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 Morningstar is trying to capture with the economic moat rating. A company that has generated capital higher than its cost of capital for many years probably has a moat, especially if its returns on capital have been rising or are fairly stable.
There are the five main things that can give companies economic moats, which we refer to as moat sources.
Where the Wide Moats Are
- Network effect: Lots of people are using the service.
- Intangible assets: Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company's products, or allow the company to charge a significant price premium.
- Cost advantage: Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins.
- Switching costs: When it would be too expensive or troublesome to stop using a company's products, the company often has pricing power.
- Efficient scale: When a niche market is effectively served by one or a small handful of companies, efficient scale may be present.
The wide-moat stocks in our coverage break down like this.
The sector with the most wide-moat firms is industrials. Firms in this sector have a wide variety of moat sources, perhaps because the sector is so wide-ranging. For instance, payroll solutions provider Paychex
has constructed a wide economic moat through onerous switching costs and cost advantages resulting from the scale the company has amassed within its niche over the years, says equity analyst Colin Plunkett. Aerospace and defense company General Dynamics
benefits from efficient scale and intangible assets in addition to high switching costs; its entrenched competitive position in shipbuilding and ground combat along with technological know-how. Chemical technology firm 3M
benefit from cost advantages, and switching costs, and especially intangible assets in the form of patents and a strong brand. Deere
, meanwhile, have built iconic brands that are associated with high-quality and are able to command a premium price; we file this under intangible assets.
The healthcare sector is also widely represented among wide-moat firms. Pharmaceutical companies such as Bristol-Myers Squibb
, and Eli Lilly
have competitive advantages in the form of patents, which we classify under intangible assets.
Wide-moat tech firms tend to have intangible assets, network effects, or switching costs, depending on the type of firm. Alphabet
enjoys intangible assets and network effect--its competitive advantages owe to overall technological expertise in search algorithms and machine learning, as well as access to and accumulation of data that is deemed valuable to advertisers, says equity analyst Ali Mogharabi. Facebook
boasts a huge network with its massive user base and also intangible assets consisting of a vast collection of data that users have shared on its various sites and apps, Mogharabi said. Software makers Adobe Systems
have developed network effects and switching costs because their high-quality software solutions are used by a large network of professionals; learning and implementing a new system would be costly and time consuming.
Where The Narrow Moats Are
Narrow moats break out a bit differently, with consumer cyclicals far and away the most represented sector.
Intangible assets are the most common moat source for these companies. For instance, casinos such as Las Vegas Sands
and Wynn Resorts
have competitive advantages that are driven by their established brand and gaming concession intangible assets in locations such as Macau. Cruise lines Carnival
and Norwegian Cruise Line Holdings
have intangible assets, efficient scale, and cost advantage; not only do these firms have well regarded brands, it would be extremely difficult for would-be competitors to scale up to the point they would need to compete with the big players in this capital-intensive industry. Retailers such as Nordstrom
and Under Armour
have brand-intangible assets worthy of significant pricing power.
Within the financial services sector, narrow-moat banks' competitive advantages often stem from cost advantages and sometimes from switching costs. For instance, Plunkett believes Capital One Financial
has developed a narrow moat from cost advantages through years of steady internal investment in information technology, rewards programs, advertising platforms, and well-timed acquisitions, resulting in a captive cardholder base. As the largest bank in the United States, JPMorgan Chase
benefits from large scale advantages. Switching costs also play a role, as benefits of changing banks often pale in comparison to the time and effort required to do so, says senior analyst Jim Sinegal.
Publicly traded asset managers in the financial services sector such as Waddell & Reed Financial
, Federated Investors
, Janus Henderson Group
, Legg Mason
, and Invesco
tend to have economic moats stemming from switching costs and intangible assets. Even though the switching cost advantage might not be explicitly large, the benefits of switching from one asset manager to another are at times so uncertain that many investors take the path of least resistance and stay put, says financial services sector strategist Gregg Warren.
Note: Since its original publication, the tables and charts in this article have been updated to include a wider universe of stocks.