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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).

In addition, the alpha generation of the Wide Moat Focus is robust over time. The portfolio generated positive alpha in 68% of three-year periods with the Carhart model, which adjusts for market, size, value, and momentum risk factors, and 88% of three-year periods with the CAPM model, which only adjusts for the market risk factor (Exhibit 3).

 
Why Does It Work?
Public equity markets are competitive to the point where many academics and practitioners believe it is impossible to consistently generate alpha. Thus, in order to generate alpha, an investor must have some type of advantage over other market participants. We believe that the alpha generated by the Wide Moat Focus stems from two of the three possible sources.

First, it is important to highlight that we do not believe the alpha from the Wide Moat Focus is derived from any sort of informational advantage. While Morningstar's approximately 100 analysts spend their time combing through financial statements, listening to conference calls, and visiting management teams, so do many others. Gathering and processing this information is a bare minimum required to understand the securities being selected.

So, what does Morningstar do differently from everyone else? First, analysts use a highly systematized methodology for assigning moat ratings. Moats are ingrained in the culture of Morningstar. Every moat rating has been vetted by the covering analyst and a moat committee, which meets regularly to ensure the consistency of the moat-rating process across Morningstar's stock-coverage universe. This rigor is not something we have seen replicated by many market participants, and it gives Morningstar analysts an analytical advantage.

Still, the analytical advantages relating to moats are replicable. Business-school students have a solid education in these subjects, and there are plenty of well-known investors with enough experience to easily spot competitive advantages. However, instead of replicating long-term investing strategies, market participants are becoming more myopic. A larger portion of trading volume is more shorter-term or higher-frequency than ever before. This nearsighted trading usually has little to do with business fundamentals, and as a result, moats are likely to continue to be mispriced, giving long-horizon investors a behavioral advantage.

Given Morningstar's long-term approach, which centers around deriving an estimate of the intrinsic value of each business based on future cash flows, analysts are in a good position to capture such mispricings. With a little patience, investors willing to take a stand on the long-term prospects of a firm while weathering the daily fluctuations of the market can find significantly under- or overvalued wide-moat firms. In addition, the recent credit crisis has demonstrated the effect of fear on the market. Investors willing to buy when others are fearful and sell when others are greedy can continue to exploit behavioral biases.

Practical Issues
Although the Wide Moat Focus has a performance history going back to 2002, we licensed it for use as an exchange-traded note in October 2007. To date, the ETN has only attracted about $6 million in assets while mirroring the Wide Moat Focus closely--nearly all of the tracking error is explained by the expense ratio. Low-liquidity wide-moat names, like MLPs, are excluded from the index, and the average market cap of one of the holdings in the portfolio is $20 billion, so we think that there is plenty of room for the strategy to scale up assets under management before suffering any performance degradation.

The Wide Moat Focus has a somewhat high turnover ratio--between 120% to 150%. The cause of this is twofold.

First, the trading process is mechanical, meaning that a stock trading at a 26% discount to Morningstar's fair value estimate will be replaced by a stock with a 25% discount to the fair value estimate. Of course, it is unlikely that a manager would make this kind of trade in a subjectively managed portfolio given that there is uncertainty inherent in our estimates of value. However, we examined the trade-off between lower-turnover construction rules and performance: Getting turnover below 50% might cost the portfolio between 150 and 200 basis points in annual performance. Thus, we've settled at the current level of turnover.

The second reason the turnover ratio appears high is because we trade in and out of entire positions all at once, and the index only holds 20 stocks. Thus, when a trade is made by selling a holding and replacing it with something new, we effectively add 5 percentage points to our annual turnover. It doesn't take many trades to reach 120% turnover.

Capitalizing on Fear
The Wide Moat Focus' combination of Morningstar's moat ratings and valuations has resulted in strong risk-adjusted outperformance over the past nine years. We hypothesize that this is because, on average, investors don't pay enough attention to long-term competitive advantages. We strongly suspect that this trend will continue, given that fear and greed have motivated short-term market fluctuations for centuries.

Warren Miller is a senior quantitative analyst at Morningstar.
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