What makes a moat? (Part 2)

In an excerpt from their new book, Morningstar's Heather Brilliant and Elizabeth Collins explore how to identify a moat and how intangible assets can help a firm carve out a sustainable competitive advantage.

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In part 1 of the article, we briefly explain our moat methodology. In this part of the article, we will dig into the moat sources one by one.

For each of the five sources we provide lists of critical questions that you can ask yourself when determining whether a particular company has a narrow or wide economic moat. For each source, we provide a few examples, so you can see how these play out in the real world.

Intangible Assets
Intangible assets is a broad category that includes brands, patents, and regulatory licenses.

A brand creates an economic moat around a company's profits if it increases the customer's willingness to pay or increases customer captivity. A moat-worthy brand manifests itself as pricing power or repeat business that translates into sustainable economic profits.

Walt Disney is a good example of a company that has built a moat based on the intangible asset of brand. In fact, strong brands support robust and sustainable economic profits at both of Walt Disney's key businesses: cable networks and Disney-branded businesses (parks, filmed entertainment, and consumer products). On the cable side of the business, strong networks like ESPN earn rich subscriber fees and profits. These profits allow the company to spend on long-term programming rights with the major professional sports leagues and college athletic conferences, which reinforces ESPN's position as the leader in its category. The strength of this brand has allowed the company to expand the franchise and has resulted in several sister channels and the most popular website dedicated to sports content. In the Disney-branded businesses, the company exploits strong characters and franchises across multiple platforms. Disney has been creating high-quality family entertainment for decades and has become a brand that children seek and parents trust. Disney's theme parks and resorts are difficult for competitors to replicate, especially considering the tie-ins with its other business lines. A Disney character franchise typically starts with a theatrical release, but can be further exploited through DVD sales, licensing to television networks, sequels, merchandising, and theme park attractions. Each new successful franchise becomes a valuable addition to Disney's large library of content, which can be monetized for decades.

Starbucks remains the dominant player in specialty coffee, and its brand commands premium pricing for what is truly a commodity. Coffee is a globally fungible commodity (in other words, it is easily replaced by another identical product) that is traded on liquid exchanges with complete price transparency. Still, Starbucks' customers are willing to fork over extra dollars for a cup with a green mermaid, thanks to the experience Starbucks has created as part of its brand. As a result, we expect Starbucks to generate handsome economic profits in the coming decades, with ROICs in excess of 20% over the long term.

Key Questions: Brands

  1. How do you quantify the strength of the brand? What is the pricing power that the brand conveys? What is the premium that the company can charge relative to competitors? High name recognition doesn't always translate into pricing power. Just think of airlines such as United or American--you're probably very aware of these brands, but that doesn't mean you're willing to pay more for a United or American ticket. Most likely you'll make your purchasing decision based solely on cost after factoring in class, mileage credits, and baggage fees, and we see this reflected in the poor returns these airlines generate. As a result, most airlines lack sustainable competitive advantages.
  2. Is the premium offset by higher costs? Some companies do indeed charge higher prices than their competitors, but that merely reflects a higher cost of production. For a brand to be moat-worthy, it must confer pricing power that at least offsets any difference in costs.
  3. How do the company's margins compare with competitors that don't have strong brands? If you don't have specific data on prices and costs, you can look at a company's profit margins relative to its peers for signs of pricing power.
  4. What gives you confidence that the brand strength, the premium pricing, and the higher operating margins are sustainable for 10-20 years? Brands come and go, and sustainability is the most important factor when determining economic moats. After all, history is littered with examples of well-recognized brands that didn't lead to sustainable returns, such as Crocs, Nokia, and Palm. Although it's hard to predict which brands will remain powerful decades into the future, companies that continuously plow money into innovation and marketing are more likely to have powerful brands in the future. Further, lifelong brands arguably have more longevity potential than companies with high-turnover client bases. For example, once a consumer develops a taste for, say, Coca-Cola over Pepsi, that's a preference that will likely hold, and Coca-Cola can rely on having the same customer for decades.



2. Patents
Sometimes patents are a source of sustainable competitive advantage for a company, although not all patents lead to narrow or wide economic moat ratings. If patents protect a company's main products, and there are no viable alternatives, then the company may have pricing power for a sustained period while other industry players are legally barred from competing.

Like other highly successful pharmaceutical companies, Sanofi benefits from patent protection that keeps competitors at bay for several years while the company charges prices that enable returns on invested capital significantly above its cost of capital. Also, Sanofi's unique entrenched position in the insulin market further reduces the threat of generic competition even after patents expire thanks to the high up-front costs needed to achieve the economies of scale for low-cost insulin production.

Key Questions: Patents

  1. What is the expiration schedule for the company's patent portfolio?
  2. How diverse is the company's patent portfolio? 
  3. What is the market potential of patentable products in the pipeline and the probability of their success? 
  4. Once products come off patent, how easy will it be for competitors to enter the market? 
  5. What are the potential substitutes for the patented product? 
  6. How strong is intellectual property protection in the relevant markets? 



3. Regulations 
Government regulations are another intangible asset that can lead to sustainable competitive advantages if the rules make it difficult or even impossible for competitors to enter the market. Regulations are especially favorable if a company can operate like a monopoly but isn't regulated like one with regard to pricing.

Casino operators with Asian facilities, such as Las Vegas Sands and Wynn Resorts, benefit from regulatory barriers to entry, giving Asian casino operators much wider economic moats than their U.S. counterparts. The China market is an oligopoly, with only six licenses granted, and legalized gambling limited to the tiny, densely populated region of Macau; Singapore is a duopoly, with only two licenses. It is extremely unlikely that the Chinese central government will authorize casinos in another province of China, as this would require a change to the Chinese constitution, and Beijing doesn't want gambling to bring societal ills to other provinces in mainland China. Advertising casinos in mainland China is illegal, and Beijing has cracked down hard on illegal gambling. Casino licensing in Macau is quite different than in the United States, in that the companies that receive licenses to operate in Macau are able to open more than one casino, with the limitation that new casinos require government approval and licensed operators must pay an additional fee to the government for each new casino. In the U.S., license holders generally do not have the right to open multiple casinos, and a new license is required for each new casino.

Key Questions: Regulations

  1. Are there offsets to the favorable regulation, such as price controls or service mandates? 
  2. If regulatory barriers to entry are the key argument, consider the threat of substitutes. 
  3. What is the most likely outcome for future regulations? 
  4. How material are the risks of adverse regulatory changes? 



Excerpted with permission of the publisher John Wiley & Sons, Inc. from Why Moats Matter: The Morningstar Approach to Stock Investing. Copyright (c) 2014 by Morningstar. This book and ebook is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.

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About Author

Heather Brilliant, CFA  Heather Brilliant, CFA, is the vice president of Global Equity and Credit Research at Morningstar.

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