Fri, 25 Oct 2013
Improved efficiencies, brand pricing power, and sufficient capital levels are some of the reasons behind these equity groups' higher moat ratings.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently upgraded our moat ratings on several groups of companies, and I'm here with Elizabeth Collins, the chair of our economic moat committee, to look at some of these groups and why they were upgraded.
Elizabeth, thanks for joining me today.
Elizabeth Collins: Thanks for having me, Jeremy.
Glaser: Let's start off with a bit of a discussion of the difference between wide and narrow moats. That can be kind of a fuzzy line. How do you decide when a particular company really has that wide moat and when it should be narrow?
Collins: As you recall, we talk about an economic moat as being a sustainable competitive advantage that allows a company to generate economic profits for a decade or more. In order for a company to get a narrow Morningstar Economic Moat Rating in our system, we need to think that economic profits are protected for at least 10 years.
In order for a company to get a wide economic moat rating, which is harder and more rare, we need to think that economic profits are sustainable for at least 20 years.
So part of it is a time difference, 10 years versus 20 years. There's also a higher degree of confidence required for a wide moat rating. If we are a little bit more unsure about what the future holds, it's more likely that a company will end up in the narrow moat bucket versus the wide moat bucket.
Glaser: So does it have more to do about the width than the depth of the moat?
Collins: Yes. The key thing about narrow versus wide is looking at the duration, the durability, the time period during which we think economic profits will be sustainable.
Glaser: So what are the five groups that you've recently upgraded?
Collins: Well, we've upgraded this year from narrow to wide North American railroads, major Australian banks, European and other luxury good providers, some European consumer companies, and some media content providers like Time Warner and Discovery.
Glaser: Let's take a look at railroads; that's a sector that we've watched grow and really prosper over the last couple of years. Why did you decide to move those to wide?
Collins: Those had been rated narrow moat before, and we recognized that they were benefiting from significant barriers to entry. But in the past the forecasted economic profit generation of the railroads wasn't sufficient enough for us to be confident that it would sustainable for 20 years or more.
What we've seen in the last several years is that these companies have really gotten more efficient, and our forecast for future earnings power improved to a degree that was sufficient enough for us to be more confident in their future economic profit generation.
Before, when their ROIC--return on invested capital--forecast was a little bit lower, any small changes in assumptions that we made to our valuation model, such as economic conditions or operating margin assumptions, would have put them in the category of not generating economic profits. But now that there's a bigger cushion, we have more confidence that they'll have economic profits for two decades or more.
Glaser: And what are our some of our favorite railroads right now?
Collins: Right now CSX is a company that we think is both a high-quality wide economic moat and trading at one of our bigger discounts to fair value estimate.
Glaser: How about luxury good purveyors--how did they earn a wide moat?
Collins: Our analysts on these names did an in-depth analysis of the strength of the brand for each of these companies and found that in many cases there have been brands that are around for decades or more that are not subject to much fashion risk, that are very hard to replicate, and as a result we have confidence that these brands will continue to convey pricing power for the companies for decades or more.
Glaser: Are any of these luxury goods a bargain, or do you have to pay up for them right now?
Collins: Unfortunately, we don't see any undervalued names in these luxury goods companies that we recently upgraded their economic moats for--even though in many cases we also increased our fair value estimates based on some operating assumption changes and the profitability that we expect to endure. The market's also been favorable on these companies. So in terms of the luxury goods companies that have been upgraded, they are more four-year radar stocks--look for a pullback--as opposed to things that we think are attractively priced right now.
Glaser: Looking at one more group--some of the banks in Australia that we have upgraded. What was the rationale behind that, particularly given some of the uncertainties in the global financial system?
Collins: Before, we were talking about the narrow versus wide distinction. It's not just about the length of economic profit generation--the time period that we think economic profits are secured--but it's also about our confidence level. With banking in general, it can be hard to be confident in future economic profits or capital preservation in general, because banks are highly leveraged, subject to economic conditions, and things of that nature.
But what we found with the Australian banks is that they have enough capital. They are conservatively enough managed. The regulatory environment is favorable enough that we actually indeed, in this one niche market--and there might be other markets around the world where conditions prevail as well--we have enough confidence in future economic profits that major Australian banks are worthy of a wide economic moat.
Glaser: Elizabeth, thanks for the updates today.
Collins: Thank you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.