Thu, 10 Apr 2014
An economic moat provides a gauge of a company's competitive advantages and overall strength, and it is a highly valuable tool for investors of all levels.
Narrator: What do moats have to do with successful investing? No, we're not suggesting you go out and buy a medieval castle. We're suggesting finding companies that have carved a moat around their business that keeps competitors at bay. We believe these economic moats are one of the keys to investing success. Over the next few minutes, we'll explore how to identify an economic moat, take a deep dive into two wide-moat firms and see what makes them tick, and talk to practitioners about how they have been using this strategy successfully for years.
Individual investors may assume that the deck is stacked against them compared with sophisticated institutions. They see these large investors piling money into private equity deals, getting in on the ground floor on the next hot IPO, and spending sums of money to speed up already fast high-frequency trading systems. But the truth is individuals and others with a long-term time horizon can actually have some distinct advantages over those that are more focused on the near term. Instead of being worried about what is going to happen next quarter or even next year, individuals just like some of the most successful investors of all time, can truly take a long-term view of the world, and this different view gives them a distinct perspective.
Heather Brilliant: We really like to think like owners of the businesses that we're investing in, and I would liken this really to way that Warren Buffett thinks about investing. Buffett has had a lot of influence on our philosophy over the years, but generally speaking we really like to think about buying a stock as owning a piece of the underlying business.
Narrator: The stock market gives you a chance to own great businesses from Johnson & Johnson to Amazon to McDonald's and, yes, even to Berkshire Hathaway. But how do you identify firms that are truly going to be able to withstand competition for years to come. At Morningstar, we've developed a framework to help investors find these companies, figure out the best time to buy them, and help investors build wealth over time.
Brilliant: We're really looking for a couple of factors when we're trying to find businesses that have an economic moat. The first is that we look at a qualitative list of different factors or sources of moat that we've identified over our research over the past decade or so. The other is really on the quantitative side; we're looking for literally a calculation of return on invested capital to exceed the cost of capital in the future. We have found over our decade-plus of experience in studying moats that companies with wide moats literally have lower risk than companies with no moats. They have a structural advantage to their business itself that helps them compete effectively against other companies in their industry and all of those things really help set them up for establishing a very long track record of strong cash flow generation.
Matt Coffina: You take a company like Coca-Cola, people enjoy Coca-Cola's products about as much now as they did 20 years ago or 50 years ago even, and we're pretty confident that people are going to still enjoy Coca-Cola products just as much 20 years from now, maybe even 50 years from now. When you think about a company that wouldn't have an economic moat, let's take Crocs for example. Crocs was a very hot product a couple of years ago and very trendy for a while, but the company never had an economic moat. It was just a fashion that quickly went out of fashion. And that's the kind of company that's much harder to predict how much sales they can generate in the short run and what people are really going to think of that product over the long run, versus something that's has a lot more history and is a lot more engrained in our society like Coca-Cola.
Narrator: Over years of studying companies, we at Morningstar have identified five major sources of competitive advantage or economic moat: intangible assets, customer switching costs, cost advantage, the network effect, and efficient scale.
Intangible assets include brands, patents, or government licenses that explicitly keep competitors away from that same business.
Brilliant: We see that for example with companies like Tiffany where customers are willing to pay 25% to 30% more for a Tiffany diamond than one available on any Jeweler's Row in America.
Elizabeth Collins: We see these in health care, for example, where a company develops a drug and then they have really a protected monopoly for the period of the patents that matter. And competitors are legally barred from entering the market.
Narrator: Switching costs are those one-time inconveniences or expenses that a customer incurs to change from one product to another. Customers facing high switching costs often won't change providers unless they are either offered a large improvement in price or performance, and even then, the risk associated with making a change may still prevent switching in some industries.
Coffina: A good example might be Oracle. They have database software that's very essential to their customers' businesses, and if anyone tried to switch away from using Oracle's database, they risk a huge amount of disruption to their core business.
Narrator: Firms that have the ability to provide goods or services at lower costs, have an advantage because they can undercut their rivals on price. They may also sell products or services at the same prices as rivals, but achieve fatter profit margins. We also consider economies of scale to be a type of cost advantage.
Collins: A good example of a company with, let's say, a natural-resource-based cost advantage would be Compass Minerals. It's a producer of salt and specialty fertilizer. They have access to the world's largest salt mine and access to one of the world's three only solar evaporation facilities on the Great Salt Lake for the production of specialty fertilizer. This means that they're able to produce these commodities at a cost much lower than their competitors, and these are ultimately irreplaceable because you can't create a salt mine or a salt deposit that's underground, and the Great Salt Lake is one of three similar lakes in the world.
Narrator: The network effect occurs when the value of a particular good or service increases for both new and existing users, as more people use that good or service. That can create a virtuous cycle that allows strong companies to become even stronger.
Coffina: A network effect occurs in a situation like MasterCard, where the more merchants accept MasterCard, the more valuable it is to cardholders. The more cardholders use MasterCard, the more merchants have to accept it. Both sides benefit as more people use the service.
