Cost Leadership Creates Moats

"How Moats Translate into Sustainable Competitive Advantages" is a five-part moat investing education series that explores the primary sources of economic moats. The idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period. According to Morningstar Equity Research, there are five key attributes that can give companies economic moats and which are viewed as sources of sustainable competitive advantages: 1) Network Effect; 2) Intangible Assets; 3) Cost Advantage; 4) Switching Costs; and 5) Efficient Scale. Here we explore the concept of "Cost Advantage."

Cost leadership provides market control

The attribute of "cost advantage" is the second most frequent source of economic moat ratings according to Morningstar. Companies that are able to produce and offer products or services at lower costs than competitors are often able to achieve much higher profit margins. Within many industries, cost leaders have a distinct competitive advantage and often exert significant control over market prices. Morningstar Research explains cost advantage as:

Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, Express Scripts ESRX controls such a large percentage of US pharmaceutical spending that it can negotiate favourable terms with suppliers like drug manufacturers and retail pharmacies.

Cost advantages are often gained through economies of scale, lower distribution and manufacturing costs, and/or access to a less expensive resource base. For moat-rated companies, cost advantage is one of the most difficult "moaty" attributes to maintain given the increasing competition in the modern global economy. For example, over the past 30 years, the U.S. manufacturing and consumer goods industries have been flattened by punishing price competition from overseas.

Economic Moat™
Five Sources of Sustainable Competitive Advantage

Source: The Morningstar^® Economic Moat^™ Rating System.

Cost advantage in action: Two case studies of moat companies

To demonstrate the power of cost advantages in creating economic moats, we highlight two wide moat companies: Starbucks and Compass Mineral.

Starbucks Corp (SBUX US) boasts a "wide economic moat" rating from Morningstar from two sources: its strong brand intangible asset and cost advantages.  Morningstar views Starbucks as "one of the most compelling growth stories in the global consumer space today, poised for top-line growth and margin expansion through menu innovations, sustainable cost advantages, and evolution into a diversified retail and consumer packaged goods platform." Starbucks is best known for producing and serving premium coffee and espresso, and distributes a wide range of packaged products under several brand names. The company operates more than 13,500 locations in the US (26,000 globally), which represents a sizable lead over competitor Dunkin' Donuts 8,900 US locations. Morningstar believes that Starbucks has developed a strong brand that commands premium pricing and meaningful scale advantages and that Starbucks should be able to maintain its leadership position while successfully accessing new growth avenues.

Compass Mineral International (CMP US) has been given a "wide economic moat" rating from Morningstar, based on an "enviable portfolio of cost-advantaged assets." Compass produces salt and magnesium chloride (used in highway de-icing), and plant nutrients including potash (a premium fertilizer) that it delivers mostly to North America. Compass is able to deliver de-icing salt at a low cost given its Goderich rock salt mine in Ontario. Goderich is the world's largest active salt mine and boasts unique geology with convenient access to a deep-water port. Also, Compass' operations at the Great Salt Lake in Utah produce sulphate of potash from one of only three naturally occurring brine sources, which avoids the costs incurred through chemical processing. Morningstar writes, "Compass' cost advantages have led to solid returns on invested capital."

VanEck Vectors Morningstar Wide Moat ETF (MOAT ) provides access to US moat-rated companies, by seeking to track the Morningstar® Wide Moat Focus Index™. The index measures the overall performance of attractively priced companies with sustainable competitive advantages in their respective markets according to Morningstar's equity research team.

Click on these links to learn more about MOAT’s holdings and  moat investing.

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^{Important Disclosures}

^{Company-specific information based on Morningstar analyst notes last updated as follows: Starbucks Corp: 5/8/2017; Compass Mineral International: 5/5/2017.}

^{This commentary is not intended as a recommendation to buy or sell any of the named securities. Holdings will vary for MOAT and MOAT Index.}

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