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Moats in Practice

Analysts discuss how they incorporate the moat methodology into their work.

Elizabeth Collins, CFA, 08/14/2017

Determining whether a company possesses an economic moat, or a sustainable competitive advantage, to hold its competitors at bay is an essential component of Morningstar’s approach to equity research. As investors, we want to hold shares in great businesses that can fend off the competition and earn high returns on capital for many years to come. But moats alone do not make for a compelling investing story. The stock must be selling at a discount, too.

Analysts across Morningstar use the moat methodology in their research. For this Morningstar Conversation, we talked with three analysts, each of whom has a different role at Morningstar, to see how they use moats in their work. Andrew Lane is a senior equity analyst who covers basic materials with Morningstar Research Services. He is also the chairman of the economic moat committee in equity research. Mike Hodel is a former equity analyst who is now a portfolio manager with Morningstar Investment Management. Kevin McDevitt is a senior fund analyst in manager research with Morningstar Research Services. Our discussion took place on June 27 and has been edited for clarity and length.

Elizabeth Collins: To start, how does the concept of economic moats have an impact on your work?

Andrew Lane: I am the chairman of the economic moat committee, and I oversee the application of our moat methodology across the roughly 1,500 companies that Morningstar covers. Our goal is to make sure that our methodology is being applied consistently by the analysts and that it is communicated effectively to our clients.

Mike Hodel: As a portfolio manager, I take the work that Morningstar’s equity analysts produce—the moat ratings, fair value estimates— and translate that into an investment strategy.

Kevin McDevitt: I primarily talk with equity-fund managers. Moats are a big part of how we evaluate portfolios and also how we frame the discussion when we’re talking to portfolio managers and evaluating what they do. In a somewhat indirect way, that feeds into our analyst ratings on individual funds. It’s very interesting on my end, because we’re the beneficiaries of the work the equity analysts are doing in terms of assigning moat ratings and how that’s become part of the discussion we have with managers. I talk with a lot of managers, and oftentimes they use the wide/narrow moat terminology. Some of that, of course, is Warren Buffett’s influence, but I also think it’s coming from the work that Morningstar’s equity analysts are doing.

Using Moats as an Investor

Collins: I want to zero in on some details of the moat methodology and how it relates to investing. Do you use moats as a screening tool only? When does valuation come into play?

Lane: The moat ratings that we assign are not necessarily indicative of the attractiveness of an investment opportunity. Instead, we contend that analyzing long-term, forward-looking competitive dynamics helps us more accurately forecast cash flows at the company level. So, it’s not enough to say that all wide-moat stocks should outperform over time or that all no-moat stocks should underperform over time. It’s the valuation overlay and the insight we glean from applying our moat methodology that helps us home in on attractive investment opportunities, This is reflected in the Morningstar Wide Moat Focus Index. (See “Moats Stake Their Claim”) The index uses inputs from the equity research team such as moat ratings and price/fair value estimates. The strategy aims to highlight moat-rated stocks that are trading at a discount to intrinsic value.

Hodel: In Morningstar Investment Management, it’s similar. We use moat rating as a first screen to identify companies that are well-positioned competitively. Valuation is an extremely important next step in the investment process, as we view stocks and companies differently. Sometimes a great company can be a bad stock, and vice versa.

Collins: What do you all think is the most commonly misunderstood aspect of economic moats?

Lane: Something that is often misunderstood is just how rare wide moats are, based on our definition of them. It seems as though just about every publicly traded company argues that it enjoys a competitive advantage. Often, they grasp at straws. The phrase competitive advantage is thrown around a lot, but our methodology helps investors cut through the noise and separate companies that enjoy durable competitive advantage from those that don’t.

Hodel: One of the most commonly misunderstood things about the moat methodology is the belief that a moat rating is infallible and static, both of which are not true. There’s not always going to be consensus and agreement among analysts and portfolio managers. Sometimes, the best investment opportunities are in those fields where there’s no consensus, where some folks believe a company’s competitive advantage is waning rapidly and others believe the opposite. Again, this idea that a moat is a static data point is just not the case. These are fluid, debatable things that make markets at the end of the day. There’s room for disagreement and debate.

Lane: It’s important to remember that our moat methodology is forward-looking, so a company that has exhibited evidence of competitive advantage may not have a sustainable moat going forward. Historical performance is no indication that whatever moat source the company enjoyed over time will be there for the long run. That’s something that separates the moat methodology from a quality-based factor analysis, which tends to be backward-looking. The moat methodology requires us to investigate what competitive dynamics will look like five, 10, and 20 years down the road. We hope our approach will lead to better investor outcomes than a methodology that’s purely backward-looking.

