What makes a moat? (Part 1)

1. Are the company's returns on invested capital, or ROIC, likely to exceed its weighted average cost of capital, or WACC, in the future?
2. Does the company appear to have at least one of the five sources of sustainable competitive advantage (intangible assets, cost advantage, switching costs, network effect, or efficient scale)?

In this regard, our moat methodology considers both quantitative and qualitative factors--the ROIC-WACC spread, also referred to as economic profits, and the moat sources, respectively. A firm generates economic profits when its earnings exceed not only accounting costs but also investors' opportunity costs. A firm can generate positive net income, or positive accounting profits, without posting economic profits if it doesn't reward equity investors for putting their money in the business.

The process of answering these fundamental questions about future economic profits and sustainable competitive advantages includes carefully researching the company and its industry. At Morningstar, our process includes analyzing the company's financial statements, talking to its managers, visiting the firm's operations when relevant, and reading industry publications. This fundamental analysis is a key component of understanding the outlook for a company's future profitability and competitive forces. If we think ROICs are likely to exceed WACC in the future, and the company appears to have any of the five sources of competitive advantage, it's possible that the firm does indeed have a narrow or wide economic moat.

But the investigation doesn't stop there. We next assess the company's ability to generate positive economic profits 10 to 20 years into the future. In free-market economies, rivals will eventually encroach on any excess profits earned by companies without protective moats--time and capital requirements aren't effective barriers to entry when we have a long-term time horizon. Some companies may generate positive ROIC-WACC spreads today and for a few years into the future. But if their competitive advantages aren't sustainable enough, competitors will begin to eat into excess profits over time.

Therefore, for a company to earn our narrow economic moat rating, we must find evidence that at least one source of competitive advantage exists and that economic profits will be positive for at least 10 years. If we think economic profits will endure for at least 20 years, the firm earns our wide moat rating. We believe sustainability is much more important than the magnitude of economic profits when assessing economic moats. In other words, a highly certain 20-year stream of modest economic profits is much more moat-worthy than a few years of extraordinarily high returns on invested capital. The 10- and 20-year benchmarks are somewhat arbitrary, but the idea is to focus on the long-term cash generation potential of the underlying business and put some parameters around approximately how long we expect excess returns to last. It's also important to note that we're considering economic profits in a normalized, or "midcycle," environment. If we expect a company to generate robust ROICs only during peak industry conditions, then it's not a candidate for our narrow or wide moat ratings. On the flip side, if a company isn't earning economic (or even accounting) profits today because it's in the depths of an industry trough or because extraordinary one-time factors are at play, it's not precluded from earning a narrow or wide moat rating.

Note that our moat-rating methodology is absolute, not relative. We're simply looking for companies that have 1) sustainable competitive advantages and 2) a likelihood of generating positive economic profits for a decade or more. Narrow and wide moat ratings are not reserved for only the best companies in a given industry, and some industries may lack any companies with sustainable competitive advantages at all. To ensure we apply our methodology consistently across our broad coverage universe, and given the central importance of the economic moat rating to the Morningstar equity research methodology, a committee of 15 senior members of the Morningstar research team oversees all of the individual company ratings. Because the committee members represent each of the major sectors, this approach provides context for an individual company's rating, and we can avoid common pitfalls such as thinking that only the finest company in an industry deserves a wide moat, or that "best-in-industry" status automatically equates to a sustainable competitive advantage.

In part 2 of the article, we will dig into the moat sources one by one.