Health Care a Leader in Moat Stocks

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Our new book, Why Moats Matter, delves into finding companies with great competitive advantages. I'm here today with Damien Conover, our director of health-care research, to look at moats in the health-care space.

Damien, thanks for joining me.

Damien Conover: Thanks for having me, Jeremy.

Glaser: You wrote in the book that health-care companies have a higher preponderance of moats than a lot of other parts of the market. Why do you think that is?

Conover: There are a few things that are really unique to health care, and most notably one of the sources of competitive advantage that we focus on a lot in health care is intangible assets. And in health care, that really boils down to either patents or brand name, but really patents are really important.

When we think about the major industries within the health-care sector--large pharmaceutical firms, large biotechnology firms, and to a lesser extent some of the large medical-device companies--they all have patents. And those patents enable these firms to charge really monopolistic pricing--very, very strong pricing, that allows these firms to have very strong returns on invested capital.

Glaser: Other than patents, what's important when thinking about moats in the health-care space? Does it differ by industry?

Conover: It does differ by industry a bit. I would say the other piece of intangible assets that is also important is brand. There is a big consumer segment in health care, where brand power really allows firms to have excess pricing advantage to get those excess returns. Also, if we think about outside the intangible assets source, there also are switching costs.

Switching costs come up a lot more in device companies, especially orthopedic companies, where a surgeon will learn how to use a particular sort of hip or knee replacement, and then it's very costly to learn a different company's hip or knee. So, hence the surgeon will stay with that particular company. The companies use that to their advantage and price up their products.

Glaser: There has been a lot of change in the sector and probably more coming from things like the Affordable Care Act and a move for cost containment. What impact do you think this will have on the competitive advantages of these firms?

Conover: I think that's a really important point. We are seeing pricing pressure intensified by payers. What the pharmaceutical firms and the biotechnology firms are doing is shifting their pipelines toward areas of true unmet medical need, so into areas like oncology and immunology. And by doing that they're really going to bring forward medicines that will still have very strong pricing power because there are not a lot of treatment options.

Despite the increased pricing pressures, these pharmaceutical firms are actually positioning themselves quite well for that trend because they're going after true unmet medical need.

Glaser: What are our favorite companies in this space? Who do you think has some of the widest moats?

Conover: One of the names we like a lot right now is Sanofi. This is a company that has a strong entrenchment in multiple industries, but really led by its entrenchment in insulin. Insulin still has very strong pricing power partly due to patent protection, but also due to the complexity of manufacturing insulin, which also gives the firm a little bit of a cost advantage, another moat source for the firm. Sanofi we think is very well-positioned for growth over the long term and a lot of it is attributable to its wide economic moat.

Glaser: Damien, I certainly appreciate you taking the time today.

Conover: Jeremy, thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.