How to Widen Your Moat

08/24/2012 10:00 am EST

Focus: STOCKS

Michael Tian

Senior Equity Analyst and Equities Strategist, Morningstar Opportunistic Investor

Here, Morningstar's Michael Tian explores two companies that have taken decisive steps to increase their competitive advantages.

How to widen your moat. We're here with Mike Tian, who's going to talk to us about economic moats and trends and how companies can improve their competitive advantages.

So, there are a lot of ways a company can go about doing this, obviously. I'll give you some concrete examples that I hope you kind of conceptualize what we're doing here.

One company I've been talking about is Covidien (COV). It's a medical device giant that directly competes with companies like Johnson & Johnson (JNJ). So it's a very high quality, high-market company.

The back story here is that a number of years ago they were owned by Tyco, and it was kind of a conglomerate. In 2007, they spun off and became an independent company.

Before that, Tyco was kind of running the thing as a cash cow. They didn't invest into any R&D, didn't invest any sales. Sales were really stagnant, and the company was doing OK but not all that great, and immediately after the spinoff they tripled their R&D as a percentage of sales.

Wow, that's impressive.

And also, they rationalized a lot of their facility, which had a lot of cost savings. At the same time, it sunk all of those cost savings into R&D and into a salesforce. So new product introductions went up,and organic sales growth has been above industry average

So you can imagine if your economic moat, so to speak, is based on intellectual property, spending all that money on R&D playing catch-up is very powerful force.

Absolutely. Well, and getting the R&D through the pipeline-which makes it a lot easier, I'm sure, without having to deal with Tyco on top of you.

Exactly, exactly.

Are there any other examples you might have?

Sure, I'll talk about a company called Autoliv (ALV). They're the world's largest maker of automotive safety equipment. So seatbelts, airbags and things of that nature.

People haven't really heard much about this company, but they actually own 35% of this market-very, very big-and they have been steadily taking share for about two decades now. And that share gain, a lot of that is also based on R&D, for example.

They outspend the rest of the industry in R&D and new products, which they introduce more frequently. They carry higher margins, and that allows them to invest more in R&D, and that in turn brings other sources of competitive advantages in scale and reputation and things of that nature.

Especially with the market moving to emerging markets, companies like Autoliv have much greater technology then the indigenous automakers. So they have greater bargaining power as well, and they're able to extract higher margins from, for example, an Indian or Chinese automaker than they're able to do from the Detroit Three, for example. So these are all positive indications for their evolving competitive advantage.

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