Thu, 10 Apr 2014
Moats are key to sound equity-investing strategies, and Morningstar's Matt Coffina details what to look for and how to leverage a stock's competitive advantages to your benefit.
Jeremy Glaser: Hi, I'm Jeremy Glaser, markets editor for Morningstar. We hope you enjoyed our moat movie, and now we're going to get a hands-on case of how to actually make moats work in your portfolio. We're here with Matt Coffina. He's editor of Morningstar StockInvestor, and he'll be giving us a presentation.
Matt's presentation slides are available to download here.
With that, I'll turn it over to Matt.
Matt Coffina: Thank you, Jeremy. As Jeremy said, I'm Matt Coffina. I'm the editor of Morningstar StockInvestor.
Before we begin, just a few disclosures: I own many of the stocks that I'm going to talk about today, both personally and in StockInvestor's Tortoise and Hare portfolios. I haven't listed the stocks individually, but it's safe to assume that my opinion might be biased on some of them.
None of this presentation is intended as investment advice. If you have any questions about your particular investment's circumstances, please consult a professional financial advisor.
I'd like to start by summing up Morningstar's investment strategy when it comes to common stocks in one sentence, which is: We look to invest in companies with strong and growing competitive advantages that are trading at reasonable prices and preferably at unreasonably cheap prices.
Moats are really the key element of this strategy. It's our starting point for everything we do. Why do moats matter? There are three big reasons.
First, wide-moat firms are able to invest incremental capital at relatively high rates of return, which means that all else equal, for any given amount of investment, a wide-moat firm is able to generate faster earnings growth. Or a different way of saying that is that, for any level of earnings growth, a wide-moat firm is able to generate more free cash flow, which can be returned to shareholders either through share purchases or dividends.
Wide-moat firms in particular are able to sustain their excess returns over a very long period of time, and this is really what distinguishes a wide-moat firm from a narrow-moat firm or no-moat firm. It's the sustainability of those excess returns.
Last and perhaps most important, Morningstar's fair value estimates are much more accurate for wide-moat firms, because future cash flows are much more predictable. So our analysts assign fair value estimates to all of the 1,500 or so companies in our coverage universe.
But in general, our fair value estimates work much better for wide-moat firms. The process we use to do this is called discounted cash-flow analysis and involves projecting the future free cash flows of the firm well into the future. That task becomes much easier when you're dealing with a wide-moat firm as opposed to a firm without an economic moat.
You can see this in the data presented here. First, a caveat, these aren't actually investable strategies. The way we calculate this data is we equal weight all of the companies in our coverage universe in each bucket and we rebalance daily. So if you tried to actually replicate this performance, the transaction costs would absolutely just kill it. The rebalancing daily would make it not feasible.
So these aren't investable strategies. But that said, I think the data is still telling, and in particular, you'll notice along the top row here, that as a group, wide-moat firms without regard to valuation, have not outperformed narrow-moat firms or no-moat firms over the last 12 or so years. We started collecting this data in mid-2002.
A wide moat by itself is not enough to guarantee excess returns. However, you'll notice that our star ratings are much more accurate for wide-moat firms than they are for narrow-moat firms and more accurate for narrow-moat firms than no-moat firms.
To see this, you can look vertically along each of the columns, and you see that for example, wide-moat firms have generated nearly a 20% compound annual return if they had a 5-star rating versus only 8% with a 3-star rating and negative 2% with a 1-star rating. What we're looking at here is the difference between a 5-star-rated wide moat and a 1-star-rated wide moat.
You look at narrow moats, you see again the 5 stars have outperformed the 3 stars, which have outperformed the 1 stars, but the discrepancy is not nearly as great as it is for wide-moat firms. When you get over to the no-moat category, you see that our star ratings are much less accurate in general. The 1 stars have actually outperformed the 3 stars, and although the 5 stars have outperformed both of the other two groups, the difference is much smaller for no-moat firms than it is for wide-moat or narrow-moat firms.
