Morningstar Magazine - December 2017/January 2018 - 9

which is a powerful winner-take-all moat source.
Compare today's giants with the capitalintensive smokestack producers that dominated
the market a generation ago. The "market" today
is simply a different beast than before, with
inherently different characteristics. Damien
Conover and Michael Holt cover this topic in depth
in this issue's cover story (Page 29). Their
conclusion: Moats are more prevalent today than
in the past. And more moats mean, other things
equal, greater profitability.

outlined above-the halcyon macro environment-
is bound to end, which strengthens our
conviction that today's levels of profitability are
not sustainable.
That's bad news for equity investors. The stock
market, as of October anyway, is priced like the air
will stay in the balloon for a long time. As
a percentage of our coverage universe, we are
at an all-time low in terms of the number of stocks
rated 5 stars. Very few stocks offer compelling
value right now, in our opinion.

that doesn't have a long list of Vanguard
funds dominating its owner list. (The top four
funds owning Apple: Vanguard Total Stock
Market Index VTSMX, Vanguard 500 Index VFINX,
SPDR S&P 500 ETF SPY, and Vanguard Institutional
Index VINIX.)
We've reached a point where Vanguard, summing
up its funds, owns about 7% of every large
publicly traded U.S. company; BlackRock BLK isn't
far behind. Throw in State Street and Fidelity,
and between them, four large money managers

3 A Dramatic Change in Ownership Structure

In 1950, less than 10% of publicly traded stocks
were owned by institutional investors. Today,
it's north of 70%, thanks in large part to the boom
that launched Morningstar-the mutual fund
explosion that began in the 1980s. Higher
institutional ownership means more demanding
owners-with large enough stakes to make
their voices heard-who can challenge
management teams and force them to focus on
returns on capital, as opposed to diversification or
growth for growth's sake. Institutional investors
have also demanded that managers are
compensated in ways that better encourage them
to boost profitability. Simply put, managements
are on a tighter leash than in the past.

Vanguard, BlackRock, State Street, and
Fidelity together are closing in on owning a fifth
of just about every significant U.S. publicly
traded company.

The New Standard Oil and Ma Bell?

Given these three broad themes, the barbarians
are partly correct. If Morningstar is right that
moats are more prevalent today than in the past,
then one implication is that competition is indeed
lower. After all, moats imply some degree of
monopoly power. Combine this with the third trend
of increasing institutional ownership, and we
don't expect normalized profitability to regress
back to the post-World War II mean. But we would
never argue that we've settled into a new
normal. It's important to point out that unless
protected by government license, moats almost
inevitably get competed away eventually-we cap
them at 20 years-which is why we think this
trend, strong as it is, doesn't mean we've reached
a permanently high plateau of profitability.
Indeed, one of the fascinating spectacles of the
next decade will be to see just how nasty the
competition will be between the FANG companies
and China's emerging technology giants
like Tencent TCEHY and Alibaba BABA for influence
over the global consumer. Plus, the first theme

The megatheme of increased institutional
ownership has many ramifications, including the
uphill battle active managers face to add
alpha (the competition with other active managers
has become too fierce) and a dangerous
tendency toward short-termism (institutional
investors must perform or perish, and pressure
the companies they own to do the same).
But the barbarians have started to focus on one
ramification in particular: the increased
concentration of fund ownership. Money
management is a scale business. Once you cover
your fixed costs, revenue flows right to the
bottom line. The ineluctable logic of economics
means that this favors large firms that can
use their scale to cut fees, gain assets, and cut
fees even further. When I started at Morningstar in
1991, you almost never saw Vanguard listed
as a major fund shareholder in a company. (If you
did, it meant the company was an absolute
wallflower because no active managers
would come near it.) Now, it's a rare company

are closing in on owning a fifth of just about every
significant U.S. publicly traded firm.
To make this more concrete, consider the leading
firms in the pharmaceuticals industry. The
table below shows the percentage of the top
three companies owned by Vanguard, BlackRock,
and State Street (information found on the
ownership pages of Morningstar's equity reports).
Because most of the assets of the three
firms are passive, the percentage stakes you see
here are pretty close to what you'll see for any
large publicly traded U.S. company.

Drug Firms
Vanguard
(%)

Black- State
Rock Street
(%)
(%)

Total
(%)

Pfizer PFE

7.01 7.40 5.30 19.71

Merck MRK

7.10 6.76

4.41 18.27

Johnson & Johnson JNJ 7.44 6.46 5.85 19.75
Source: Morningstar Direct.

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