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Morningstar.com's Interactive Classroom

Course 109
Finding Economic Moats

Introduction

Why is it that some investors are able to rise far above the crowd? Are they smarter than everyone else? Do they have access to "inside" information that others don't? To find out, Morningstar looked back at hundreds of interviews we've done with elite stock investors over the past 15 years. Because Morningstar talks to great investors every day, we're uniquely qualified to delve into their investment styles and strategies. And what we found was fascinating. On the surface, many of these managers don't have much in common. They grew up in different places, came from different educational backgrounds, manage different kinds of funds, and hold different stocks within different industries.

In fact, there's really only one obvious trait shared by almost all the great stock market investors we talk to. What is it?

It's a methodology for uncovering great stocks at reasonable prices--a methodology we call the Four Principles of Profitable Investing. This class deals with the first principle: Find Economic Moats.

About Economic Moats

What separates a bad company from a good one? Or a good company from a great one? In large part, it's the size of the "economic moat," or competitive barrier, a company builds around itself. In general, the greater the competitive positioning, the greater the shareholder value companies are able to create. We've identified four main types of economic moats:

1. High customer switching costs
2. Economies of scale
3. Intangible assets
4. The network effect

High Customer Switching Costs

If a business sells you something you can't get elsewhere--at least not easily--then that business has high customer switching costs. For example, if you have only one grocery store in your neighborhood, and you don't own a car, you'd be willing to pay extra to buy your food there. To get to another store, you'd have to walk a long way. Thus, there are high "costs" to switching to a different grocery store. In this scenario, the grocery store can charge higher prices and generate excess profits.

Let's look at an example from the stock market. Paychex PAYX does payroll processing for other businesses that don't want to hire and train a staff of people for this function. Since Paychex is a specialist, it can offer similar services as an in-house staff of payroll employees, but at a lower cost, more quickly, and with fewer errors. What happens if a company decides it wants to forgo using Paychex's services and bring the job in-house? Well, it's looking at hiring payroll employees and training them, buying computers, buying software, and dealing with IRS audits and employee complaints because of frequent errors. Not many small businesses would willingly make this trade-off unless the cost savings of bringing the job in-house were enormous. Thus, Paychex enjoys very high customer switching costs.

Another example: Have you ever moved to a different residence in the same city and asked the local phone company to let you keep your phone number? It's a real headache to notify everyone that your phone number has changed. The same holds true for e-mail addresses. And that's why AOL's customers don't leave once they're hooked, despite the sometimes-spotty service they may get.

Speaking of being hooked, the great granddaddy of high customer switching costs is the tobacco industry. Getting customers physically and psychologically addicted to your product is a recipe for monster profits--legal and ethical issues aside.

Economies of Scale

In commodity industries such as oil, steel, and personal computers, economic moats are very difficult to create. Take the airline industry (please). Most travelers are looking for the lowest fare, regardless of the airline. That forces airlines to compete aggressively on price to generate business, which translates into small profits when the economy is hot and large losses when it's not. In fact, according to Warren Buffett, in the entire 100-year history of the airline industry, not one net dollar of profit has been made.

An economic moat is a barrier against competition. When price is the only thing to compete on, there is only one form of barrier--the ability to offer lower prices than your competitors for the same product or service. However, for those rare companies that thrive on being the low-cost provider in a commodity industry, profits are plentiful.

In the airline industry, that low-cost provider is Southwest Airlines LUV. Southwest's entire mission is centered on offering cheaper flights than competitors, without shirking on service. By keeping costs down, it has been able to thrive in an environment that forces many other airlines to take large losses or declare bankruptcy. Southwest has been able to dramatically increase its profits and, subsequently, its stock price.

As the "economies of scale" name implies, many times this lower cost structure comes from being the largest in an industry. This is because the behemoths can typically negotiate better deals from suppliers while spreading their fixed administrative costs over a larger sales base. The bottom line is that if a company can provide a product or service for less than its competitors, it has a major advantage.

Intangible Assets

Some companies have an advantage over competitors because of unique nonphysical, or "intangible," assets. Intangibles are things such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage.

In some cases, whole industries derive huge benefits from intangible assets. These industries, such as drugs and software, are exactly the opposite of commodity industries. Companies in these industries live and die by their ability to generate intellectual property (IP) rights such as patents, copyrights, and governmental agency approvals. The great thing about IP rights is that they are protected by law, which means a company that owns a lot of patents or copyrights can raise prices without fear of being undercut by competitors. This can be one of the best types of economic moats because it virtually guarantees a monopoly on a product until the IP rights expire.

The Network Effect

Perhaps the strongest type of economic moat is the network effect. For those rare companies that successfully take advantage of this phenomenon, the reward is often a legal monopoly. A common trait among these types of companies is that they are the first, or one of the first, to enter an emerging industry or business niche.

Let's take a trip back to March 7, 1876, the day Alexander Graham Bell was awarded a patent on a new invention called the telephone. Even though this marked one of the most important inventions in the history of the world, many people saw it as a mere curiosity. The telephone didn't immediately catch on for one reason: Since no one else had access to a telephone, there was no one to call. Who wants to buy something that can't be used?

But slowly, more and more people gained access to a telephone, giving them the ability to communicate with friends, family, and associates. As more people gained access to a telephone, the more valuable telephones became and the faster phone usage grew. This is a classic example of the network effect (or winner-take-all effect): The more people that are within a network, the more valuable the network becomes to new and existing users.

A more recent example is eBay EBAY. Because it was the first to connect individual buyers and sellers over the Internet in an auctionlike format, it grew very quickly. It had (and still has) the most sellers, which attracted the most buyers, and vice versa. EBay gained a critical mass and retains a near-monopoly position in the online-auction market.

One final thought about economic moats: It is possible for some companies to have more than one type of economic moat. For example, many companies that use the network effect also benefit from economies of scale, because these companies tend to grow so large that they dwarf smaller competitors. In general, the more types of economic moat a company has--and the wider those moats are--the better.

Quiz 109
There is only one correct answer to each question.

1 Which one of these is not an economic moat?
a. Economies of Scale
b. Intangible Assets
c. Low Customer Switching Costs
2 Which company best exemplifies the use of the Network Effect?
a. eBay
b. Southwest Airlines
c. Paychex
3 Southwest Airlines takes the most advantage of what kind of economic moat?
a. High Customer Switching Costs
b. Economies of Scale
c. Network Effect
4 If I keep my AOL account open just to keep my email address, what is AOL taking advantage of?
a. Intangible Assets
b. Economies of Scale
c. High Customer Switching Costs
5 Why are economic moats advantageous?
a. They allow a company to keep competitors at bay and profit more.
b. They help a company swim with the sharks and get eaten alive.
c. They help investors make sure a company's CEO isn't too shallow.
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