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When It Comes to Performance, Moats Matter

Mon, 19 Nov 2012

Morningstar's Heather Brilliant details our 10-year track record for stocks, particularly the strong outperformance of 5-star names with competitive advantages.

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Video Transcript

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. One of the questions we get the most about our stock research is how have the ratings performed? We now have a 10-year performance record, and I am here with Heather Brilliant, director of global equity and credit research here at Morningstar, to look at the performance.

Heather, thanks for talking with me today.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: So, like I mentioned in the third quarter, we have passed that 10-year mark on the Morningstar Rating for stocks. Can you talk to us little bit about what's worked and what's been successful so far?

Brilliant: Sure. So what we found is that over the last 10 years, the most successful area of performance is when you buy companies that have a wide moat, and when you buy them when they are undervalued or they are 5-star rated. And that really is not that surprising because we do the most amount of work around companies’ moats, their competitive advantages, in trying to really assess whether we think firms have an economic moat. And so with all the work we've put into that, it's really gratifying to see that it does pan out in the performance.

Glaser: What would the returns have been if you had bought those 5-star wide-moat stocks and held them until they were not 5 stars anymore?

Brilliant: If you did that you would have seen a return of 42.9% per year over the last 10 years through the end of October, and over that period the S&P 500 was up just 6.9% per year. So you'd see some really amazing outperformance, which we think is really validating of the strategy to buy very strong competitively advantaged firms and buy them when they are trading at a big discount to what we think they are worth.

Glaser: What if you didn't care about competitive advantages and just bought anything that looked cheap?

Brilliant: Well, if you just bought anything that was cheap, then we would look at what we call a synthetic portfolio where you buy anything that's 5 stars and hold it until it's 3 stars. And if you had done that over the last 10 years, you would have had a return of about 32.7% per year. So it's still nothing to sneeze at. It's still very much stronger than you'd see overall. But when you also take moat into consideration, you get another 10 percentage points per year of excess return.

Glaser: So moats definitely matter. What didn't work? When you look at the performance data, what stands out as being a negative there?

Brilliant: Well, it's really gratifying to see that actually across the board our performance looks very strong over a long-term period over the last 10 years. But if you look at shorter periods, you certainly find pockets where we didn't perform as well. For example, even this last trailing one year, while we do see that wide-moat 5-star stocks have strongly outperformed, they are up about 30% over the last year, the S&P 500 is up 15%, so you get still a very strong outperformance there. But if you look at 1-star wide-moat companies, you could have performed as well as the index, too. They are up a little over 14%. So sometimes our research doesn't work as well in the short term as it does in the long term. And even if you went back to excluding moats, just buying 5-star stocks and selling 3-star names, those stocks are only up about 10% over the last one-year period as opposed to the S&P 500 which is up a little over 15%.

Glaser: You talked a little about the short term and long term. Certainly we've seen the success of the last 10 years, but is that any indication that there's going to be success over the next 10 years? What markets do you think could potentially derail this rating system?

Brilliant: We really do believe that our rating system will work over the long term. We've seen it over the last 10 years, and we believe our process has remained consistent over that period. Consistency of process is really important to ensuring long-term outperformance in our opinion. So we do a lot of work around the moats of companies that we cover and a lot of work around the intrinsic value and valuation, as well. I do think that in some market cycles you can certainly see some periods where our ratings don't perform as well, particularly when quality becomes less important and you see what I call a junk rally. Then often our 1-star stocks or our no-moat stocks will outperform companies that have moats and are trading at discounts. But over the long term, we still expect that this strategy will work.

Glaser: Heather, thanks for the update on performance.

Brilliant: Thanks for having me, Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.

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