We continue to present excerpts from Morningstar's new book, Why Moats Matter: The Morningstar Approach to Stock Investing, which details what makes a moat and how to identify the five sources of moat.
Companies can dig economic moats around their businesses by having sustainably lower costs than their competitors. A favorable cost position can stem from process advantages, a superior location, scale, or access to a unique asset. Process advantages are interesting, but we award economic moat ratings to companies with this edge only if the process can't or won't be easily replicated by competitors. An advantageous location can also give a company a cost edge, and this leg up can be sustainable given the difficulty of duplication. Meanwhile, companies that enjoy economies of scale have lower average costs than their competitors with smaller capacities.
Managed care organizations, or MCOs, provide a good illustration of the economies-of-scale version of the cost advantage source. These firms provide health insurance services to their members (individuals, groups, or the government). One of the most valuable effects of having a large membership base is that the MCO can significantly scale its selling, general, and administrative, or SG&A, costs.
Furthermore, an MCO with a large membership base also has a better ability to control overall medical costs by negotiating advantageous pricing with its providers (hospitals and doctors). To obtain profitable pricing, companies need to either have a large geographic reach to provide demand at multiple nationwide sites or have the local density to control a large portion of demand in a specific geography. Basically, a provider will give better pricing to payers that control more demand. This dynamic is a product of a few factors. First, a procedure usually becomes cheaper to execute for a provider each additional time it is done. Therefore, a provider can cut pricing for a payer with a large membership base and still preserve its gross margins. Second, since a payer that controls a large portion of demand also potentially controls a large portion of a provider's gross profits, the provider will be more apt to provide discounted pricing.
Key Questions: Cost Advantage
- Does the company benefit from economies of scale? Many companies claim that they benefit from economies of scale, but it's important to look for proof that a company with larger volumes indeed has lower per-unit costs than a smaller competitor.
- Does the company benefit from economies of scope? Which costs are spread over a variety of products?
- Does this company benefit from low transportation costs?
- Does this company have a unique production process that results in a cost advantage?
- Does this company have bargaining power with suppliers that results in a cost advantage?
- Does this company have advantaged access to raw materials?
Switching costs are the expenses--whether in time, hassle, money, or risk--a customer would incur to change from one producer or provider to another. Customers facing high switching costs won't necessarily make a switch even if a competitor is offering a lower price or a better-performing product or service. The improvement in performance or price must be large enough to offset the cost of switching. High switching costs are especially prevalent and powerful when there is a high cost of failure, or the cost of the specific product or service in question is fairly insignificant relative to the customer's total operating costs.
Apple is a good example of a company whose customers would suffer switching costs if they changed products. There are a variety of switching costs around the iOS platform that should allow the company to retain a good portion of its current user base without having to compete on price alone. iCloud adds another layer of switching costs by synchronizing media, photos, notes, and other items across all Apple devices. We believe an owner of an iOS device--say, an iPad--is less likely to switch from an iPhone to an Android phone if it means that the individual will be unable to sync or access a portion of his or her content.
Asset managers such as BlackRock also benefit from switching costs. While the costs for investors might not be explicitly large, the perceived benefits of switching from one money manager to another are at times so uncertain that many investors take the path of least resistance and stay where they are. "Asset stickiness," or the degree to which money stays with an asset manager over time, plays a vital role in determining which companies in the asset management industry have the widest economic moats.
Looking more closely at BlackRock, which we feel has the widest moat in the asset management industry, we find that the company benefits from a diverse product portfolio, which is equally split among active and passive investment strategies. This effectively makes the firm agnostic to shifts among asset classes and investment strategies, limiting the impact that market swings can have on its overall level of managed assets. With much of BlackRock's assets under management sourced from institutional clients, which tend to be more long-term-oriented than retail investors, the company has also been able to tap into a far stickier set of assets than many of its peers. While BlackRock may not be a household name, it is well known and well respected in the institutional channel, especially in fixed income, where it effectively forms an oligopoly with PIMCO and Legg Mason. BlackRock's ownership of iShares, the leading provider of exchange-traded funds, or ETFs, on a global basis, has endeared it to institutional investors, and should provide the firm with strong brand recognition in the retail advisor channel--in our view, the stickiest part of the retail channel. These attributes have all combined to build a wide economic moat around BlackRock's operations.
Key Questions: Switching Costs
- What are the costs and benefits of switching? Comparing the costs of switching with the price differences among available alternatives is the best way to prove that a company benefits from switching costs.
- Sometimes it's hard to quantify switching costs, but high degrees of asset specificity, significant training needs, long lead times, and high potential for business disruption all help create customer switching costs.
- What are renewal rates for this company?