At Morningstar we think that companies with an economic moat – a durable advantage that stops competition from eroding returns on capital – make for the best long-term investments.

Broadly speaking, there are five different sources of moat:

  • Switching Costs: Customers find it hard or undesirable to leave for another supplier

  • Efficient Scale: The cost of entering a company’s market is prohibitive compared to the market size

  • Intangibles: Things like brands, know-how, patents and legislation that entail pricing power or barriers to entry

  • Network Effect: Each new product user adds value to other users, meaning biggest is best

  • Cost Advantage: A company can produce a product for far less, and therefore sell it profitably at prices that others cannot match

Once our analysts have established that a company has a moat, they are most interested in how long the moat is likely to remain in place. A Narrow Moat rating means they think that the structural advantage can last at least 10 years. A Wide Moat is expected to deliver excess returns on investment for at least two decades.

Some industries are more suited to truly durable competitive advantages than others.

This is reflected by the fact that only three industries have ten or more companies with a Wide Moat rating, out of the roughly 1600 shares our analysts cover globally. Of the 209 Wide Moat stocks in our global coverage, twenty sell software and fifteen are drug manufacturers. The only other industry in double digits is Aerospace & Defence.

When you think about it, this makes sense.

The software business is prone to high switching costs. If your business depends on a certain piece of software – to run its payroll, for instance – the potential disruption of changing provider is likely to outstrip most of the benefits.

Meanwhile, the defence business is rife with barriers to entry. I’ve not tried it, but I’m sure that starting a new missile company would involve a fair amount of paperwork. And when it comes to equipping their military and protecting their borders, most countries would rather stick with proven suppliers.

Contrast this with the mining industry, where the product is a commodity with little differentiation. This alone ensures that most mining firms, except for those with a huge cost advantage, are price takers rather than price makers. Once you exclude Deterra Royalties, which collects royalty cheques as opposed to digging holes, no company in the mining industry has a Wide Moat rating.

The other moaty industry I mentioned – drug manufacturers – is the subject of today’s article. This is the first of a two-part series. Because as well as being home to several companies with strong competitive advantages, the drug manufacturing industry is currently deeply out of favour.

As a result, shares in several high quality drug manufacturing companies currently look cheap relative to Morningstar’s estimate of Fair Value. Today we’ll explore why the drug manufacturing industry is home to so many Wide Moat stocks. Tomorrow we'll look at some of the potential bargains on offer.

The P word

The most powerful – and most talked about – source of moat in the drug manufacturing industry is patent protection. This is because a patent blocks other companies from selling treatments that use the same molecular formula for a set period. As long as their formula continues to be among the best treatments for the condition in question, the patent holder can charge highly profitable prices with no direct competition.

The patents also buy the company time to develop the next generation of drugs before generic competition arises. For drugs made purely from chemical molecules, it is easy for other companies to study the treatment and sell an unbranded version once the patent expires. As these copycat treatments are chemically or biologically identical to the branded version, sales for the previously patented product will usually plummet and / or prices will have to be cut substantially. If a patented product is harder or more expensive to manufacture, this can provide a buffer against generic competition. An example here are biologics, which are developed using organisms (like a virus or bacteria) as opposed to small-molecule chemicals.

If a company faces a big revenue hit from one or several key patents expiring, you might hear this referred to as a “patent cliff”. To get around this, most drugmakers will dedicate a sizable portion of their profits to researching (or acquiring) new treatments. As a result, the two key variables that investors focus on for drugmakers are their patent portfolios and drug development pipelines.

The power of size

As you can imagine, developing new treatments and getting them through several stages of clinical trials is expensive. You will often see a figure of USD 800m quoted to get a drug from laboratory to first revenue. I first saw this figure in a book that was published in 2003, which made me wonder if this is a low-ball estimate. But then again, there have been advances in technology and potentially some efficiency gains from outsourcing clinical research.

Either way, getting a drug candidate through to regulatory approval costs a lot of money with no guarantee that the drug will be a commercial success. Few companies other than the major pharmaceutical firms have the funds or experience to stomach this.

This leaves the majors in an advantaged position when it comes to developing, buying or getting access to the most promising new treatments via partnerships. The long business relationships these firms have with buyers is a further advantage here, as it increases the smaller company’s chance of success.

In short, major pharmaceuticals can derive huge profits from patent-protected drugs and are highly advantaged when it comes to securing the next blockbuster drugs. No wonder so many of them have Wide Moat ratings.

Opportunity knocking?

Despite these durable competitive advantages, many shares in the drug manufacturing sector trade at multi-year lows. In some cases, our analysts think this spells opportunity for long-term investors.

Tomorrow I’ll reveal three companies in the industry with five star Morningstar ratings. We’ll dive into why these shares have fallen, what each company’s prospects look like, and how much our analysts think the shares are really worth.

To make sure you don’t miss it, sign up to our newsletter here.

In the meantime, here are some more of our articles on finding moats and high quality investments: