switching costs for consumers are extremely low, so companies in these industries need scale, a well-established brand, or some other defensible advantage to give them a moat. Without some advantage, those high ROICs could dissipate quickly--history is full of hot retail or restaurant concepts that have flopped as quickly as they've become temporary hits, which is why only 40 of the 122 restaurants and retailers we cover have narrow moats, and only five have wide moats.

When we look for moats, we look for one of four broad advantages. First, has the company made it tough for customers to switch from its products to those of the competition? (Computer databases might be a good example of this.) Second, does the firm have lower costs than competitors? This usually comes about through larger size or better processes, and it's especially important in commodity industries like steel and airlines. Third, does the company have an intangible asset that makes it tough for competitors to take its business? Patents, trademarks, and regulatory approvals are the most obvious examples here, but brand names or a tough-to-replicate geographical advantage would also fall in this category. Finally, does the company benefit from network economics, in which its service or product becomes more valuable the more users it has?  First Data's  Western Union business and  eBay (EBAY) are a couple of well-known examples in this category.

Finally, if we have evidence of solid returns on capital and confidence that those returns are sustainable, we have to decide whether the firm has a wide or narrow moat. To rate a stock as having a wide moat, we have to be very confident that the firm's competitive advantage will persist for quite some time, which means that competitors would have a very tough time going up against the company we're looking at. We're pretty selective about this--only about 10% of the stocks we cover receive wide-moat ratings. How do we decide whether a company has a wide or narrow moat? It's often a tough call, so let's run through a few examples.

Is the Moat Wide or Narrow?
On the surface, making large commercial aircraft might seem like a pretty good business. It's essentially a duopoly between Airbus and  Boeing (BA), the barriers to entry are massive, and it requires a ton of R&D to stay competitive. Unfortunately, large jets are something of a commodity when you get right down to it--whichever one costs the least to move X passengers Y distance is likely to get the nod from airlines, since neither has a large technological advantage at the moment. Moreover, airline buyers are a pretty concentrated group, which increases their bargaining power relative to Boeing and Airbus. Coupling this with Boeing's middling returns on capital and a pretty attractive but not fantastic defense business, we arrive at a narrow moat rating.

 FedEx (FDX) and  United Parcel Service (UPS) also help illustrate where we draw the line. Although they look similar on the surface, UPS typically posts ROICs in the 15% range, which we think will improve to 20% in time, while FedEx has been posting high-single-digit returns on capital that we're projecting to only improve to a bit more than 11%. One reason for this is that planes make up a bigger portion of FedEx's capital base, and planes are more-expensive (and less productive) assets than the ubiquitous brown trucks that comprise a big chunk of UPS' invested capital. Second, a larger portion of FedEx's business comes from overnight/time-sensitive package delivery, which is a more competitive market than the residential package delivery that's UPS' bread and butter. The bottom line is that UPS delivers way more packages with a similar asset base than FedEx, which makes UPS a more attractive business.

A final pair of companies that make for a good case study as to where we draw the line would be  Wal-Mart (WMT) (wide moat) and  Target (TGT) (narrow moat). Though we've toyed with the idea of upgrading Target to wide moat--and might still do so at some point--the firm's competitive advantage is at this point based more on smart marketing and merchandising than anything else. It's a very good strategy that has served the firm well, but it's also one that could, in time, be replicated by a competitor. Wal-Mart, on the other hand, is the poster child for scale economies. The firm's distribution efficiencies and buying power relative to suppliers are simply unmatched, and it would be very difficult for a competitor to replicate them and match (or surpass) its lean cost structure. To us, this is a more defensible competitive advantage than Target's "cheap chic" strategy, and so we give Wal-Mart a wide moat and Target a narrow moat.

Conclusion
That, in a nutshell, is how we do it here at Morningstar. We look for quantitative evidence of competitive advantage in the returns on capital that firms are able to generate, we investigate whether those returns are sustainable, and then we determine just how sustainable they are. Needless to say, it's not an exact science--but it sure is a lot of fun.