In a free-market economy, capital seeks the areas of highest return. Whenever a company develops a profitable product or service, it doesn't take long before competitive forces drive down its economic profits.

Only companies with an economic moat--a structural competitive advantage that allows a firm to earn above-average returns on capital over a long period of time--are able to hold competitors at bay. This concept of an economic moat is the cornerstone of Morningstar's stock research philosophy and methodology.

In the latest Morningstar international magazine, Damien Conover and Michael Holt came up with some amazing research with regards to moats. Their study revealed that the presence of economic moats is increasing among the world's largest firms.

The five largest companies today by market cap--Alphabet, Apple, Microsoft, Amazon, Facebook--all enjoy economic moats. Not only that, but one significant source of their moats is the Network Effect, a powerful winner-take-all moat source.

Never before have companies been able to scale so quickly--from nothing to $100 billion in revenue in a matter of years--that too with so little need for external capital. That's only possible because of the scale of economies and network effects allowed for by digital media, the web in particular.

Moats are more prevalent today than in the past. More moats mean, other things being equal, greater profitability. If we are right that moats are more prevalent today than in the past, then one implication is that competition is indeed lower. After all, moats imply some degree of monopoly power.

Comparing the largest 100 firms in 2017 to those in 1987, we find an increased representation of wide moats. The market-capitalisation weight of wide-moat firms among the top 100 has risen to 57 per cent from 35 per cent.

Simultaneously, the number of no-moat firms has fallen. Their market capitalisation has declined to 9 per cent from 19 per cent.

Moat sources are evolving

More firms on the list in 2017 derive their moats from Network Effect, Intangible Assets, and Switching Costs. Additionally, these moat sources support higher returns on capital. Moat sources with stronger fundamentals have seen increased representation over the past 30 years.

Additionally, the higher representation from the Network Effect source is helping elevate profits.

Network Effect significantly expanding

What is the Network Effect? The network effect occurs when the value of a company's service increases for both new and existing users as more people use the service. This is a potentially quite potent source of competitive advantage, and often applies to the first mover in an emerging technology.

Network Effect tends to drive the highest levels of profit, and technological advancements that have increased interconnectivity have opened the door for this moat source to support more firms. Notably, network effects support moats for Alphabet, Microsoft, Facebook, Alibaba, and Tencent, enabling strong operating margins.

The outsize profits from the network effect makes sense, given that this source is generally associated with a wide moat and a winner-take-all-outcome, as was the case with Facebook destroying Myspace, once the web's most visited site before Facebook.

While network effect tends to drive higher operating margins, this moat source has also been the most volatile, partly due to changes in investment levels, which may increase the variability of earnings.

Minor gains for Intangible-Asset Moats

What is the Intangible-Asset moat? Intangible assets generally refer to the intellectual property that firms use to prevent other companies from duplicating a good or service. Returns on capital are also elevated for the intangible-asset moat source, a highly prevalent moat source.

The key dynamics supporting it range from across several areas including patents, brand equity, regulation and proprietary technology. Since this moat source has the highest level of cross-representation with another source, firms with an intangible-asset moat are likely to have another type of moat.

Alphabet is a good example of a firm that sources its moat from intangible assets as well as network effect. Alphabet's search algorithms, machine learning, and valuable data support the moat, leading to the eponymous term "google it," which reinforces its brand power stemming from its perceived best-in-class search capability.

Switching costs grow in importance

What are High Switching Costs? Switching is a barrier to entry that involves an expense a customer incurs to change over from one product or service to another. If not an expense, it could be a one-time inconvenience.

Switching costs tend to carry high returns on capital. This can manifest itself in many ways, but the key element is generally a one-time inconvenience for a customer to switch products.

This moat source is the driver behind Apple, which has an outsize impact on the trend in profit gains over the past few decades and has grown from the 135th largest company by market capitalisation in 1987 to the top spot today.

Apple's structural retention (by limiting the transfer of media to non-Apple devices) creates an ecosystem that is hard to leave

Slight increase in cost-advantage moats

What is the Low-cost Producer moat? Firms that can figure out ways to provide a good or service at a relatively low cost have an advantage because they can undercut their rivals on price. This means that you can either charge the same price as the other competitors out there, and reap a higher profit margin, or you can charge slightly lower prices and maybe try and gain some share from competitors.

Cost advantages, typically gained through scale, allow firms to offer lower prices to secure more volumes or extract higher profits. Several factors can create this scale, including buying power (Wal-Mart), route density (UPS), manufacturing (Novo Nordisk), low-cost finance (JP Morgan), research and development (Pfizer), advertising (Nike) and low occupancy costs (Costco).

Efficient scale falls in representation

What is Efficient Scale? When a niche market is effectively served by one or a small handful of companies, efficient scale may be present.

When you have a company that's providing a service to a limited market, and there's a relatively small number of competitors supplying to that market, it may not make sense for a new competitor to enter the market, because that new competitor would destroy the returns for all the players involved.

Contrasting the moat source gains over the past three decades, the lower-return-on-capital moat source of efficient scale has declined significantly. Efficient-scale firms serve a market of limited size that potential competitors have little incentive to enter because if they were to do so, returns would fall to the cost of capital.

Efficient-scale markets tend to exhibit one or more of the following characteristics: mature demand, excess capacity, commodity products, inelastic demand, high sunk costs, significant entry barriers, and credible deterrence.

This moat source had a higher level of representation 30 years ago, led by utilities and railroads, which tend to carry lower returns on capital. All 10 of the utilities that ranked among the largest companies in 1987 fell out of the top 100 by 2017.

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This article initially appeared on the Morningstar India website. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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