The Competitive Advantage Period Explained

Morningstar's belief in the importance of economic moats (i.e., sustainable competitive advantages) should come as little surprise to regular readers of this column. We've even gone so far as to provide a "size of moat" rating on each stock we cover. We're zealous about this because companies with sustainable competitive advantages are more likely to create value for shareholders over time. As Warren Buffett said in a November 1999 Fortune article, "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."

Defining "Competitive Advantage Period"
Buffett's quote hits home with me because he accurately highlights what's most important (and difficult) about examining a company's economic moat: the sustainability. The concept that Morningstar analysts consider when measuring the life of a firm's economic moat is the competitive advantage period, which is defined as the length of time a company can generate returns on invested capital (ROIC) in excess of the cost at which it can access capital (either debt or equity).

Finance theory suggests a company generating returns in excess of its cost of capital will attract competition. As those rivals get a piece of the action, the superior firm's returns will ultimately decline to its cost of capital, perhaps even below. However, a company with a wide economic moat--high customer-switching costs, economies of scale, intellectual property rights, or a network effect--will be able to hold off the competition and preserve excess returns for a longer period of time.

Industry and Competitive Advantage
There are a number of factors, such as management's strategy, that help determine the length of a company's competitive advantage period, but an industry’s makeup is the primary determinant. For example, competitive advantage periods in the software industry, which is my area of expertise, are extremely short. Successful software vendors can generate huge excess returns because they have high profit margins and few capital requirements. However, the duration of those returns is typically very short due to the rapid pace of technological change. In other words, today's leader can quickly become tomorrow's loser because the company must continuously reinvent itself.

However, there are some exceptions to the software-industry rule. Microsoft (MSFT) has a monopoly on the desktop, explaining why it has generated excess returns for so long. Adobe Systems (ADBE) also has a wide economic moat in the form of high customer-switching costs; graphic designers are trained early in their careers to use the company's software and can't do their job without it. In essence, customers have little choice about using a rival’s products.
 
Of course, not all industries are the same; some have longer competitive advantage periods than others. Pharmaceutical companies with patented drugs can fend off generic competition and post excess returns for as long as 20 years (the life of most patents). Another is the payroll-processing industry, where high switching costs make it difficult for companies to abandon such services. (Switching would require hiring additional employees and dealing with the Internal Revenue Service, neither of which is easy or fun.) But most industries have only a few superior companies with sustainable competitive advantages.

Margin of Safety and Star Ratings
Why does any of this matter? The competitive advantage period is important because it's one of the primary considerations when determining the value of a company. If two companies generate similar excess returns, the one that investors think has the longer competitive advantage period will be valued higher, all else equal. Many investors and analysts try to determine a reasonable estimate for future cash flows and then discount them back to the present at a risk-adjusted rate of return. Deciding how far out to project those cash flows is a critical component of this exercise. 

Competitive advantage period also has a bearing on the concept of margin of safety. Margin of safety, as devotees of value investor Benjamin Graham well know, is a measure of the discount to intrinsic value at which investors would consider buying a stock. We require a smaller margin of safety before buying a wide-moat company than a narrow-moat one. And since long competitive advantage periods and wide moats go hand in hand, we'd typically require a smaller margin of safety to feel comfortable buying these types of stocks. Morningstar uses this same principle when calculating our star ratings, something Morningstar StockInvestor editor Mark Sellers discussed recently.

This methodology encourages investors to seek out companies with wide economic moats that will generate returns in excess of their cost of capital for many years to come.