Not All Moats Are Created Equal

Editor's Note: Since the publishing of this article, Morningstar equity analyst Matthew Coffina was named editor of Morningstar StockInvestor.

Identifying long-term competitive advantages, or economic moats, has long been at the core of our equity research methodology. We recently completed a study focusing on the sources of a company's moat for all of the names in our equity coverage universe. As part of this study, we explicitly identified the source(s) of competitive advantage for every company with a narrow- or wide-moat rating and detailed how each of these companies sources their moat from one or more the following five categories: intangible assets, cost advantage, switching costs, network effect, or efficient scale. We found some rather striking differences in groups defined by the source of competitive advantage.

There are five major sources of moats:

1. Cost Advantage
Firms that can figure out ways to provide goods or services at a lower cost have an advantage because they can undercut their rivals on price. Alternatively, they may sell their products or services at the same price as rivals, but achieve a fatter profit margin.  Wal-Mart Stores (WMT) is a textbook example of a low-cost producer because it can use its size to acquire and distribute merchandise with lower expenses than competitors. Beyond economies of scale, other examples are basic materials and energy firms such as  Potash Corp. of Saskatchewan (POT), Compass Minerals (CMP), or even  Eldorado Gold (EGO)--all of which have world-class and inherently low-cost sources for the commodities they produce.

2. Intangible Assets
Intangible assets are things like patents or government licenses that explicitly keep competitors at bay. Pharmaceutical firms such as  Abbott Laboratories (ABT) or 
 Pfizer (PFE) certainly benefit from patents, which give them legalized monopolies for their products for a period of time. Another sort of intangible asset that can provide an advantage is a strong brand. Not just any brand will do--it has to attract customers and entice them to pay more.  Sony (SNE) is a great example of a company that has a readily recognized brand but the inability to charge more for consumer electronics simply because of its brand. On the other hand,  Harley-Davidson (HOG) can charge a significant premium over lesser brands of motorcycles or jackets.

3. Switching Costs
Switching costs are those one-time inconveniences or expenses a customer incurs to change from one product to another. As they say, time is money (and vice versa). Companies whose customers have switching costs can charge higher prices (and reap more profits) without the threat of losing business. Consider companies like   Oracle (ORCL),  Micros Systems , and  Fiserv (FISV); the risk and man hours a company would incur from potentially disrupting its operations far outweigh any small potential reduction in costs it might have from switching away from one service provider to another. Therefore, customers just tend not to switch, giving these companies some pricing power.

4. Network Effect
The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service, often creating a virtuous circle that allows the strong to get stronger. Take  eBay (EBAY) as an example; it has the most buyers on its platform, so it attracts the most sellers. Meanwhile, because it has the most sellers, it is the most compelling source for buyers looking for nonstandard goods. A timelier example is  Facebook (FB). People use Facebook because that's where their friends are.

5. Efficient Scale
This is primarily a dynamic where there is a limited market size that is being effectively served by one or a small handful of companies. In many of these situations, the incumbents have economic profits, but a potential competitor has less incentive to enter because the limited opportunity would cause returns in the market to fall well below cost of capital, not just to the cost of capital itself. The companies that benefit from this phenomenon are efficiently scaled to fit a market that only supports one or a few competitors, limiting rivalry.  International Speedway is a great example; there is simply not enough demand for more than a single NASCAR racetrack in any given city. Airport operators like  Grupo Aero del Sureste (ASR) also benefit from efficient scale because, for most cities, it makes sense to have just a single commercial airport.

Companies can sometimes fall into just one of these buckets, while others may have two or more sources of advantage. Take Grupo Aero del Sureste: Even though efficient scale alone would keep competitors at bay, the company also sources its moat from intangible assets in the form of government concessions that limit new airports from being built in the geographies in which it operates. Or consider
 Coca-Cola (KO): The company obviously benefits from the intangible assets represented by its brands. But even if the brands were to lose their value and the company were to produce generic cola, the company would still have a major cost advantage because of its distribution network.