Narrator: Efficient scale describes the dynamic in which a market of limited size is effectively served by one or just a few companies. The companies involved generate economic profits, but potential competitors are discouraged from entering because doing so would result in insufficient returns for all players.
Collins: Imagine a pipeline that transports oil from City A to City B. It wouldn't make sense for another pipeline company to build a similar pipeline along the same corridor because the capacity utilization for both pipelines would be substandard, and neither company would generate suitable economic profits.
Brilliant: In addition to the qualitative elements of the sources of moats that we've identified, we also will look quantitatively for businesses that can generate returns for shareholders well into the future. Now there's many different ways to measure returns, and the way we like to look at it would be to look at what we call return on invested capital, which is really just the idea that we want to look at the return a business can generate relative to the investments the business needs to make in order to generate that return.
So if you have a company that has to invest $1 billion just to make $100,000 every year, that's probably not worth it at the end of the day because that return that you're getting on that incremental dollar invested is not very high. But on the other hand, some businesses have to invest very, very little in order to generate tremendous returns, and we see that in what we would call asset-light businesses, or businesses that don't require a lot of high capital or a lot of capital intensity in order to function well.
Narrator: But there is no magic level of returns on invested capital that automatically means a company has a moat.
Brilliant: The persistence of excess returns is much, much more important than the magnitude of excess returns.
Narrator: Railroads are an example of an industry where the persistence of returns is more important than the level of returns. We assign a wide moat rating to all of the North American Class 1 railroads due to their cost advantage over other forms of long-haul shipping across land as well as the railroads' efficient-scale advantage since building a new railroad would be virtually impossible today.
Keith Schoonmaker: When it comes to long-haul shipping of freight or goods across the land, railroad is hard to beat. Certainly barging is less expensive if there's a river handy, but for routes where there is not a convenient river transporting the goods from origin to destination, railroading is going to be the most economical for any kind of long haul. Its advantage over trucking are obvious; it has quadruple the fuel efficiency per ton mile, and as far as use of manpower per container, for example, the railroads have a tremendous advantage over trucking.
Canadian Pacific has recently made changes that the rest of the industry made earlier in the past decade. However, the velocity and magnitude of changes that CP has made in the past year and a half have been simply breathtaking. The new CEO, Hunter Harrison, who came in about 18 months ago, continues to aggressively reduce assets. In fact, he has identified about $2 billion worth of assets that can be liquidated for cash that the railroad no longer needs. We would expect him to continue to press CP operations to increase velocity, thereby reducing the number of locomotives and cars it needs, and in general to continue to escalate operations.
Hunter Harrison: If you ask the competition, they'd say that we're very good at cost control. You've got to keep some balance with that issue of cost control, but clearly it's an advantage to be the low-cost carrier. As we started this journey, when we were 10 or 12 points on a margin behind the competition, it's very, very tough. There is business they can handle that we can't touch. So, as your costs come under control, it opens up your markets and expands it.
At the same time, we have always seen, contrary to conventional wisdom, compatibility between low-cost and good service. If you understand and recognize that and can put those two together, it's a pretty simple agenda, but it's pretty successful. I've always been a believer that we don't set the price; the market does. We effectively say whether we want to play or not. Here's the market, here's where we go to be to be competitive, and can we get our costs down to where we can be effective and competitive there. When it gets to the point that you either can become efficient or effective, or else you lose the market, then it inspires people to control costs better and to maintain that status of low-cost carrier.
Narrator: Another firm that earns a wide moat is Facebook. Facebook has over 1.2 billion monthly active users, making it by far the largest social network on the Web.
Rick Summer: I think Facebook really truly has a wide moat because it is a network. It has that social network, and you think of the old-line phone system where everyone has to connect to some sort of interchange to be able to connect to other people. Facebook is very unique with the fact that you've got to sign up for it and you create these friends and you create a network maybe even of professional friends or family and you can do different things with that.
I think it has to go a little bit beyond that, though. So, it has to be repeatable; it has to be something that's really almost indispensable, not necessarily as part of your daily life, but at least some sort of recurring fashion, as well. So it's something that's not going to be easily replaced, whatever you're doing out there. Clearly the way folks are messaging back and forth, sharing pictures, sharing comments, and sharing news stories, it ends up being very interesting how that dialog happens. But most important, you've got to make money from it. And the ability for Facebook to actually monetize that network, to turn those people into eyeballs that advertisers are very excited about, primarily because they know so much about each individual user, all of that together really creates quite a compelling economic moat.
Narrator: As you may suspect, these great businesses are rare, but even the greatest company can be a bad investment if you overpay. So how do you decide when it is the right time to buy? At Morningstar, the first step is figuring out how much a company is actually worth.
Brilliant: I think there's many ways to value a business, but here at Morningstar we use discounted cash flow in order to estimate the underlying value of a business because if we're looking at the cash flows a business can generate over the future several years and decades, we can really get a sense of what kind of cash that business can bring to investors. And that's really what we're trying to estimate at the end of the day.
