Morningstar - Q4 2023 - 6

Dispatches
Moat Over Management
Great businesses beat
great managers.
Phillips Curve
8
A Stock-Picker's Market
Ivory Towers
10
Retirement in America:
Were We Better Off 50 Years Ago?
Advisor Insights
11
3 Misconceptions About Roth
IRA Conversions
Sustainability Matters
12
Are There Too Many
ESG Shareholder Proposals?
15
23
Global Briefs
Americas
Greater Europe
27 Australia & New Zealand
LETTER FROM THE BOARD
Adam Fleck
At Morningstar, we often preach about
finding stocks with durable competitive
advantages, or economic moats, along with
exceptional management teams. But an investor
has to frequently choose between the two.
After all, among the more than 1,500 companies
Morningstar equity analysts cover, only
8%-fewer than 130 companies-have both
carved a wide Morningstar Economic Moat
Rating and earned an Exemplary Capital
Allocation Rating (a measure of management
quality), and as of September, only 10 of
those companies have a Morningstar Rating
of 5 stars (EXHIBIT 1 ). Hardly enough
to build an entire portfolio (though each is
worth exploring further).
When forced to choose between management
and moats, based on recent stock performance,
moats win out. Of course, having smart
people running a company is preferable to the
alternative. But it can be difficult for even the best
corporate leaders to outmaneuver competitors in
industries where durable cost advantages,
brand power, network effects, or other drivers
prevent most firms from having an economic moat.
Let's look at the data. In a sample of nearly
1,000 companies that Morningstar equity analysts
have covered from 2017 through today, only
13 stocks were assigned an Exemplary Capital
Allocation Rating alongside no moat. But despite
the rarefied air, these firms saw their median
performance underperform wide-moat stocks with
Standard- or even Poor-rated capital allocators
at the helm (EXHIBIT 2 ).
6
Morningstar Q4 2023
I'd rather invest in a business run by mediocre
managers but operating in a higher-quality end
market than in the best C-suite managing a
lower-quality firm. Of course, past performance
does not guarantee future results, and valuation is
another important overlay. But if forced to choose,
give me a moat over management anytime.
Be Wary of Acquisitions
Another reason to focus on moats rather than
management is the mixed track record
of mergers and acquisitions. Plenty of research
suggests that these purchases have tended
to destroy value for shareholders. But not every
acquisition is a complete disaster. Data from
Morningstar's equity coverage shows that
acquisitions don't necessarily spell doom for a
company's moat.
Going back to our sample of nearly 1,000
companies, there's not much indication of which
way a moat is likely to move after a big
acquisition. Within this group, more than 200
made a substantial acquisition from January 2017
through July 2023 (defined as purchases
that were more than 10% of the company's market
cap at the beginning of the relevant year).
About 75% didn't see any change to their moat
rating, while another 11% had moat changes
that were unrelated. That leaves just 28 companies
with their competitive positions substantially
reassessed after a major acquisition.
Among these firms, the moat results were split:
13 were downgraded, 11 upgraded, while
another four saw offsetting changes that left them
where they started. In my view, this highlights
that each acquisition case is unique.
Take the case of Thermo Fisher Scientific TMO,
for example. In March 2021, the stock was
upgraded to a wide moat, with our equity analyst
noting that " the firm's acquisitions have been
an enormous boon for its competitive positioning. "
Conversely, our analyst downgraded the moat
rating of JM Smucker SJM to none from
narrow in early 2019, in part because of poor
acquisitions of pet-food providers Big Heart
(in 2015) and Ainsworth (in 2018). The high prices
for these purchases led to sluggish returns on
https://www.morningstar.com/stocks/xnys/tmo/quote https://www.morningstar.com/stocks/xnys/sjm/quote
Morningstar - Q4 2023

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