Morningstar Magazine - August/September 2017 - 34

Spotlight: Moats

EXHIBIT 3

Strong Combination Companies that have both intangible assets and cost
advantage as moat sources have delivered high returns on invested capital.
Fundamental Performance by Combination of Moat Sources

Top Performer

Bottom Performer
ROE
Operating
Trailing Margin Trailing
10 Yr (%)
10 Yr (%)

Number of
Companies

ROIC
Trailing
3 Yr (%)

ROA
Trailing
5 Yr (%)

Intangible Assets/Cost Advantage

167

12.4

7.1

17.8

14.6

9.7

Network Effect/Intangible Assets

49

12.2

4.9

18.0

19.7

14.0

Switching Cost/Cost Advantage

94

12.0

1.4

14.3

20.2

14.3

Network Effect/Cost Advantage

38

11.3

4.7

17.8

14.8

9.7

Switching Cost/Intangible Assets

179

11.2

6.8

17.3

14.1

9.7

Network Effect/Efficient Scale

19

9.7

6.0

18.2

24.1

15.2

Switching Cost/Network Effect

24

9.6

6.5

19.1

19.9

12.4

Cost Advantage/Efficient Scale

70

9.0

5.8

14.8

17.3

11.2

Intangible Assets/Efficient Scale

41

8.4

5.1

12.7

16.7

9.5

Switching Cost/Efficient Scale

29

6.6

3.5

13.6

17.0

7.3

Moat Sources

Net Margin
Trailing
10 Yr (%)

Source: Morningstar. Data as of 05/16/2017.

with the combination of intangible assets and cost
advantage provide the highest returns on
invested capital. This cohort includes companies
such as Amazon.com AMZN, Procter & Gamble PG,
and Nike NKE.
We also looked at equity total returns by moat
source combination ( E X H IB IT 4 ). We
discovered that the efficient-scale moat source
has a polarizing effect. Over the past five years,
efficient-scale firms that also benefit from
intangible assets delivered very high total returns.
However, efficient-scale firms that also enjoy
cost advantage delivered the lowest total returns.
The cohort with the highest total returns
(intangible assets and efficient scale) includes
companies such as International Speedway ISCA,
Carnival CCL, and Waste Management WM.
Combinations involving network effect generally
performed well, ranking second, third, and
fourth (as well as ninth) on trailing five-year total
returns (with the ninth-place cohort representing
the smallest sample size of any combination).
Network effect and intangible assets performed
the best in combination. This group includes

34

Morningstar August/September 2017

companies such as Facebook, Alphabet GOOG,
and American Express AXP.
We did not look at companies with three or more
combinations because the cohorts are too
small to draw meaningful conclusions. Only 74
companies in our coverage universe source their
moat from three or more advantages.
Network Effect Drives the Highest Earnings Volatility.
In looking at the stability of earnings through time,
we took a 10-year time series of the median
return on equity, return on assets, and operating
margin for each moat source cohort and
measured the associated standard deviation over
those 10 years. The network effect had the highest
variability across all three metrics.
We took this analysis one step further by breaking
down each of the five sources of moat
into wide- and narrow-moat cohorts. Wide-moat
companies with switching costs had the most
stable returns on equity, narrow-moat companies
with efficient scale had by far the most stable
returns on assets, and wide-moat companies with
cost advantage had the most stable operating

margins. Conversely, narrow-moat companies with
network effect had the least stable returns on
equity, wide-moat companies with network effect
had the least stable returns on assets, and
narrow-moat companies with network effect had
the least stable operating margins.
We also divided each profitability metric by its
associated standard deviation to create
a risk-adjusted index for each metric. For each
risk-adjusted profitability metric, wide-moat
companies stand out as top performers across
each moat source. However, within the
wide-moat cohort, companies with network effect
performed the worst. For these companies,
although profitability is high, they are also subject
to elevated risk.
Network-Effect Firms Have Delivered the Best
Market Performance on a Total-Return Basis.
Over the trailing five and 10 years, network-effect
firms have outperformed other moat source
cohorts on a total-return basis, with efficient-scale
companies bringing up the rear ( EX HIB IT 5 ).
We'd anticipate these findings to change over
time depending on the performance of growth
stocks versus value stocks. The constituents
of the network-effect bucket lean toward growth
characteristics, while the constituents
of the efficient-scale bucket lean toward value
characteristics. When we conducted this analysis
in 2012, efficient-scale stocks had delivered
the best trailing total returns, and network-effect
stocks delivered the second-lowest.
Additional Conclusions
Moving beyond profitability and total-return
measures, we looked at other metrics not related
to fundamental or market performance.

We observe that wide-moat firms trade at the
highest price/earnings ratios, are the least shorted,
have the highest market caps, and offer the
lowest dividend yields. Narrow-moat firms offer
the highest growth. No-moat firms trade
at the lowest P/E, offer the lowest growth, are the
most shorted, have the lowest market caps, and
offer the highest dividend yields.
Switching-cost firms trade at the lowest trailing
five-year P/E. Network-effect firms trade at
http://www.Amazon.com
Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017
