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Making a Moat with 'Efficient Scale'

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

If you are a regular reader on Morningstar.com, you know that our analysts spend a lot of time thinking about economic moats, and they recently came up with another explicit source of economic moat.

Here with me to talk about the details of that is Morningstar's Paul Larson. He is editor of Morningstar's StockInvestor newsletter.

Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: So, for a long time you had identified four sources of economic moat. Economic moat being a company's competitive advantage. Can you walk through what those four sources have been and how they lead to an advantage for a company?

Larson: Sure. When you are looking at economic moats, we’ve historically identified four major sources of competitive advantage.

One is the network effect, and this is an effect where when you have a network, the value of that network grows as the network grows. Meaning, as more users use it, the more attractive it becomes for additional potential users. You might think of the social networking platforms that have cropped up over the last couple of years. Facebook is more valuable, the more people that are on it, or you think about eBay, which is company that's had a network effect for a long period of time. It has the most buyers on its platform, therefore it attracts the most sellers. It has more sellers, so it attracts the most buyers. So, that’s the network effect.

Another major source of economic moat is a cost advantage, and this is when a company can source its services or goods cheaper than the competition. You might think of Wal-Mart. They can user their enormous scale to get the supplies into their stores cheaper than the mom-and-pop stores can.

Another source of economic moat, intangible assets; these are things like brands that allow companies to charge more for their products, or patents, a very explicit way of keeping competition at bay, or things like government licenses.

And the last of the historical categories of economic moat that we've identified for a while is customer switching cost. I'd like to explain this one by saying that time is money and money is time. When you are using a service, it may not cost you money to switch to another service, but if it costs you time, that’s basically the same thing. There is a reason why very few people, for instance, change their checking account in any given year, even though money and interest paid and fees paid are sort of like the ultimate commodity, but it would cost us time to go and switch to a new checking account. So, very few people do it.

Stipp: So the analysts were recently going through and formally categorizing the companies that had economic moats, what was the source of those moats? And you found that for some companies that had moats, there was a source that really didn’t fit in any of those four buckets, hence a new bucket for source of economic moat. What is that?

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Larson: The new source of economic moat that we came up with in going through this exercise is something that we're calling "efficient scale." And what this is, is when you have a market that is limited in size--and that’s a very key attribute of this competitive advantage--a limited market being efficiently served by one or a very small number of companies, that alone is going to keep competitors at bay. You might think of it as a pie being quite attractive when one person is eating it, but if you start to slice that pie in two different ways, all of a sudden the economics may not make sense for the potential business that these companies are going to be going after.

Stipp: So ... if it's sliced too many ways, there's just not enough money for someone else to come in and want a piece of that?

Larson: Exactly.

Stipp: So, what are some examples then of a company that would have this kind of efficiency of scale? Where might you see it happening?

Larson: ... You may see this is in areas where you have natural geographic monopolies. One area is the airport business. We don’t have publicly traded airports here in the United States, but they are prevalent elsewhere around the world. And when you have an airport, most cities can only support one airport, some of the bigger cities have two or three, but for the vast majority of cities, when you have an airport, you sort of have a 50- or 60-mile natural geographic monopoly on that area.

Also, when you think about a company like an International Speedway, which owns racetracks around the United States; here in the Chicago market we have exactly one NASCAR racetrack, and frankly that's all we need in this potential market. It's not that we can't get $1 billion together and build a second racetrack somewhere in Chicago, but there wouldn't be enough demand to support two racetracks. So, International Speedway has these little geographic monopolies wherever it goes.

Stipp: I also tend to think about utilities when you're talking about a certain geographic area that's served in a way that might not really make a lot of sense for other companies to come in. Would utilities fall into this category?

Larson: Utilities and certain telecom companies certainly fall into this category, too, where the utilities are natural monopolies. Of course, the utilities also have the overlay of regulation, but even if they did not have the regulation--there are areas of the world where utilities are unregulated--and you still see these natural geographic monopolies. So, utilities certainly do fall into this efficient scale description.

Stipp: So, Paul, we do know also that there are different levels of the moat rating. So, there is narrow and there is wide, and the wide moats are the ones that have the strongest, most sustainable competitive advantages. With this source of moat, do you find these companies tend to be more narrow moat or do they tend to be wider moat?

Larson: Well, they are frankly in both. We have companies like a Lockheed Martin. We only need one next-generation strike fighter supplier. Companies like that are efficient scale stories, and they are in the wide-moat bucket. But there are many more, actually, in the narrow-moat bucket, and that's because essentially the entirety of our utilities coverage universe and a large number of telecom companies are going to fall into this efficient scale bucket. So, it's relatively rare in the wide-moat universe, but in the narrow-moat universe, this should be slightly more common.

Stipp: Last question for you, given that there is ... a certain market of a certain size that's served by these companies, would you tend to see them as more mature or slower-growth, maybe more likely to pay a dividend because of that? Even though they do have that [competitive advantage], maybe their prospects for gangbusters growth aren't as high as another kind of company?

Larson: Right. As I mentioned at the outset, a key attribute is a limited market, and that sort of implies that these companies are not necessarily growing, because a rapidly growing market provides lots of opportunities for competitors to come in. But if you are benefiting from this particular competitive advantage, you're going to tend to be in a relatively low-growth industry. So, you are right, they are going to be typically more mature, higher-dividend-paying companies.

Stipp: All right, Paul. It sounds like an interesting new insight on the moat rating. Thanks for joining me today.

Larson: Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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