The Four Moats That Matter

Pat Dorsey: Hi, I am Pat Dorsey, director of equity research at Morningstar. At Morningstar, thinking about economic moats, or structural competitive advantages, is central to how we do equity research, so I thought it might be worth spending a few minutes and just giving you some basic background on what we mean when we say economic moat, and just what the kinds of moats are that we look for in businesses.

So, when we say economic moat, you might think of the old moat around a castle that protected it from barbarians who want to plunder its treasure. Well, it's really the same concept with a business. All businesses, profitable ones anyways, attract competition, and economic moats basically protect them from the competition that wants to move into their profit pool.

If you look over long spans of time, highly profitable businesses tend to become less profitable over long periods of time as competitors move into their business. Yet we know empirically and intuitively that some small number of businesses do manage to, in essence, defy the laws of economic gravity and post high returns on capital, higher profitability, over even decades at a stretch.

You might think about a Procter & Gamble, a Disney, a Microsoft--pick almost any industry--you can find a business with an economic moat that is basically managed to stay profitable even in the face of concerted competition. And these kinds of businesses have done this because they've erected structural barriers, barriers that are inherent to the business and then are sustainable.

So, the four kinds of economic moats that we look for when we analyze businesses are:

• Intangible Assets
• Customer Switching Costs
• The Network Effect
• Cost Advantages

<TRANSCRIPT>

So, an intangible asset is just what it sounds like. It's an asset that gives you pricing power, but you can't really feel it or hear it.

Think about a brand, think about a patent, think about a regulatory approval: can't touch or feel these things, but you will certainly pay more for a stuffed Mickey Mouse than you will for a generic stuffed rat. You will pay 30% more for a diamond, if it happens to come in a blue cardboard box, labeled Tiffany. It's great cardboard that Tiffany has.

A brand gives Tiffany pricing power, and that pricing power basically changes your behavior as a consumer, and we think that's what defines a brand that gives a company a moat. It's very different than say the brand that Sony has; it's very well know, but do you really pay anything more for a Sony DVD player relative to one from Philips or Panasonic? If you do, you're in the minority; not many people do.

The second kind of moat we look for are customer switching costs--basically when it costs a lot of money in terms of time or labor or resources to move from product A to product B, so you just pay a little bit more for the first product year after year.

If any of you use TurboTax, or you use Quicken, or you use Adobe Photoshop or perhaps you're an engineer and you use Autodesk, you'll know that these are very complicated software programs that are very, very tough to learn and require a lot of work to retrain on, so you basically don't want to switch from product A to product B. Any business where it has a product where it's hard for customers to switch, it's a switching cost and usually it is able to extract some pricing power from consumers.

The third kind of moat we look for is the network effect, which occurs when the value of a product or service increases with the number of users; it's perhaps most powerful of the four kinds of moats. You might think of credit cards. I'll bet you every single person watching this video has a Visa, MasterCard, Amex, or Discover in their wallet right now. And the reason you have those in your wallet is because merchants accept them. Merchants accept them because you carry them.

And so, both parties benefit by the increasing usage of those cards. Auctions and financial exchanges work the same way; everybody buys and sells random stuff on eBay because everybody else buys random stuff on eBay. eBay, despite its slow growth recently, has retained very high market share in online auctions because it benefits from that very same network effect that credit cards do.

And the fourth kind of economic moat is cost advantages. And this sounds like B-school 101. If you are the low-cost producer in a commodity business, you've got a competitive advantage, but we think it's very important to differentiate one kind of cost advantage from another because some are more durable.

Process-based cost advantages--where you essentially invent a better mousetrap, a better way of creating a product or delivering a product or service--tend not to be that durable. Think about Dell's build-to-order business model, think about Southwest's point-to-point, "fly one kind of aircraft" low-cost model that was much cheaper than the major airlines. Both of those had great runs; Dell and Southwest were wonderful businesses for quite some time, but both of those processes got copied, and those firms are no longer the low-cost leaders in their industry.

Contrast those process-based cost advantages with a scale-based cost advantage, the cost advantage that only gets stronger as the company gets bigger. You might think of a company like UPS that has a very dense network of brown vans going all around the world delivering packages, and so the incremental cost of putting one more package on a van that's already going along a certain route is almost nothing.

And that means that that incremental profit on that package is very, very high, and of course that cost advantage just gets bigger as that network gets denser and denser and UPS sends out more and more vans along more and more routes--very different than a process-based cost advantage and one that we would say is more durable.

So, these are the four kinds of economic moats we look for, intangible assets, customer switching costs, the network effect, and cost advantages, and those are the things we think about when we think about economic moats.

I'm Pat Dorsey and thanks for watching.