Hodel: Sometimes, we talk about moat width versus moat depth. No one can cross a moat that’s deep, but maybe it’s not very wide. It won’t take long for competitors to figure out how to get across that moat. But in that short window of time, when the moat is extremely formidable, this company’s going to earn high returns on capital. You see this a lot in consumer-products companies that are able to build a brand that resonates with consumers for a short period but that doesn’t have staying power. Once that moat is breached, it becomes just like any other company that can’t preserve those excess returns on capital. So, that forward-looking idea is really important. There are companies that can be posting really impressive numbers for a short time, but if there isn’t something structurally sustainable behind what the firm is doing, those returns can dissipate very quickly.

McDevitt: I also find in talking with managers that they’ll look at the moat rating as a very broad, comprehensive rating on quality, when really, it’s capturing just the business competitiveness itself. Especially these days, with quality being such a popular factor with exchange-traded funds and other types of funds, you see that moats are getting lumped in with it, and people miss the nuances. Also, because portfolios that own companies with high-quality moats have done well in the past three bear markets, we’re starting to see this notion that portfolios with wide-moat companies are safer. You guys alluded to this already that just because a company has a wide moat doesn’t necessarily make it a good stock.

I’d also throw in that it doesn’t necessarily mean it’s low-risk, either. Just because a fund has a portfolio full of wide-moat companies doesn’t necessarily make it safer, As you guys said, it really comes down to valuation; that’s a huge part of this.

Collins: Kevin, do you see any managers who claim to have a moat investing strategy but end up having a lot of companies that don’t agree with our equity analysts’ ratings in their portfolios?

McDevitt: Absolutely, and it becomes a great discussion point, too. If you have someone who talks about competitive advantages and then you don’t see that reflected in the portfolio, well, then it starts a conversation. You have to reconcile the difference between what someone says they do versus what’s actually showing up in the portfolio. You also get managers who focus on wide-moat companies who conflate the concept with their own strategy. Just because 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 Neutral-rated fund that has performed well, but has also had some changes with its management team, which led to its Neutral rating. Bronze-rated Amana Income Investor AMANX has social criteria that lead it to buy a lot of wide-moat 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 reason, because they’re investing in some sort of sustainable competitive advantage that will benefit the firm over a long period of time. It could be some company that’s developed a new technology and is trying to build switching costs around that technology. Think of a software company that’s investing heavily in sales and marketing to get a product into as many customers’ hands as possible because they know that once they’ve done that, they have enough switching costs around that product to make it very sticky, enabling the firm to earn very strong lifetime values out of those customer relationships.

Companies where you’re taking that short-term pain to build a long-term competitive advantage can be attractive investment opportunities if the market has chosen to be myopic in those situations and not give the firm credit for what it’s trying to do.

Collins: Andrew, any companies come to mind that fit the profile here?

Lane: Amazon.com AMZN, which has a wide moat rating. On a strictly backward-looking basis, Amazon hasn’t necessarily harvested all the enormous investments that it’s made, but looking forward, we expect profitability to grow substantially.

Hodel: Amazon’s a great example, maybe the ultimate example of a firm that’s been willing to invest very aggressively at the expense of near-term profitability. Their shareholders expect that. It’d almost be a negative if Amazon slowed its investment and started to become too profitable. “Has Jeff Bezos lost his long-term vision?” It’s a really interesting case study.

Collins: Guidewire GWRE is another example. They do software for property and casualty insurers. It takes them up to 18 months to deploy at an insurance company, but they offer claims management, billing, and underwriting software for their customers. But once they’re there, it’s highly likely that their customers wouldn’t defect because the switching costs are so high. But because of accounting rules, they have to expense all of the marketing and deployment over the life of the initial contract, when in actuality it’s highly likely that those costs are, in economic terms, amortized over the life to the customer. So, as they’re growing, they’re posting operating margins of low single digits, but ultimately, we think as they go into harvest mode, if they ever decided to, this is more of a high-20s-operating-margin-type business.

Lane:  I’d also mention Salesforce.com CRM. Salesforce has the relatively rare designation of wide moat and positive moat trend. The company has a sustainable competitive advantage based on switching costs and network effect that we expect to last perhaps 20 years or more, and we think switching costs are actually intensifying. So, the company already has a very compelling competitive position, yet that competitive position will strengthen further in the future.

Salesforce offers a wide variety of software solutions for their customers. Just to elaborate on the power of switching costs, in the second quarter of 2013, only about 13% of the company’s top 40 customers used four or more of Salesforce’s software solutions. As of the second quarter of 2017, about 75% of its top 200 customers used four or more of the company’s software solutions, and 99% of those 200 customers used at least two of the company’s software solutions. So, phrased differently, when Salesforce lands a customer, it tends to entrench itself in that customer’s business, which increases the customer’s cost of switching to a different vendor.