The strategy that I just mentioned is not an investable strategy. That's why I think it's important to look at our actual investable strategies that we have devised using our moat methodology. One of them you just heard about in the video that we just watched, the Wide-Moat Focus Index. That strategy owns the 20 cheapest wide-moat firms based on the price/fair value ratio, equal weighted and rebalanced quarterly. And as you saw, that strategy has significantly outperformed the market over the past 10 years.
My own strategy is the Tortoise and Hare strategy in StockInvestor's real money portfolios. These are real money portfolios invested with Morningstar's own cash. We make all the trades in real time in a real brokerage account. The Tortoise portfolio invests in more conservative stocks. The Hare portfolio invests in relatively faster-growing, greater return potential, but also higher-risk companies. We own about 20 stocks in each portfolio and we've been doing this since mid-2001.
Here you can see the performance of the Tortoise and Hare strategy. Again, this is a real investable strategy. We publish our trades every day. It wouldn't take much to track the strategy, and you see that over all important trailing periods, we've outperformed the S&P 500 over the trailing one-year, five-year, 10-year, and since inception period.
You will notice that the five-year is actually pretty tight, and that's really because the last five years with this very strong bull market has been a difficult period for a relatively conservative strategy such as ours and in particular our Tortoise strategy, to keep up with the market. But we do generate our greatest outperformance during the downturns, which is what I'm going to talk about next.
There are some other benefits to a wide-moat approach. It's not just about performance. The Tortoise and Hare historically have experienced very low turnover, about 18% per year on average versus 89% for the average equity mutual fund, according to Morningstar data. Our standard deviation of returns has also been below the S&P. Our beta has been below 1. Again this is since inception.
But I think the most telling statistic is that the greatest outperformance occurs during the down markets. And I think this is a benefit in general of a wide-moat approach. So you see that when the S&P has been down 20% or more over a 12-month period, we have outperformed on average by 9.5 percentage points. And that steadily declines to the point where if the S&P is up more than 20 percentage points in a 12-month period, our portfolios have been barely above the index.
Basically, keeping up with the market and the strong bull markets and then generating most of our outperformance during the down markets, which I think makes it much easier for an investor to really stick to their guns and stick to their strategy through both the good times and the bad. I like to always start with some real-world performance numbers to give you a reason to care about what I'm saying here. But now let's get into the meat of it.
What is an economic moat? The video went into a lot of these points, but just to review very quickly. An economic moat is a sustainable competitive advantage. It enables a company to earn positive economic profits, that is, return, on invested capital in excess of the weighted average cost of capital, and to do that sustainably. And to give a company a moat, we also have to be able to identify at least one of our five moat sources.
We assign all of the companies we cover a moat rating, either wide, narrow, or none, and the width of the moat is really determined by the duration of competitive advantage. It doesn't have as much to do with the extent of excess returns, but rather how sustainable they are over time. You can have a company like a railroad or pipeline that might only generate a very small excess return, returns are only slightly ahead of the cost of capital, but it can do that for 20, 30, 40 years into the future, and that could be a wide-moat company.
Whereas you could have--on the video, we used the example of Crocs, a company that earns very, very high returns over a limited window of time, and then the business doesn't do very well after that. So it's not so much the extent of the excess returns, but how durable they are. And our technical definition is that a narrow moat will earn excess returns on capital more likely than not 10 years in the future. A wide-moat firm on the other hand will earn excess returns with near certainty 10 years in the future, and more likely than not, 20 years in the future.
Wide moat ratings are rare; we assign a wide moat to only 14% of our global coverage universe. You see that 49% get our narrow moat rating, but I think it's important to keep in mind that Morningstar intentionally covers high-quality companies, so this is not a representative basket of stocks.
If you looked at the overall market, the percentage of wide moats would be much, much lower. Probably most if not all of the wide-moat companies that are out there, we cover, and a lot of the companies that we don't cover would not have economic moats. But even within our high-quality coverage universe, the wide moat rating is reserved for only the top 14% of companies.
Here you see the prevalence of moats by sector and you can see that this also varies by sector. For example, basic materials has a lot of no-moat companies; wide moats are extremely rare. The communication services, utilities, and real estate sectors tend to have a lot of narrow-moat companies, but because of competition, in the case of communication services and real estate, and because of regulation in the case of utilities, wide moats also are very rare. Narrow moats really dominate in these sectors.
