Morningstar Magazine - August/September 2017 - 59

someone buys companies with competitive
advantages doesn't give the strategy itself
a competitive advantage over other fund managers.
Sometimes managers want to conflate those
two things.
Collins: Do you have any examples of
funds or managers that explicitly follow the moat
investing philosophy?

McDevitt: Jensen Quality Growth JENIX has been
doing it for a long time, before it became trendy
the past three to five years. I hear it more
and more among managers who talk a lot about
moats, about competitive advantages, but Jensen
Quality Growth was doing it long ago.
Collins: Are there any Neutral- or Bronze-rated funds

that have a moat philosophy?

McDevitt: AB Large Cap Growth ALLIX, a Neutralrated fund that has performed well, but has also
had some changes with its management team,
which led to its Neutral rating. Bronzerated Amana Income Investor AMANX has social
criteria that lead it to buy a lot of widemoat companies.
Collins: Andrew and Mike, how does corporate
governance-management and board effectiveness-
have an impact on your moat thinking?

Lane: On the equity research side, we do not view
a strong management team as a moat source
in and of itself; human capital tends to be fungible.
So, we separate management efficacy from
our moat analysis and instead use the Morningstar
Stewardship Rating to assess the quality
and effectiveness of the management team based
on their capital allocation decisions. But discussions of management can arise when we
debate moat ratings for companies, and that's
typically when poor capital allocation decisions
have been made, and, in turn, are likely
to impair returns on invested capital into the future.
Accordingly, although we don't view management teams as a source of competitive advantage,
we often see weaker management teams
destroy moats.
Hodel: Good businesses tend to throw off a lot
of cash flow, so you need a management team
that's going to be wise with how that cash
is deployed. Management is as much about capital

allocation as day-to-day operations, and management evaluation is different than assessing
the intrinsic qualities of a business, which are
usually formed in the past and may or may
not be the responsibility of the current management team. The capital allocation piece is the most
important aspect of management, in my view.

Building Moats
Collins: How does cyclicality come into play?
Do companies that have high leverage
to the macroeconomic cycles preclude themselves
from having an economic moat?

Lane: No. We certainly take cyclicality into
consideration when assigning moat ratings, but
a high degree of cyclicality does not prevent
a company from earning a narrow or wide moat.
When we think about the quantitative
elements in assigning moat ratings, we typically
compare forecast returns on invested
capital to a company's weighted average cost of
capital. When you compare the returns of invested
capital curve over the course of a business
cycle to that of a company's cost of capital, we like
to see that the area above the curve nets out
to a positive number relative to the area below the
curve for companies with moats.

So, one of the elements that we think about
when assigning moats is whether or not the
company will face the possibility of material value
destruction in the form of weak returns on
invested capital. For highly cyclical companies,
we like to see a wider margin of safety for returns
on invested capital versus capital costs
in a midcycle environment. But just operating
in a cyclical industry or having a cyclical
business model does not preclude a company
from earning an economic moat.
McDevitt: That's a really interesting point,
and it speaks to the forward-looking nature of the
moat rating. I sometimes speak to managers
who talk about finding companies with competitive advantages or moats within more
commodity-oriented industries. The example that
comes up a lot is in energy, where a manager
will talk about a company that, for example, has
access to a highly valuable asset such as

an oilfield with low extraction costs. They believe
it gives the company a moat. But I don't know
that that necessarily comes across in higher
returns on capital. At least, it may take years for
that to happen. How do you look at those
type of situations, such as commodity-oriented
companies, where they have a highly valuable
asset but it isn't yet showing up in higher returns
on capital?
Lane: There are two main situations that lead to
a sustainable cost-advantage moat source. These
include access to a unique asset, as well as
economies of scale, whereby very large production
volumes are spread across a fixed cost base.
So, for basic materials companies that produce
and sell commodities, we take the shape of
the industry cost curve into consideration because
for those companies, cost advantage is going
to be the only relevant source that might provide
an economic moat. Different shapes of cost
curves can have different impacts on the outcome
of the moat ratings that we assign. You mentioned
an energy producer. If, indeed, they have very
low-cost assets that are yet to be developed, we
would take that into consideration, and if 10
years down the road, we feel very confident that
those particular assets would allow the company
to sustainably outearn its cost of capital,
we would likely feel comfortable assigning at least
a narrow moat rating.

I cover the steel industry, and a handful of
companies I cover operate very low on the global
cost curve for steelmaking, including Nucor NUE
and Steel Dynamics STLD. But steel is interesting
in that steelmakers consume commodities
in the form of iron ore, metallurgical coal, or scrap
metal and then produce commodities. So, of
course, they're price takers, but because of that
dynamic, their cost curve is very flat and cost
advantages tend to be modest. Therefore, none of
the steelmakers under our coverage earn a moat.
Hodel: There's a Buffett quote out there, something along the lines of "the best businesses are
those that are willing to endure short-term
pain for long-term gain." I think some of the best
investment opportunities are those examples
where companies are underperforming today, but
they're underperforming for a good long-term

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Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017