McDevitt: Some of these companies, such as Alphabet GOOG and Facebook FB, have high fair value uncertainty ratings right now. There’s a heavy percentage of the assumed present value of those businesses that’s based far in the future, right?

Lane: Yes. We only have five wide-moat-rated companies globally with a very high uncertainty rating, and that reflects the margin of safety we require to feel comfortable with assigning a wide moat when we’re really analyzing competitive dynamics 20 years into the future.

Uncertainty and Trends

Collins: Can we talk more about the uncertainty rating and the moat trend rating? Why are these significant?

Lane: The moat trend rating aims to indicate whether the moat sources underpinning an economic moat will be strengthening, weakening, or stable over time. So, to assign a positive or negative moat trend to a company, the analyst must propose a compelling argument as to specifically which source of competitive advantage is strengthening or weakening.

The moat trend rating should be independent of the economic moat rating. Accordingly, some companies have a no-moat rating and negative trend rating. Here, any traces of competitive advantage they might have remaining are diminishing. We also, therefore, have some wide-moat companies that have a positive moat trend. I mentioned Salesforce earlier. There’s a clear, durable competitive advantage, yet competitive position is strengthening further in the coming years.

With regard to uncertainty, this is effectively a measure of the degree of conviction we have in forecasting future cash flows for a company. We look at factors such as margins, financial leverage, revenue cyclicality, and operating leverage. We also look at company-specific risks that face a given company, such as unique liabilities that might lie down the road. Anything that would require investors to demand a wider margin of safety for their entry point relative to our fair value estimate may lead to a higher uncertainty rating.

These are not static ratings. Whether it’s our moat rating, fair value rating, uncertainty rating, the stewardship rating—these are all being assessed constantly by our analysts and are always subject to change.

Collins: Andrew, what do you think are the most important activities that an equity analyst who is trying to figure out what the future holds over the long term should do?

Lane: Particularly for an analyst who is new to an industry, cutting through the noise presented by those companies’ management teams is an important skill. Doing this is more difficult than it might sound. When you have a limited amount of information from which to draw conclusions, and much of that information is coming directly from the company that you’re covering, it can be difficult to sort through and weigh all the information that’s being proposed. It’s a skill that only improves as an analyst covers an industry group for a longer period of time, but at first, it can be quite challenging.

Collins: Mike, when you were on the equity research team, you covered Comcast CMCSA, and you determined that it had a wide economic moat. You covered Comcast for many years. As an analyst, what were your most important high-level activities? What did you spend your time on that you felt had the most impact on your ability to forecast the future?

Hodel: Andrew mentioned that tenure covering a company is important. Whenever I would pick up a new company, I would try to build what I called “virtual experience” by studying the history of the industry and the company as deeply as I could. We said numerous times that moat ratings are forward-looking, but I don’t think you can understand what the future’s going to look like unless you understand why the past evolved the way it did. So, building that virtual experience was really important for me. Going back and looking through changes in the competitive landscape and why they took place—consolidation, new entrants, what fostered entry, what fostered consolidation— it’s important to understand why an industry is the way it is today, and how conditions may be different from what they were in the past.

In the case of Comcast, it was a matter of understanding the technology and how it had evolved to where industry was in the mid- 2000s. To do that, I had to understand the technology choices that companies had made over the preceding decade and the impact of those choices in the subsequent decade. We could see that the technology choices Comcast made and the pain that it had endured in the late 1990s/ early 2000s spending billions of dollars to build a network that was able to meet customers’ needs were important. Its competitors were thinking short-term trying to fund shareholder returns rather than investing in the long-term competitive positioning of their networks.

So, understanding the technology and the investment choices that companies competing in the industry were making, and what that meant for the industry’s future competitive dynamics, was key. And we’ve seen that story play out over the past 10 years. Cable companies have taken all of the growth in Internet access. The phone companies are fighting for the scraps.

Where does it go from here? If I were looking at Comcast today, I’d ask a whole set of other questions around technology and wireless. What’s the future of the next generation of wireless technology, and how’s that likely to have an impact on the cost position of cable versus other players? Staying on top of the evolution of technology and figuring out how past investment choices will affect a company’s ability to take advantage of new technologies is really important.

This is very specific to determining Comcast’s moat, but the takeaway here is that every industry is unique and has its own points of competition where companies meet and compete for the customer’s dollar. Understanding what those points of competition are and how they’re likely to evolve over time are important.

 

This article originally appeared in the August/September 2017 issue of Morningstar magazine.

Elizabeth Collins, CFA, is an associate director of equity research with Morningstar.

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