Determining moat

Ashley Redmond 2 April, 2014 | 1:00PM Carr Lanphier

 

 

Ashley Redmond: Economic moat is a Morningstar data point that refers to how likely a company is going to keep competitors at bay for an extended period. Two keys to long term investments are strength and sustainability. And that’s really what we are looking for with economic moat. Here to join me and to talk about this further is Carr Lanphier.

Carr thanks so much for joining me.

Carr Lanphier: Thanks for having me.

Redmond: What’s the economic moat methodology? Can you walk me through it?

Lanphier: Sure. It's an interesting process when we are picking up a company and when we are trying to decide, okay is this a company that has a moat or not? Typically what we are going to do is we are going to look at its past performance. And ask the question is this a company that's been able to sustain return on invested capital over its cost of capital, over a good period of time? If it’s a new company it's a little more difficult because we have to look at its potential relative to its peers. But once we've determined that in fact we think that this is a company that can be profitable over the long term, we ask, what's the competitive position? From there we determine if it does have a moat for various reasons. We'll then present the information in a formal presentation. We take it through a committee and then have to defend it on a fairly rigorous basis.

Redmond: How do you categorize the company? How do you decide if it has a wide moat, a narrow moat or no moat at all?

Lanphier: So, if we think it has a wide moat, we think that more likely than not its returns on invested capital 20 years from now are going to still be above its cost of capital. And that’s a very difficult thing to say with confidence for the vast majority of companies. We would say that it would be a narrow moat, if we think that those returns are going to be greater than its cost of capital 10 years from now and if we aren’t sure if that’s the case than we would say it’s a no moat company.

Redmond: What attributes give companies good economic moat?

Lanphier: We basically have five different sources of moat that we look at here. The first one would be switching costs. If you look at a company like an Oracle for instance, we think switching costs are both time intensive and money intensive. Oracle provides data to a lot of different customers and those operations are very reliant upon that data. So if they want to go to someone else for that same data it's going to be both risky and very difficult to extricate themselves from Oracle. So it's going to take Oracle either raising their prices or doing something bad to get them to switch. So that would be switching costs.

We also think that intangible assets are another example. An intangible asset could be something like an IP or a patent. So if you have a patent and you are a pharma company obviously something like LIPITOR you have a very clear profit opportunity that other companies just can't touch for an extended period of time.

Another example would be network effect. It’s interesting; it's like a fax machine basically. The more people you have using one product or one company the better it gets and so another example might be insurance. The bigger the pool you have the more profitable that company can be. But you are going to have to have a critical mass to get to that point.

Another source would be cost advantage and that would be something like a Walmart. They have the bargaining power and the scale in order to really be able to provide themselves a differentiated cost structure relative to their competitors like Target or a Dollar Store.

And then a final source would be efficient scale and we would look at something like a pipeline provider for instance to be an efficient scale. They are basically able to address the market by themselves and prevent other companies from moving in. If you have one pipeline that provides transportation from an oil field to a distillery there is no reason for another pipeline to come in. It would just completely wreck the market. Both companies wouldn’t make returns.

So, we think those are basically the five different elements that can really provide a sustainable competitive advantage.

Redmond: Great, thanks so much Carr.

Lanphier: Thanks very much.

Redmond: Tons of great information for investors. To find out more on Morningstar methodology, visit the funds page of Morningstar.ca.

About Author

Ashley Redmond

Ashley Redmond  Ashley Redmond is a Vancouver-based freelance writer.