Moat refers to the water that once surrounded medieval castles to keep the barbarians at bay. Twenty-first century nobility (corporations) have no real need for water to protect the front office, but to succeed, they have to find ways to prevent competitors from eroding their returns.
The factors leading to an economic moat can be categorized in a number of ways. Morningstar's approach breaks them into the following four broad categories.
Intangible assets allow a firm to create a differentiated product or service without encountering direct competition. The patent on Pfizer's (PFE)cholesterol-lowering drug Lipitor falls into this category. Nothing stops the scientists at Bristol-Myers (BMY) or Merck (MRK) from analyzing Pfizer's pill to discover the formula, but because of the patent, the government will stop those firms from ripping off Pfizer's research. Pfizer will be able to sell Lipitor without direct competition for the term of its patent (usually 17 years in the United States). Thus it may charge whatever price customers will bear without worrying about peers offering a cheaper version. Anyone who pays cash for an expensive prescription can understand this concept.
Brands and government licenses are two more examples of intangibles. Anyone can create a cola-flavored beverage, but only the Coca-Cola Company (KO) can call it Coke. Anyone with the requisite millions could build a casino, but only the lucky holders of a limited number of government permits are allowed to.
As a side note, you'll often see intangible assets or goodwilllisted as an asset on a firm's balance sheet. These intangibles are mere bookkeeping entries that arise as the result of acquisitions. The presence of real intangible assets shows up not on the balance sheet, but in the firm's return on equity after excluding intangibles.
As hundreds of empty downtown shopping districts across America can attest, size equals strength. Largely by virtue of its size, Wal-Mart Stores (WMT)can buy merchandise and transport it to thousands of stores cheaper than anyone else. This allows Wal-Mart to charge lower prices and still earn higher profit margins and returns on equity than smaller chains and independent merchants.
Mere heft does not automatically convey this advantage. This phenomenon only applies to firms whose size relative to competitors allows them to lower costs without lowering selling prices in concert. Very few airlines, no matter how large, are capable of generating decent returns. ExxonMobil (XOM) and Ford Motor (F) are two of the largest companies in the world, but while ExxonMobil's size enables it to find, extract, and refine oil very cheaply, Ford's massive size today is more of a curse than a blessing.
A useful example of this phenomenon comes from the retail propane industry. When a homeowner signs up for new propane service, a distributor like AmeriGas Partners (APU) customarily offers her a free tank to be buried somewhere on her property. Nice, huh? Well, there's a catch: AmeriGas won't let just anyone fill that tank. If another propane supplier in town offers a better per-gallon price, AmeriGas will gladly come with a backhoe and rip up her yard to retrieve its tank. Few homeowners are willing to have their properties destroyed to save a few bucks, so there's a strong tendency not to switch suppliers on the basis of price. When customer switching costs are present, competitors in a particular field can charge higher prices than they otherwise could, and the benefit lands squarely in the firms' pockets. (Who knew Hank Hill had it so good?)
Banks like Wells Fargo (WFC) benefit from a similar phenomenon; when was the last time you changed checking accounts without moving? So do software makers like Microsoft (MSFT); who wants to learn a whole new spread-sheet program that might render existing Excel documents unreadable?
This one is interesting in part because it's so rare. Imagine you're looking to sell some rare stamps from your ample and well-cared-for collection. Where do you want to go? Wherever the most buyers are to be found, of course. Selling them at a garage sale, you'd be lucky to get more than a buck even for a rare treasure. Sell them on eBay (EBAY), and you'll find more buyers than anywhere else in the world. Other knowledgeable collectors will bid against one another to provide you with the best price, and eBay gets a nice piece of the action.
The network effect arises when a business can provide a service that becomes more beneficial the more people use it. Microsoft, too, benefits from the network effect; the more people who use its Word and Excel programs to create and exchange computer files, the more people who are more or less obliged to go on using Word and Excel.
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