After we categorized our entire coverage universe of wide- and narrow-moat stocks, we then created different cohorts, sorted by the sources of competitive advantage. We then looked at the different quantitative aspects of these cohorts. Our initial insights from this analysis follow below.

Wide-moat firms are more profitable than narrow-moat firms.
There is zero surprise here, as return on invested capital and return on equity are two of the primary metrics we look at when assigning the economic moat ratings in the first place. (We look primarily at the expected duration of excess returns and not just the absolute level, though the two are correlated.) But we can now quantify the difference and say the typical (median) wide-moat firm has an ROIC nearly 6 percentage points greater than the typical narrow-moat firm.

Wide-moat firms have more sources of competitive advantage.
When identifying what source(s) of competitive advantage each firm had, firms rated with a wide moat were much more likely to have more than once source of competitive advantage. Sixty-three percent of wide-moat firms derive their competitive advantage from more than one source, while just 41% of narrow-moat firms do the same.

The most common combination (121 companies) was switching costs and intangible assets, as seen at  Intuitive Surgical (ISRG),  Zimmer Holdings (ZMH), and
 National Oilwell Varco (NOV). The combination of network effect and efficient scale was by far the rarest, with only six companies falling into this cohort.

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Efficient Scale is far more common among narrow-moat firms, while the Network Effect is far more common among wide-moat firms.
This makes intuitive sense. When a company is benefiting from the network effect, it can often be a "winner take all" situation, giving the leading firm a wide moat while leaving competitors with no moat at all. The other sources of competitive advantage simply lend themselves to more shades of gray. Less than 9% of narrow-moat firms benefit from the network effect, versus 24% of the wide-moat firms.

Concerning efficient scale, it also makes intuitive sense that this would be more common among narrow-moat firms. The entire dynamic is actually based upon companies operating in a niche that is profitable enough to generate positive economic profits, but not large or profitable enough to attract competition. 

The utilities sector also plays a big role here. We have almost the entire sector rated narrow-moat, a rating which balances the sector's relatively high stability of earnings and a tendency toward natural geographic monopolies against the fact regulators keep a cap on profits, leading to relatively low returns on capital (typically high single digits). A full 26% of the companies that benefit from efficient scale are utilities, despite utilities making up only 7% of the companies in our entire coverage universe of wide- and narrow-moat companies.

All else being equal, companies with multiple sources of competitive advantage have better fundamental performance than those with a single source.
There was a major unanswered question going into this analysis: Was it better for a company to have one very strong source of moat, or better to have multiple (but presumably weaker) defenses against the competition? Our analysis shows that, all else being equal, companies with multiple advantages tend to fundamentally outperform those with just a single advantage. In addition, this dynamic is not just a matter of mix and having more wide-moat firms in the multiple-advantage cohorts. Rather, this correlation holds (albeit to a lesser extent) when looking at only wide-moat firms, too.

This being said, all is not equal in the real world. When looking at companies with wide moats and one advantage, and comparing them with narrow-moat firms with two or more advantages, the wide-moat companies clearly outperform the narrow-moat firms. In other words, even though the number of advantages is correlated to fundamental performance within each moat rating cohort, the absolute width of a company's moat trumps the number of advantages.

Among the different potential sources of moat, the intangible assets category has the companies with the best fundamental performance.
As the table below shows, among the five potential sources of moat, the cohort of companies that derive their competitive advantage from intangible assets has posted the best returns on capital over our measurement periods. Conversely, companies that benefit from efficient scale have had the worst fundamental performance by a fairly large margin.

Digging further into why the intangible assets category has performed as well as it has, it appears the relatively large exposure to the high-performing health-care sector--which benefits both from patents and other advantages related to intellectual property--is one driver of the outperformance. Another is the large exposure to the consumer sectors--which tend to benefit from brands--that have relatively strong returns on capital.