Investors often judge companies by looking at which ones have increased profits the most and assuming the trend will persist in the future but more often than not, the firm that look great in the rearview miror wind up performing poorly in the future | 3 Economic Moats Investors often judge companies by looking at which ones have increased profits the most and assuming the trend will persist in the future. But more often than not the firms that look great in the rearview mirror wind up performing poorly in the future simply because success attracts competition as surely as night follows day. And the bigger the profits the stronger the competition. That s the basic nature of any reasonably free market capital always seeks the areas of highest expected return. Therefore most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises. You can see this every day in the headlines. Why do generic drug firms employ armies of lawyers to look for patent loopholes Because large pharmaceutical firms such as Pfizer and Merck are immensely profitable and even one successful patent challenge will pay off in spades. Why were venture capitalists throwing money at every start-up firm in the networking industry during the late 1990s Because Cisco was growing at 40 percent per year with operating margins of 25 percent. If a firm is generating big profits it will surely attract competition. 22 ECONOMIC MOATS The concept of economic moats is crucial to the way Morningstar analyzes stocks because a moat is the characteristic that helps great-performing companies to stay that way We ve learned much about the subject by studying investment great Warren Buffett and Harvard professor Michael Porter who first set down many of the main principles for analyzing competitive strategy and economic moats. To analyze a company s economic moat follow these four steps 1. Evaluate the firm s historical profitability. Has the firm been able to generate a solid return on its assets and on shareholders equity This is the true litmus test of whether a firm has built an economic moat around itself. 2. If the firm has solid returns on capital and consistent profitability assess the sources of the firm s .
