Morningstar Advisor - Winter 2008 - 30

Gray Matters In a League of Their Own By Pat Dorsey Companies that have strength to keep competitors at bay for decades make for good investments. A new index offers an easy way to invest in them. For reasons that I can’t quite comprehend, most equity investors pay scant attention to the competitive advantages of the companies they own. Business schools teach budding managers about how to build great companies that stand the test of time, and countless business books on the same topic litter airport bookstores, all aimed at road-weary middle managers with dreams of becoming the next Jack Welch. But oddly, competitive advantage is almost exclusively discussed from the perspective of an insider—a business owner or manager who wants to thrive in a competitive world. At Morningstar, we think competitive advantage—that is, the attributes that separate wonderful businesses from the pack—is an investing tool as well as a managerial one. After all, when you own a stock, you own a tiny piece of a business, and businesses that can deliver strong returns on capital for many years are going to create more shareholder value over the long haul than businesses with less sticking power. This is why our equity research team spends a great deal of time thinking about the competitive advantages of the 2,000 companies that we cover. And it’s why we recently created the Morningstar Wide Moat Focus Index, which tracks companies with big competitive advantages that trade at substantial discounts to our estimates of their intrinsic values. In an open economy, capital will always seek the area of highest expected return, so companies with high returns on capital often see those returns dwindle as competition moves in. But some companies are able to withstand the relentless onslaught of competition for long periods of time, and these can be real wealth-compounding machines. For example, think about companies like AnheuserBusch BUD, Oracle ORCL, or Johnson & Johnson JNJ—they’re all extremely profitable, and they’ve all faced intense competitive threats for many years, yet they still crank out very high returns on capital. Maybe they just got lucky, or (more likely) maybe those firms have some special characteristics that most companies lack. To identify companies like these—ones that are not only great today, but that are likely to stay great for many years into the future—we ask ourselves a deceptively simple question: What prevents a smart, well-financed competitor from moving in on this company’s turf? The answers to this question lie in specific structural characteristics called economic moats. Just as moats around medieval castles kept the opposition at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies. We look for four specific types of economic moats when we analyze companies: r Intangible assets, such as brands, patents, or regulatory licenses that allow a company to either enjoy a protected market position or to sell its products for a premium price. r Cost advantages that allow a company to produce goods or services at a lower cost than competitors. r Customer switching costs that give companies pricing power by locking in customers to their products or services. r Evidence of the network effect, which occurs when the value of a service to each customer increases with the number of users. (Think of a financial exchange, or communications network.) This type of moat can be very powerful, locking out competitors for a long time. You can see examples of these moats in action every day. Over the past couple of years, the brand strength of Coca-Cola KO and McDonald’s MCD enabled both companies to bounce back from prior managerial missteps that might have permanently damaged companies without such iconic brands. The cost advantages 30 Morningstar Advisor Winter 2008

Morningstar Advisor - Winter 2008

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