Tech Companies with Wide Moats

“Ultimately, they’re all toasters.”

This statement, by Columbia University finance professor Bruce Greenwald, is one of my all-time favorites about the hypercompetitive nature of the technology business. 

Greenwald is a dyed-in-the-wool value guy--he’s written a great book called "Value Investing"--so you might think at first blush that this is just some kind of knee-jerk, anti-tech attitude. It’s not, though, because a lot of evidence shows that superior technology is actually one of the least sustainable types of competitive advantage. High profits attract strong competition, and if the only things keeping competitors at bay are the 10 features on your firm’s gizmo, you can be sure competitors are working hard on a 20-feature gizmo so they can steal your customers.

The Next Best Toaster
Given the pace of technological innovation, it’s almost a certainty that any technological advantage will be quickly superceded--or made irrelevant. Think about one-time highfliers U.S. Robotics/3Com , Check Point Software Technologies  (CHKP), and EMC .

When modems were selling like crazy, U.S. Robotics was one of the hottest companies around. But then the rapid product-development cycle hit a wall (remember how you kept upgrading your modem speed from 14.4 kbps to 28.8 to 33.6, and then finally to 56?). Modems became less of a developing innovation and more of an interchangeable commodity, because you simply couldn't push any more data over a copper phone line. At that point, cost superceded innovation as the defining competitive issue, and modems weren’t such a great business anymore.

EMC and Check Point haven’t hit technological walls yet, but competitors have been introducing better (or at least comparable) products, which have chewed away at the two firms’ margins. Check Point made gobs of money--operating margins topped out near 65%--when it managed to bundle two different kinds of Internet security features into the same software. Unfortunately, competitors such as Cisco Systems (CSCO) saw these profits and started producing software with similar functionality, which eventually sent Check Point’s margins south. EMC’s story is similar. After years of playing catch-up, IBM (IBM) and Hitachi (HIT) introduced storage products with similar features, which forced down EMC’s high prices.

Enduring Advantages
The point here is not that technological superiority is irrelevant, merely that the benefits it confers can be very fleeting. The best tech firms realize that better technology isn’t a sustainable competitive advantage, and so they work to build different kinds of economic moats. We expect such firms to build real shareholder value over the long haul. Right now, only 11 (8%) of the 129 companies Morningstar covers in the software, hardware, and telecommunications sectors have “wide moat” ratings, compared with 21% of the nontech companies we cover.

So what kinds of competitive advantages should investors take seriously when evaluating technology firms? Consider the following:

The network effect. This essentially means that a product becomes more valuable the more people use it. Adobe Systems  (ADBE) and Microsoft (MSFT) fall into this category--Adobe because its Acrobat software is the standard for electronic publishing, and Microsoft because it essentially owns the market for PC operating systems. Each person who downloads a free copy of Acrobat Reader, or who buys a PC preloaded with Windows, makes the network of users that much more valuable.

High switching costs. If you’ve been trained on Adobe Photoshop, or you’ve used Microsoft Word or Excel for years, you’d be unlikely to switch to a competing product unless it was a heck of a lot better, given the time it would take you to master the new programs. This helps Adobe and Microsoft retain their current customers. Autodesk (ADSK) and Intuit (INTU) also benefit from high switching costs--designers are trained on AutoCAD early in their careers, and Intuit's Quicken has become the de facto standard for small-business bookkeeping. In both cases, the costs of switching to competing products would be very high.

Economies of scale. Chip giant Intel (INTC) and Applied Materials (AMAT), a chip-equipment manufacturer, both dominate their industry to such a degree that they can spread fixed costs, such as marketing and research, over a much larger sales base than their competitors. This economy of scale makes them a heck of a lot more profitable. Think about it--how many times has Advanced Micro Devices (AMD) tried to take on rival Intel, succeeded for a few months, and then been beaten back as Intel cut prices? That’s the kind of advantage that size can bring.

Cost advantage. You don’t have to be large to have low costs, though. For example, even when Dell Computer   wasn’t the largest PC manufacturer, its build-to-order business model gave it a huge cost advantage over its peers. Being the low-cost producer in a commodity industry is a very large competitive advantage, especially if you’re able to keep driving your costs lower than your competitors.

Intellectual property. Patents and licenses can confer a big competitive advantage. Qualcomm (QCOM), Linear Technology , and Maxim Integrated Products  are prime examples of this. Qualcomm owns patents galore on different flavors of wireless standards and reaps high-margin royalties every time a chip based on its patents is sold. Linear and Maxim, meanwhile, have many years of in-house experience designing analog chips, which is a more subtle form of intellectual property. Be warned, though--just having patents on a cool technology doesn’t do a company any good until that technology gets adopted, as Rambus (RMBS) shareholders have found out over the past few years. Additionally, patents by themselves are no guarantee of profits, since a competitor can easily patent a better widget and take away your business. The trick is to make sure that the patents apply to either a standard that other firms have to use (Qualcomm) or that the expertise used to create the patented technology isn't easily replicable (Linear and Maxim).

The bottom line is that building a better toaster doesn’t give a firm a big competitive advantage. Making a standard toaster cheaper, getting everyone else to use your toaster, or patenting your toaster, however, are the kinds of competitive advantages that can last for a while.