Morningstar Magazine - August/September 2017 - 28
Spotlight: Moats
EXHIBIT 1
and successful investing involves a thorough
evaluation of whether a business will stand the
test of time.
A firm must have a competitive advantage inherent
to its business to possess a moat. To help
investors identify companies that have a moat, we
assign one of three Morningstar Economic Moat
Ratings: none, narrow, or wide. There
are two major requirements for firms to earn either
a narrow or wide rating: 1) The prospect of earning
returns on invested capital above a company's
weighted average cost of capital, and 2) some
competitive edge that prevents these returns from
quickly deteriorating.
Moats stem from at least one of five sources of
competitive advantage-cost advantage,
intangible assets, switching costs, efficient
scale, and network effect. Of the 200 or
so wide-moat companies we cover, 72% benefit
from intangible assets, 47% from sustainable cost
advantage, 37% from customer switching
costs, 20% from network effect, and 12% from
efficient scale. (Because firms can achieve
a wide moat from multiple sources, the
percentages do not add up to 100%.) Great
management, size, dominant market share, easily
replicable technology or efficiencies, and
hot products are advantages to any business,
but none of them is a structural advantage
that can sustain high returns over a long period
of time.
Why Do Moats Matter?
The concept of an economic moat plays a vital
role not only in our qualitative assessment of
a firm's long-term investment potential,
but also in the actual calculation of our fair value
estimates. A company that is likely to compound
cash flow internally for many years is worth
more today than a company that isn't. Therefore,
when comparing two firms with similar growth
rates, returns on capital, and reinvestment
needs, the company with a moat has a higher
intrinsic value.
High returns on capital will always diminish over
time due to competition. For many companies
(and their investors), economic profit erosion
can be swift and painful. However, a few generate
28
Morningstar August/September 2017
Hefty Outperformance The Morningstar Wide Moat Focus Index consistently beat
the market over the past 15 years.
Trailing Annualized Total Return (%)
1-Year
3-Year
5-Year
10-Year
Inception
10/01/2002
Morningstar Wide Moat Focus Index
22.4
8.7
16.0
11.0
14.6
Benchmark: Morningstar US Market Index
12.4
8.5
14.6
7.2
10.1
Out/Underperformance vs. Benchmark
10.0
0.2
1.4
3.8
4.5
Source: Morningstar. Data as of 12/31/2016.
excess returns for many years, and moat
analysis gives us a framework for identifying them.
Moreover, if a firm can fall back on a structural
competitive advantage, it's more likely to
recover from temporary troubles. Moats provide
a margin of safety because if an investor is
confident in the moat, it's easier to average down
if he or she initiates a position too early.
Finally, the benefits conferred by a moat often are
not fully factored into stock prices for several
reasons. Most market participants own securities
for short time periods, and moats matter
much more in the long run than over shorter
time periods. Also, recency bias causes most
investors to assume that the current state
of the world persists for longer than it usually
does. Being patient and buying wide-moat
stocks when they become cheap is a compelling
investment strategy.
Wide-Moat Strategy in Practice
How do we know? We now have evidence that
investing in a portfolio of undervalued
wide-moat stocks can earn a better-than-market
return over the long term.
In 2007, Morningstar created the Wide Moat Focus
Index based on the most undervalued wide-moat
stocks in our coverage. To construct the index,
we start with all U.S.-based and U.S.-traded
companies to which we assign a wide moat rating
(excluding master limited partnerships). We
then select the cheapest stocks, as measured by
the relationship of market price to Morningstar's
estimate of fair value. The index consists
of two subportfolios, each holding 40 stocks. The
number of holdings that make it into the index
depends on how many stocks are replaced when
each subportfolio is reconstituted. Typically,
the index holds about 50 stocks. The staggered
reconstitution allows the index to hunt
for undervalued stocks more frequently than
a traditional semiannual reconstitution. It also
aims to reduce total portfolio turnover.
Our record demonstrates the benefit of investing in
stocks of undervalued, high-quality businesses.
From 2007 to the present, results are based on the
index's actual performance. Before 2007,
Morningstar compiled hypothetical results going
back to late 2002, when moat ratings were first
assigned. Including these results, the Wide Moat
Focus Index outperformed its Morningstar US
Market Index benchmark by 4.5 percentage points
annually ( EXHIB IT 1 ).
This period of outperformance encompassed a
variety of market conditions, including boom
and bust cycles in the commodity and housing
markets. Since 2002, periods of underperformance
by the index typically have been followed
by periods of outperformance. This speaks to
the fact that our process helps us identify
situations where valuation has become dislocated
from intrinsic value, allowing us to capitalize
on mispricing. The Wide Moat Focus Index's
strong performance through several major market
fluctuations highlights its disciplined and
repeatable strategy.
On the other hand, the Morningstar Wide Moat
Index, which is a passive portfolio of all
Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017
Contents
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