Digging an Economic Moat

Basically, the idea of an economic moat refers to how likely companies are to keep competitors at bay for an extended period. All businesses that earn excess economic profits attract competition, and the bigger those profits are, the more capital will pour into those areas of the economy to compete with existing firms. That's the basic nature of any (reasonably) free market. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it's this characteristic--think of it as the strength and sustainability of a firm's competitive advantage--that we're trying to capture with the economic moat rating.

Obviously, assigning moats is a complicated process, and relies heavily on our analysts' knowledge of their companies and industries. One of the first things we do when we're thinking about the size of a firm's economic moat is look at the company's historical financial performance. Companies that have generated returns on capital higher than their cost of capital for many years running are usually doing something right, especially if their returns on capital have been rising or are fairly stable-- Paychex or  Microsoft are good examples.

Of course, the past is a highly imperfect predictor of the future, so we look carefully at the source of a company's excess economic profits before assigning a moat rating. For example, a competitive advantage created by a hot new technology usually isn't very sustainable, because it won't be too long until someone comes along and invents a better widget. Tech companies with wide economic moats--like Microsoft,  Intel , or  Dell Computer --usually have some kind of strength other than technological prowess. Microsoft has the network effect on its side, Intel has economies of scale relative to a competitor like  Advanced Micro Devices , and Dell is the low-cost producer in a commodity industry. These competitive advantages are all much harder to duplicate than a piece of hardware or software that just has more features than everyone else's.

We also look at whether the company (or the industry) has changed significantly, which gives us insight into whether the company's future is more or less likely to be as bright as its past. Paychex, for example, has as bright a future today as it did five years ago--it still has plenty of room to expand, and is still the only payroll-outsourcing firm focused on smaller companies. Microsoft, on the other hand, is facing a big slowdown in its core PC market, which means it's looking for growth opportunities in markets like enterprise software and consumer products in which it has a much smaller economic moat. So, revenues from these new markets are likely to be less profitable. Although we still rate Microsoft's economic moat as wide for now, we're nonetheless watching the success of its new ventures closely, and our fair value estimate assumes lower profit margins. It's not inconceivable that we could lower our opinion of Microsoft's moat a year from now.

So, what are some attributes that can give companies economic moats? There are quite a few, but here are some of the big ones:

1. Huge Market Share
When a firm enjoys economies of scale in areas like manufacturing, sales, and marketing, it can be pretty tough for a competitor to catch up. For example, AMD has had a tough time beating Intel in the PC-chip industry because Intel has so much market share it can spend heavily to duplicate anything AMD does. Intel also enjoys other advantages because of its leadership--such as the ability to raise cheaper capital and economies of scale in advertising, marketing, and manufacturing.

2. Low-Cost Producer
This is related to number one above, but not necessarily tied to market share. For example, Dell and  Southwest Airlines don't dwarf their competitors, but they are able to make PCs and fly planes cheaper than any of their competitors. This advantage is especially potent in commodity industries.

3. Patents, Copyrights, or Governmental Approvals and Licenses
This is a sticky one. Drug companies, for example, generate enormous profits when their drugs are patent-protected, but patent extensions are often successfully challenged by generic competitors. Similarly, the value of governmental licenses--such as the approvals granted to local television stations or wireless carriers--can be quite high or quite low depending on the situation and the ease with which other licenses can be obtained.

4. Unique Corporate Culture
Although you should be careful of placing too much emphasis on this attribute, since it's such a "soft" method of determining competitive advantage, there's no question it can make a difference. Jack Welch said that  GE's core competency is training managers, and the culture of excellence and performance at GE certainly seems to have contributed to the company's success over the years.  Expeditors International of WA --which I've profiled before--also falls into this category.

6. High Customer-Switching Costs
This can create a gigantic economic moat. If you can make it tough for your customers to use a competitor, it's usually easy to keep ratcheting prices up just a bit year after year--which can lead to big profits. Most data-processing firms--like  First Data or Concord EFS  --have this characteristic, as do most banks. Microsoft is another good example.

7. The Network Effect
This is a relatively rare, but potentially quite potent, source of competitive advantage, and often accrues by the first mover in an emerging technology. Since a network's value increases as more people use it, the company that creates the network can create a massive economic moat. The classic example is  eBay --more buyers attract more sellers, which attract more buyers, and so forth--but companies that sell industry-standard software (like  Adobe Systems and  Autodesk ) also fall into this group.

(Thanks to Morningstar StockInvestor editor Mark Sellers for compiling this list.)