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