Morningstar Magazine - December 2017/January 2018 - 31

EXHIBIT 3

Moats Protect Profits The wider a
company's moat, the bigger its margins.
Average Median Over the Past 10 Years (%)
Return on Operating
Invested Capital
Margin

Moat Rating

Net
Margin

Wide

11.8

20.9

13.7

Narrow

7.4

14.3

8.6

None

3.7

6.0

3.3

Source: Morningstar, based on the average of the past 10 years of
annual median data.

Higher Concentration of Moats

Comparing the largest 100 firms in 2017 to those
in 1987, we find an increased representation
of wide moats. The market-capitalization weight of
wide-moat firms among the top 100 has risen
to 57% from 35% ( E X H IB IT 4 ).

EXHIBIT 4

Moat Heavy The largest 100 firms have
more wide moats.

hardware focus toward a software and data
direction that is more conducive to moats.
The free cash flow yields/sales ratios1 of today's
largest technology companies exemplify
the strength of companies with moats: wide-moat
Alphabet GOOGL is at 29% and wide-moat
Facebook FB is at 43% (generated in 2016). In
contrast, in 1987, no-moat Hewlett-Packard had
a ratio of only 8%.
While the presence of wide-moat firms among the
top 100 has increased over the past three
decades, the number of no-moat firms has fallen.
Overall, the representation of no-moat firms by
market capitalization has declined to 9% from 19%
as firms with less competitive advantages
have fallen behind those in a stronger position.
Overall, when applying the average profit
levels by moat rating, the shifts in moats appear
to have contributed over 200 basis points
of operating margin expansion over the past
three decades.
Sector Composition Change

Market-Cap Weight of 100 Largest Firms

Moat Rating:

Wide

None

Narrow

100%
35
57

75
50

46
34
19

25
0

1987

2017

Source: Morningstar.

This is driven by an increase in wide-moat
healthcare and technology firms. Drug companies
lead the wide-moat healthcare gains, partly
due to a shift from a conglomerate healthcare
structure (including no-moat chemicals companies)
toward a focus on wide-moat drug development.
RETURNS ON INVESTED CAPITAL

HIGHER

The gains within the technology sector have largely
66
stemmed
60 from a transition from a less moatworthy
50

Beyond changes in moat representation, the
composition of the 100 largest firms (by market
capitalization) traded on U.S. exchanges
has changed dramatically. Only 23 companies
appear on both the 1987 and 2017 lists of
the 100 largest firms. Notably, the rotation of firms
has not been evenly spread across sectors,
and the list now includes significantly more firms
from the financial-services, technology,
and healthcare sectors. In contrast, many of the
departed names were concentrated in the
consumer cyclical, industrials, and utilities sectors.
Significant changes occurred within sectors, too.
Several weak no-moat firms of 1987 in technology,
autos, basic materials, and publishing dropped
off the list, making way for more profitable firms.
The historical weakness in technology is
pronounced, with 1987 leaders Eastman Kodak
1987 2017
KODK, Sony SNE, Xerox XRX, and HewlettLOWER
Packard all lacking moats and losing relative
competitive positioning. Meanwhile, many of the
wide-moat-rated firms that are no longer on

the list were acquired, including Pharmacia,
Gillette, Wyeth, Ralston Purina, Anheuser-Busch,
Seagram, Schering-Plough, and Warner-Lambert.
Shifting Moat Sources

Beyond the increasing presence of firms with
moats on the largest-100 list, moat sources
of these companies are evolving, too. More firms
on the list in 2017 derive their moats from
network effect, intangible assets, and switching
costs. This is consistent with the increased
presence of technology and healthcare firms,
which tend to earn their moats from these sources.
Additionally, these moat sources support higher
returns on capital. Moat sources with stronger
fundamentals have seen increased representation
over the past 30 years ( EXHIBIT 5 ). Additionally,
the higher representation from the network effect
moat source is helping elevate profits.
Network Effect Significantly Expanding

Network effect tends to drive the highest levels
of profit, and technological advancements
that have increased interconnectivity have opened
the door for this moat source to support more
firms. Notably, network effects support moats
for Alphabet, Microsoft MSFT, Facebook, Alibaba
BABA, and Tencent TCEHY, enabling strong
operating margins.
The outsize profits from the network effect make
sense, given that this source is generally
associated with a wide moat and a winner-take-all
outcome, as was the case with Facebook
destroying Myspace, once the web's most visited
site before Facebook.
While network effect tends to drive higher
operating margins, this moat source has also been
the most volatile, partly due to changes
in investment levels, which may increase the
variability of earnings.
Minor Gains for Intangible-Asset Moats

Returns on capital are also elevated for the
intangible-asset moat source, which has grown
slightly over the past 30 years. This is a highly

1 The free cash flow yields/sales ratio is cash from operations minus capital expenditure divided by sales.

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Table of Contents for the Digital Edition of Morningstar Magazine - December 2017/January 2018