Narrator: Morningstar analysts use this discounted cash flow model to come up with a fair value estimate, or how much we think each share of a company is worth. Fortunately, for wide-moat investors there are some advantages to figuring out the fair value estimates of wide-moat stocks versus their no-moat counterparts.
Coffina: Most importantly, it's relatively easier to assign fair value estimates to wide-moat companies. They tend to be more predictable, and our fair value estimates tend to perform much better with wide-moat companies. The other reason is that wide-moat companies tend to increase in intrinsic value over time. So they generate a lot of cash flow. They don't have high capital-reinvestment needs, and then they reinvest that capital in their businesses at relatively high rates of return, which leads to growth over the long run. The key is to look for these very high-quality companies when they're available at reasonable prices or preferably at large discounts to what they're intrinsically worth.
Narrator: But how do you know when the discount is large enough to buy. Morningstar thinks that uncertainty around that fair value estimate offers a clue.
Coffina: If a company has a fair value estimate of $100 a share, that doesn't mean it's worth exactly $100 a share. For Coca-Cola, with a low degree of uncertainty, that means the company is may be worth $90 to $110 because there's so many assumptions that go into these discounted cash flow valuation models. On the other hand, a steel company that we say is worth $100 a share, that's probably going to have a much wider range around that. That company could be worth as little as $60 or as much as $150, and we just don't know because there's too much inherent uncertainty in the assumptions and the drivers of that valuation. In those circumstances, you might want a much larger discount to fair value before concluding that that company is undervalued, maybe a 30% or 40% discount to fair value would not be unwarranted.
Narrator: But sometimes these discounts just aren't available. Take the market environment of early 2014, where most shares were trading for more than their intrinsic worth. Should investors pay up to stay fully invested or stay in cash and wait for the prices to come down?
Brilliant: I personally think that in this type of environment where we're seeing a lot of wide-moat stocks trading at or above fair value that it makes sense to keep some dry powder, so that when the market does decide to correct, you can really step in and take advantage of that. On the other hand, though, I do also think that for people who really would like to stay fully invested throughout market cycles, which I think also makes a lot of good sense, that focusing on wide-moat businesses anywhere below fair value is still better than buying no-moat fliers that could certainly end up going against you in a very painful way.
Coffina: As a general rule, I would prefer a fairly valued, very high-quality company over a lower-quality company that's cheaper. Those very high-quality companies tend to exceed your expectations. They tend to compound their intrinsic values relatively quickly over time. They find investment opportunities that you might not have thought existed, and over time they tend to be worth much more than they are today.
Narrator: Ariel Investments manages over $9 billion in mutual funds and separate account strategies. Their investment philosophy centers on finding high-quality companies and taking a long-term view.
John Rogers: We don't want to overpay even when we find a great business with a great moat, and we do believe that all things being equal, it's better to pay a little extra for a wonderful business--Warren Buffett often talks about that--than to go in and buy a sort of [bad] business at a bargain price. You always have to make sure it has those characteristics, so even if the moat is a little bit smaller now than you would like to be, you can determine in the future that the moat is going to be greater and growing into the future.
Narrator: In many cases, it can make sense to pay up for the quality of wide-moat stocks. However, that doesn't mean you should pay any price or hold on to them forever, if the competitive landscape were to change.
Coffina: If we're worried about the company still having a competitive advantage five and 10 years from now, then I'm happy to sell it at fair value and look for better opportunity. Selling based on valuation alone, I think, is something you have to be careful with. If you're dealing with a very, very high-quality company that has a very wide moat and is likely to increase in intrinsic value over time, often you are better off just waiting because over time the intrinsic value is going to catch up to the valuation. Even if the valuation gets a little bit ahead of itself in the short-run, it's really just a matter of time.
Rogers: Sometimes you are going to sell a company simply because it's gotten expensive, and you think that that great moat is already priced into the company. But our self-discipline has a lot to do with looking forward and looking to the future and determining whether the moat is going to get narrower and narrower and narrower and disappear over time. A lot of our sales over the last several years have been when we and our team have determined that that solid moat won't be maintained into the future and that new competitors will come in and wreak havoc to the industry, and wreak havoc to the pricing. And that will be a reason for us to sell today before that happens. And again that's the hardest part of this business: to see the future. But that's what we get paid to do.
Narrator: This strategy of paying a reasonable price to become the owner of a company with great competitive advantages has worked well over time. Over the last decade, the Morningstar Wide Moat Focus Index, which owns the 20 wide-moat stocks which are trading at the biggest discount to their fair value estimate, has returned over 13% a year. This is compared with the broad based Morningstar U.S. Market Index which is has returned just a little over 8% a year in that same period.
No one knows for sure what is going to happen in the future. But at Morningstar, we firmly believe that buying and holding companies with sustainable competitive advantages is one of the best ways to stack the deck in your favor.