Lesson 3.3 · 3 of 5 · The quality of a business
Competitive advantage (moat): the five sources and how to spot one
A competitive advantage, or moat, is what lets a company earn more than its rivals year after year, without them being able to copy the recipe easily. In the numbers it shows up as high, steady margins and returns on capital over many years. Morningstar describes five sources: network effect, switching costs, intangible assets, cost advantage and efficient scale.
Terms in this lesson
- Economic moat
- What protects the company from competitors, year after year.
- ROIC
- How much the company earns on all the capital invested in the business, debt included.
- Operating margin
- How much operating profit is left from every $100 of sales.
What a company’s competitive advantage is
Definition
Where does the word “moat” come from?
A moat is the ring of water around a castle: what keeps rivals at a distance.
The term is Warren Buffett’s. Morningstar turned it into a rating and defines it in numbers: a company with a competitive advantage earns a ROIC above its cost of capital and can keep doing so for many years. A “wide moat” means high confidence that those excess returns last at least 10 years and, more likely than not, at least 20. A “narrow moat”: more likely than not, at least 10 years.
- Wide moatReturns above the cost of capital, very likely for 10 years and probably for 20.
- Narrow moatReturns above the cost of capital, probably for at least 10 years.
- No moatCompetition pushes returns down to the cost of capital.
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Create a free accountThe five sources of competitive advantage
- Network effectEach new user makes the service more useful for everyone else. With a card network, the more shops accept the card, the more useful it is to cardholders, and the other way round.
- Switching costsCustomers would lose time, money or data by moving to a rival. Morningstar’s example is HR software for businesses, which is hard to replace.
- Intangible assetsPatents, licences that keep competitors out, or a brand customers will pay more for. Patents run out: in Europe, 20 years after the application is filed.
- Cost advantageThe company makes or buys things more cheaply than its rivals, usually thanks to its size. It can sell for less or keep a fatter margin.
- Efficient scaleThe market is so small that one more competitor would not make money. Morningstar’s examples: railways and utilities.
How a competitive advantage shows up in the numbers
Columns showing Visa’s operating margin for financial years 2016-2025, ending on 30 September: 52.3%, 66.2%, 62.9%, 65.3%, 64.5%, 65.6%, 64.2%, 64.3%, 65.7% and 60.0%. The years 2016 and 2025 are highlighted: the margin is lower because of unusually large costs, a loss linked to Visa Europe and a litigation provision.
Visa does not lend money to cardholders: it earns fees because payments run over its network. In nine of the ten financial years its operating margin sat between 60.0% and 66.2%. The two lower columns come from unusually large costs: in 2016, a one-off $1.88bn loss linked to the agreement to buy Visa Europe; in 2025, a $2.56bn litigation provision, more than five times the 2024 figure.
Real case
Visa, financial year ended 30 September 2025
Revenue of $40.0bn, operating income of $24.0bn and net income of $20.1bn: more than 50 cents of every dollar taken was left as net profit. The operating margin slipped to 60.0% from 65.7%, mainly because of the $2.56bn litigation provision.
Watch out
A cost advantage does not look like a big margin
Costco’s operating margin is under 4%, but steady, and its ROE is above 30%.
Costco’s operating margin was 3.4%, 3.7% and 3.8% in financial years 2023-2025. Its cost advantage shows in low prices, in stability and in its return on capital (an ROE of 30.7% in 2025, from the lesson on ROE and ROIC), not in a big margin. That is why you compare it with direct rivals, not with Visa.
Why no competitive advantage lasts for ever
Touchscreen phones and digital photography wiped out advantages that looked secure, such as Nokia’s and Kodak’s. The next lesson shows how.
Regulators can cap fees or open up a protected market. At Visa, litigation already costs billions in some years.
Patents expire, licences can be lost and a brand can fade if the product falls behind.
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: Morningstar, “How to Measure a Company’s Competitive Advantage” (Buffett’s term, the five sources, the United Airlines and Ford examples, Workday’s HR software, railways and utilities) and the Morningstar Equity Research methodology (14 June 2023): definition of a moat, ROIC above the cost of capital, wide and narrow moats, the five sources; Visa, Form 10-K annual reports for financial years 2017, 2020, 2023 and 2025 (revenue and operating income for financial years 2016-2025, ending on 30 September; the $1,877m Visa Europe loss in 2016; the litigation provision of $2,562m in 2025 and $462m in 2024; net income $20,058m in 2025); Costco, Form 10-K for financial year 2025 (revenue and operating income for 2023-2025); European Patent Convention, Article 63 (20-year term).