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The Inefficient Pricing of Moats

Why Morningstar's wide-moat strategy is paying off.

Warren Miller, 06/08/2011

The Morningstar Wide Moat Focus Index, an equal-weighted portfolio of the 20 cheapest wide-moat stocks, has generated significant excess returns relative to both the broad market and our overall wide-moat universe. Over the trailing three- and five-year periods, as well as since its late 2002 inception, this strategy has outperformed 95% of large-cap mutual funds.

We believe that these excess returns stem from analytical advantages in our moat and valuation processes and behavioral advantages inherent to our long-horizon mind-set. These returns are unlikely to be eroded because they are not attributable to a unique set of market characteristics and are difficult to arbitrage away.

What Is a Moat?
Morningstar has been assigning moat ratings since 2002 to provide investors with a quick and consistent gauge of our opinion of the strength and sustainability of firms' competitive advantages. The backbone of our methodology lies in the most basic of microeconomic theories: Economic profit attracts competition. Morningstar's equity analysts work tirelessly to understand this competition and the erosion of economic profits over time and why some firms thrive while others are left behind.

Morningstar believes that moats stem from four sources of advantage over competitors: intangible assets, switching costs, network effects, and cost advantages. Analysts judge each stock in Morningstar's coverage universe against the existence, strength, and durability of each of these four characteristics. Firms with the strongest and most durable competitive advantages receive a wide moat rating. About 10% of our coverage universe has a wide moat rating at any given time. Firms with no sustainable competitive advantages receive a no-moat rating. As one would expect, a much larger portion, 43%, of the universe has a no-moat rating. Narrow-moat companies make up the remaining 47% of the universe.

Having moat ratings is great, but it's another thing entirely for them to be useful in the investment decision-making process. Morningstar has been rating moats for nearly nine years and has amassed a great amount of evidence that they are useful.

Still, moat ratings are not meant to predict future excess returns on their own. There is no reason that a wide-moat company should outperform a no-moat company over any particular time horizon. This is because the moat rating does not take value or price into account. However, analysts have found empirically that using moats in conjunction with valuations is a very powerful investing strategy. Morningstar created the Wide Moat Focus Index to capitalize on this observation.

The Wide Moat Focus is an equal-weighted index that rebalances and reconstitutes quarterly to hold our 20 cheapest wide-moat stocks. Since its inception in 2002, the index has trounced both the S&P 500 and an equal-weighted index of all wide-moat stocks (Exhibit 1). In fact, it has outperformed the S&P 500 in 58% of all rolling monthly periods and 66% of all rolling quarterly periods.

What About Risk?
With returns exceeding the market and the wide-moat benchmark, one would expect that the Wide Moat Focus is somehow taking on more risk. According to risk measures, this is not the case (Exhibit 2).

Warren Miller is a senior quantitative analyst at Morningstar.

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