Four Companies with "Almost-Wide" Moats

We classify companies into three broad buckets based the size of their economic moats. Of the 546 companies that have an economic moat rating, here's the breakdown:

Wide Moat: 96
Narrow Moat: 269
No Moat: 181

The 96 companies rated "wide moat" possess long-term structural advantages relative to competitors and reside in sectors or industries we think will still be healthy 20 or 30 years from now. These include retail, data processing, biotech, pharmaceutical, financial services, medical devices, and asset management, among others. We feel that we can predict the future more accurately for these types of companies than we can for companies in embryonic or declining industries.

That doesn't mean, however, that there are no quality companies in less-desirable areas of the market, but these firms are held back by their weak or unstable industries.

Common Traits of Wide-Moat Companies
Most wide-moat companies have some sort of structural advantage versus competitors. By "structural," I mean a fundamental advantage in the company's business model that wouldn't go away even if the current management team did.

Maybe a company is the low-cost operator in a competitive industry (think  Progressive (PGR) in auto insurance or  Fifth Third Bancorp  (FITB) in banking). Not only are they the lowest-cost companies now, but their business models are so distinctive that competitors can't possibly match them.  Dell   and  Wal-Mart Stores (WMT) are also good examples. This type of structural advantage means a company isn't dependent on having a great management team to remain profitable. To paraphrase Peter Lynch, these are companies that could turn a profit even with a monkey running them, and it's a good thing, because at some point that may happen.

But I don't want to single out low-cost producers as the only companies with structural advantages. A low-cost position is certainly not a universal trait among wide-moat companies. Most industries in which being a low-cost producer is the only way to gain a competitive advantage aren't attractive enough to harbor wide-moat firms in the first place (think airlines, steel, railroads, or mining).

A much more common trait among wide-moat companies is pricing power--the ability to maintain high prices year after year despite competitive pressure (think  Amgen (AMGN),  PepsiCo (PEP),  Gillette ,  American Express (AXP), or  Medtronic (MDT)). In fact, a quick scan of our Bellwether 50 list (a watch list of wide-moat companies that appears each month in Morningstar StockInvestor) indicates that pricing power is the most common trait among these companies. A company possesses pricing power when it owns unique assets, either physical or intellectual. Examples include patents, trademarks, a strong brand name, a database, a natural gas pipeline, an exclusive long-term contract with a key customer or supplier, or government approval to do something competitors can't (e.g.,  Freddie Mac (FRE),  SLM (Sallie Mae) (SLM), and  Fannie Mae (FNM)).

Almost-Wide-Moat Companies
We cover 269 narrow-moat companies. Generally, these companies generate lower returns on invested capital than wide-moat companies, and come in two varieties:

Narrow-Moat Variety #1: These companies have competitive advantages that are eroding due to a shifting industry landscape. This is the scenario faced by some of the consumer-products companies we cover. For example, we rate both  General Mills (GIS) and  Kellogg (K) as narrow moat. The pricing power they once enjoyed is eroding as a result of increased competition and an ever-consolidating retail landscape (read: Wal-Mart). The Baby Bells are another example; their economic moats are also slowly eroding. In future years, they won't enjoy the monopoly pricing power they once did because of the increased use of wireless phones and, of course, the Internet.

Narrow-Moat Variety #2: A company in this category dominates its peers, but resides in an industry where wide moats are nearly impossible to create. For example, in the airline industry, which I mentioned above, it's pretty much impossible to create pricing power, and even being a low-cost provider doesn't always bring stable profits because the industry itself is just too commodified. Even Jesse Owens couldn't sprint in quicksand.

Here, I'd like to highlight a few narrow-moat companies of the latter type. They have good management, are stars of their industries, and generate higher profits than their peers. If you feel that you need to have some money in these industries for diversification purposes, these are the companies to consider. Even so, we don't feel comfortable rating them wide-moat because the long-term industry outlook isn't stable.

 Alcoa  
Alcoa is the undisputed leader in aluminum. It controls one fourth of the world's production of bauxite (the mineral from which aluminum is refined), and its smelting capacity is almost double that of  Alcan , its closest rival. Alcoa is the industry's low-cost producer, so margins and profitability have traditionally bested Alcan's. To maintain its lead, Alcoa is expanding capacity at existing and new, high-efficiency facilities while closing inefficient operations. Also, antitrust regulators will make it difficult for existing major competitors to challenge Alcoa's position.

This dominance doesn't ensure smooth performance, though. Alcoa's core raw aluminum business is in a deep downturn, and two key markets for engineered products--aerospace and industrial gas turbines (IGTs)--are in poor health. Emerging aluminum producers, particularly in China, pose a more vexing challenge to Alcoa's competitiveness. We still think Alcoa is the aluminum firm to own, if you must own an aluminum firm. But given the industry's weakness, we'd require a pretty large margin of safety.

 Exxon-Mobil  (XOM)
In an industry where economy of scale is an important advantage, ExxonMobil is off the charts. The company is the largest in the oil patch with a $162 billion asset base, nearly 23 billion barrels in reserves, and the capacity to refine more than 6 million barrels a day--all stats that are head and shoulders above the competition. ExxonMobil's refining capacity, for example, is more than 50% greater than the nearest peer. This scale has allowed the firm to keep unit costs low enough recently to earn a refining profit while the rest of the industry is in the red. Years of positive, if variable, profitability and solid management have given ExxonMobil one of the most impressive balance sheets around.

Even so, oil is a commodity with volatile and unpredictable prices, and oversupply can greatly sap profits. If OPEC loses its stranglehold on world oil markets, prices will fall and industrywide returns will suffer. Such unpredictable factors outside of Exxon's control make it difficult for us to label the company as wide moat, despite its dominance over competitors.

 Electronic Arts  (ERTS)
This company is on the borderline between wide moat and narrow, in my opinion, and we've had several internal debates here at Morningstar about whether it should be upgraded to wide-moat status.

On the one hand, EA is indisputably the strongest of the pure-play video-game makers and arguably the strongest of all video-game makers. The company sells games for all three major game consoles (Xbox, GameCube, and PlayStation 2), personal computers, and handheld game devices. Year after year, the company has held one of the top three share slots in the console and PC game markets, and more often than not in recent years, the top spot.

Still, EA operates in a highly cyclical industry littered with the corpses of former highfliers. Just as troubling is the fact that it must continually create new games to meet insatiable demand among gamers for new thrills. And the customer base shifts regularly: Few game-players will become lifetime customers, so EA must constantly acquire new customers to replace the core customers who outgrow video games. This shifting customer base is similar to that of a pharmaceutical company, but video gamers, who are making a completely discretionary purchase, are naturally a more fickle customer base.

 Southwest Airlines (LUV)
Regular readers know we really like Southwest. Its management and employees grasp what it takes to be successful in the airline industry: Keep costs low. This is essential because of the large swings in demand that come with the business cycle. When travel demand ebbs with economic weakness, ticket prices fall, and only the airlines with the lowest costs can avoid huge losses. We think Southwest has significant advantages over its rivals.

However, many factors outside the firm's control, such as rising maintenance costs and variable economic conditions, can hurt results. And because industry competition is so fierce, profit margins aren't that great even in the good years. For these reasons, we think Southwest deserves only a narrow-moat rating.