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Click to edit Master title style,Click to edit Master text styles,Second level,Second level,first level,*,2008 Morningstar,Inc.All rights reserved.,Click to edit Master title style,Click to edit Master text styles,Second level,Second level,first level,*,Durable Competitive Advantages:Using Economic Moats to Improve Investment Returns,Pat Dorsey,CFA,Director of Equity Research,Durable Competitive Advantages,2,Agenda,Our Approach to Competitive Analysis,What is an Economic Moat,Whats Not,Where Morningstar Finds Moats,Why Moats Matter,Using Economic Moats in the Investment Process,2AgendaOur Approach to Competi,3,Whats A Moat?,Capital seeks the areas of highest potential return,so all firms face competition that seeks to force down high returns on capital.,But some firms generate high returns for a very long time.,How?By creating,economic moats,around their businesses.,An economic moat is a,structural,business characteristic that allows a firm to generate excess economic returns for an extended period.,Note that“structural”means“inherent to the business.”,Smart managers and great execution are important,but theyre,not,structural attributes.,3Whats A Moat?Capital seeks t,4,Whats a Moat?,The key to having an economic moat is the,sustainability of excess returns,rather than the absolute level of return on capital.,A company with 40%returns on invested capital(ROIC)due to a hot product has no moat.The returns cannot be forecasted with any level of confidence.,Fashion stocks(Crocs,Heelys),Motorola Razr,A company with 12%ROIC and a low cost of capital that is structurally protected from the competition may have a wide economic moat,because we can forecast those returns with a high degree of confidence.,Pipelines,Railroads,4Whats a Moat?,5,Sources of Economic Moats,Intangible Assets,Brands,Patents,Approvals&Licenses,Customer Switching Costs,The Network Effect,Cost Advantages,Process,Location,Unique Assets,Scale,5Sources of Economic MoatsInta,6,Sources of Economic Moats,Intangible assets,Brands:Does it increase the consumers willingness to pay,or reduce search costs?,Sony vs.Tiffany,Doublemint&Juicy Fruit,Patents:Valuable,but subject to expiration&challenge.,Big pharma vs specialty pharma,Licenses&Government Approvals.,Waste haulers,aggregate companies,6Sources of Economic MoatsInta,7,Sources of Economic Moats,Switching Costs,:Do the costs in time or money of switching to a competing product/service outweigh the benefits?,Monetary/Labor Costs,-Oracle,-Autodesk,-Data processors,Low or uncertain benefits from switching,-Amazon,-Asset managers,7Sources of Economic MoatsSwi,8,Sources of Economic Moats,The,Network Effect,One of the most powerful types of competitive advantage,which occurs when the value of a good or service increases with the number of users.,Examples of the Network Effect,eBay,Western Union,MasterCard,American Express,Discover,Visa,Microsoft,Financial Exchanges,8Sources of Economic MoatsThe,9,Sources of Economic Moats,Cost Advantages,Not necessarily tied to size,Process,Invent a cheaper way of delivering a good or service that rivals cannot(or will not)replicate.Dell,Nucor,Steel Dynamics,Southwest/other LCCs.,Low-cost resource base,Ultra Petroleum,Compass Minerals.,Scale,-Distribution Stericycle,Cintas,Sysco,UPS,-Manufacturing Intel,-Niche Markets/Single-Scale Efficiency Graco,Blackbaud,9Sources of Economic MoatsCost,10,Whats,Not,An Economic Moat,Size/Dominant Market Share:High market share does not give a firm a moat.(Ask Compaq or GM.)In fact,market share may be irrelevant bigger is not necessarily better.,Technology:What one smart engineer can invent,another can improve upon.(Exception:Creating a standard thats widely adopted.),Easily-replicable cost advantages(lean manufacturing,outsourcing.),Hot Products:Krispy Kreme,Tommy Hilfiger,Crocs,Iomega,etc.,Can generate high returns on capital for a short period of time,but,sustainable,returns are what make a moat.,10Whats Not An Economic MoatS,11,Whats,Not,An Economic Moat,Management,:Smart managers may,create,a moat over time,but great management is not a moat by itself.,Go for a business that any idiot can run because sooner or later,any idiot probably is going to run it.Peter Lynch,“When management with a reputation for brilliance tackles a business with a reputation for poor economics,it is the reputation of the business that remains intact.”Buffett,Management matters,but moats matter more,.,11Whats Not An Economic MoatM,12,Where Morningstar Finds Economic Moats,Three groups:Wide,Narrow,and None.,Wide moats are tough to find.Less than 10%of the 2100 companies that we follow have wide economic moats.(169,to be precise.),Moats vary by sector&industry.,Fewer moats in highly commoditized or competitive sectors like computer hardware,consumer services(retail/restaurants),or industrial materials.Only 1/3 of the companies in these three sectors are wide/narrow moat.,More moats in areas with high switching costs(data processors)and durable brands(consumer produ
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