Investing insights
With Pat Dorsey
Morningstar.

Pat Dorsey: Hi, I'm Pat Dorsey Director of Equity Research at Morningstar. At Morningstar thinking about economic moats or structural comparative advantages is central to how we do equity research so I thought it might be worth spending a few minutes and just give you some basic background and what we mean when we say economic moat and just what the kinds of moats are that we look for in businesses.

So when we say economic moat, you may think of the old moat around a castle and that protected it from barbarians who want to plunder it straighter, it's the same concept with the business, all businesses, profitable ones anyways attract competition and moats basically, economic moats protect them from the competition that wants to move into their profit pool. If you look over a long spans of time, highly profitable businesses tend to become less profitable over long periods of time as competitors move into their business. Yet we know empirically and intuitively that some small number of businesses do manage to in essence defy the laws of economic gravity and post high returns on capital, high profitability over even decades at a stretch. You might think about a Procter & Gamble, a Disney, a Microsoft pick almost any industry and you can find a business with an economic moat that is basically managed to stay profitable even in the face of consorted competition.

And these kinds of businesses have done this because they've erected structural barriers that are inherent to the business and then are sustainable. So the four kinds of economic moats that we look for and reanalyze businesses are Intangible Assets, Customer Switching Costs, The Network Effect, and the Cost Advantages.

So an intangible asset is just what it counts like. It's an asset that gives you pricing power but if you can really feel it or care it think about a brand, think about a patent, think about a regulatory approval can't touch for a few of these things which will certainly pay more for stuff then you will for a generic stuffed rat. You will pay 30% more for a diamond if it happens to come in a blue cardboard box labeled tiffany, great cardboard that tiffany has. And brand gives tiffany pricing power and that pricing power basically changes your behavior as a consumer and we think that's what defines a brand that gives a company a moat. It's very different then say the brand that Sony has they're well known, but do you really pay anything more a Sony DVD player relative to one from Phillips or Panasonic if you do you are in the situation not many people do.

The second kind of moat we look for are customer switching costs basically when it costs a lot of money in terms of time or labor or resources to move from product A to product B so you just pay a little bit more for the first product year-after-year. If any of you use turbo tanks or you maybe use quicken or you use Adobe Photoshop or perhaps you're an engineer and you use Autodesk you'll know that these are very complicated software programs that are very very tough to lean and require a lot of work to retrain on, so you basically don't want to switch from Product A to Product B. Any business where it has a product that it's worth hard for customers to switch the switching cost and usually it's able to extract some pricing power from consumers.

The third kind of moat we look for are is the network effect which occurs when the value of a product or service increases with the number of users it's perhaps the most powerful of the four kinds of moats. You might think of credit cards of which a every single person watching this video has a Visa, Mastercard, Amex or Discover and they are paying in the world right now and the reason you have it in this new world because merchants accept them, merchants accept them is because you carry them and so both parties benefit by the increasing usage of those cards. Your auctions and financial exchanges work the same way everybody buys and sells random stuff on eBay because everybody else buys around themselves on eBay. eBay is despite its slow growth recently has retained a very high market share and online auctions because it benefits in that very same network effect that credit cards do.

And the fourth kind of economic moat is cost advantages and this sounds like these go one on one if you're the low cost producer in a commodity business you've have got a competitive advantage we think it's very important to differentiate one kind of cost advantage from another because some are more adorable. Process based cost advantages where you essentially invent a better mouse trap better way of creating a product or delivering a product or service tend not to be that adorable think about Dells built order business model think about southwest point to port point fly one kind of aircraft low cost model that are much cheaper than the major airlines both of those had great run scale in south west for wonderful business for quite sometime but both of those processes got copied and those firms are no longer the low cost leaders in the industry.

Contrast those process based cost advantages with a scale based cost advantage that cost advantage that only gets stronger as the company gets bigger you might think of a company like UPS it is a very dense network of ground events going all around the world delivering packages and so the incremental cost of putting one more package on a van that's already going along a certain round is almost nothing and that means that incremental profit on that package is very, very high and of course that cost advantage just gets bigger as that network gets denser and denser and UPS sense out the more and more vans and more and more rounds very different that a process based cost advantage in one that we would say is more adorable. So it's the four kinds of economic moats we look for.

Intangible assets, customer switching cost, the network effect and cost advantages and those are the things we think about, when we think about economic moats. I'm Pat Dorsey, and thanks for watching.