Stocks with strong competitive advantages offer a path to returns with less risk.
Competition is great for consumers; it drives prices lower and spurs innovation. It is also the enemy of profits. Virtually every business faces competition of one kind or another, but only some businesses can successfully defend their profits from competitive threats. These identifiable, structural, and durable defenses form what we refer to as an economic moat. Based on the moat attributes a company possesses, we award it a wide, narrow, or no moat Morningstar Economic Moat Rating.
For investors, moats get to the heart of what separates a good business from a bad business, a reliable dividend from a risky one, and an attractive total return from a poor one. It probably comes as no surprise that moats also tell us about the riskiness of a company. None of the measures in the graphs below is explicitly incorporated in our moat methodology, yet we find that they all have correlation to our moat ratings.
These statistics are a mix of fundamental and price-based indicators of risk. A couple of them jump out. No-moat companies are 53 times more likely to go bankrupt as are wide-moat companies. Wide-moat companies are more than three times as profitable as no-moat companies. Wide-moat companies have lower market beta than do no-moat companies. Of course, the market recognizes all of this and compensates investors accordingly. Wide-moat companies generate less excess returns than do narrow- and no-moat firms. However, if investors add a valuation rating, such as the Morningstar Rating for stocks, to a wide moat rating, they increase their chances of earning better returns with less risk.