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By Matthew Coffina, CFA and Jeremy Glaser | 03-22-2014 12:30 PM

Build a Moat in Your Portfolio

Moats are key to sound equity-investing strategies, and Morningstar's Matt Coffina details what to look for and how to leverage a stock's competitive advantages to your benefit.

Jeremy Glaser: Hi, I'm Jeremy Glaser, markets editor for Morningstar. We hope you enjoyed our moat movie, and now we're going to get a hands-on case of how to actually make moats work in your portfolio. We're here with Matt Coffina. He's editor of Morningstar StockInvestor, and he'll be giving us a presentation.

Matt's presentation slides are available to download here.

With that, I'll turn it over to Matt.

Matt Coffina: Thank you, Jeremy. As Jeremy said, I'm Matt Coffina. I'm the editor of Morningstar StockInvestor.

Before we begin, just a few disclosures: I own many of the stocks that I'm going to talk about today, both personally and in StockInvestor's Tortoise and Hare portfolios. I haven't listed the stocks individually, but it's safe to assume that my opinion might be biased on some of them.

None of this presentation is intended as investment advice. If you have any questions about your particular investment's circumstances, please consult a professional financial advisor.

I'd like to start by summing up Morningstar's investment strategy when it comes to common stocks in one sentence, which is: We look to invest in companies with strong and growing competitive advantages that are trading at reasonable prices and preferably at unreasonably cheap prices.

Moats are really the key element of this strategy. It's our starting point for everything we do. Why do moats matter? There are three big reasons.

First, wide-moat firms are able to invest incremental capital at relatively high rates of return, which means that all else equal, for any given amount of investment, a wide-moat firm is able to generate faster earnings growth. Or a different way of saying that is that, for any level of earnings growth, a wide-moat firm is able to generate more free cash flow, which can be returned to shareholders either through share purchases or dividends.

Wide-moat firms in particular are able to sustain their excess returns over a very long period of time, and this is really what distinguishes a wide-moat firm from a narrow-moat firm or no-moat firm. It's the sustainability of those excess returns.

Last and perhaps most important, Morningstar's fair value estimates are much more accurate for wide-moat firms, because future cash flows are much more predictable. So our analysts assign fair value estimates to all of the 1,500 or so companies in our coverage universe.

But in general, our fair value estimates work much better for wide-moat firms. The process we use to do this is called discounted cash-flow analysis and involves projecting the future free cash flows of the firm well into the future. That task becomes much easier when you're dealing with a wide-moat firm as opposed to a firm without an economic moat.

You can see this in the data presented here. First, a caveat, these aren't actually investable strategies. The way we calculate this data is we equal weight all of the companies in our coverage universe in each bucket and we rebalance daily. So if you tried to actually replicate this performance, the transaction costs would absolutely just kill it. The rebalancing daily would make it not feasible.

So these aren't investable strategies. But that said, I think the data is still telling, and in particular, you'll notice along the top row here, that as a group, wide-moat firms without regard to valuation, have not outperformed narrow-moat firms or no-moat firms over the last 12 or so years. We started collecting this data in mid-2002.

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