Then you get to other sectors like consumer defensive, energy, health care, and industrials, where wide moats tend to be relatively prevalent, certainly much more so. Although, still not all that common, but maybe 20%-25% of our coverage universe, within those sectors, will have a wide economic moat.
The five sources of moat, again, reviewed in the video, but I'll just go through this very quickly as a review: the network effect, intangible assets, cost advantage, switching costs, and efficient scale.
The network effect occurs when the value of a company's service increases as more people use it. A great example would be eBay. The more sellers there are on eBay the more likely a buyer is to find what they're looking for. The more buyers there are, the easier it is to sell things.
Intangible assets: These could be patents, brands, regulatory licenses, and so on, that protect excess returns. A company like Unilever, for example, very well-known consumer products brands, a lot of share of mind of consumers, and consumers seek out those brands, which gives some degree of pricing power to a company like Unilever.
Cost advantage: Here we're thinking of economies of scale, access to a unique asset. A great example would be Express Scripts. A tremendous amount of bargaining power against pharmaceutical manufacturers, which gives them relatively low costs compared to competitors.
Switching costs: Sometimes this could be a case where it's very, very difficult or expensive to switch away from a given company's product. For example, Oracle's database software. It would be very disruptive for an enterprise customer to stop using that software. But sometimes it's just that there's not enough benefit to switching away. For example, with BlackRock, the switching costs aren't necessarily all that high, but the benefits of switching from one asset manager to another are usually so uncertain that people often just stick with the status quo, especially when you're dealing with institutions--institutional investors.
Lastly, efficient scale: This is probably the least intuitive of the moat sources, but you get an efficient scale advantage when a niche market is effectively served by one or a small handful of companies. This is especially common with railroads, pipelines, certain distributors. In the case of Enbridge, for example, it often doesn't make sense to build two or three or four competing sets of pipelines to serve the same routes from point A to point B, which can give these companies basically a geographic monopoly.
In terms of the prevalence of moat sources, what you'll see in this slide is that the percentage of wide-moat companies and the percentage of narrow-moat companies that have each of the moat sources. You'll see that summing the dark blue bars and the light blue bars, that adds up to more than 100%. The reason is that firms often have multiple moat sources, which can often reinforce each other.
You'll see the intangible assets are the most common moat source, particularly among wide-moat companies, whereas network effect is relatively rare. But when we find a network effect, it tends to be one of the most powerful sources of a moat. It can lead to very high excess returns and very sustainable excess returns when it can be found.
Quickly, some other evidence of a moat: None of these factors would be enough on its own to assign a moat rating to a company, but they're the kinds of things that our analysts keep in mind when determining from a qualitative perspective if a company has a moat. Things like high barriers to entry, a strong or improving market share would be a good sign, particularly if it's coupled with an ability to raise prices. High customer retention is usually a good sign, and a lack of competitors or low competitive rivalry, especially in the presence of high excess returns.
Again, you can think of a moat as the thing that protects the economic castle from the onslaught of competitors. If you have a really great castle and it's earning very high excess returns, you'd expect a lot of competitors to be going after those, and if they're not, for whatever reason, that can often be sign of a moat.
Lastly, margins that are ahead of peers, particularly again when coupled with pricing power and/or sustainable margin expansion can all be signs of a moat.
Now, the most important quantitative evidence of a moat, again, is that returns on invested capital exceed the weighted average cost of capital. It's not enough for a moat on its own but a wide-moat company or a narrow-moat company should be able to, over the long run, achieve returns on capital that exceed its cost of capital.
The reason that we use return on invested capital as opposed to, for example, return on equity is that ROIC isn't affected by the capital structure or the degree of leverage. In other words, you can influence your ROE by taking on more leverage, but you can't manipulate your ROIC in that way.
The ROIC is compared against the weighted average cost of capital, which reflects the cost of both equity and debt capital. So ROIC greater than WACC is the ultimate test of shareholder value creation. Is this company taking the money that it gets from investors and making it worth more than what they are receiving, thus creating value for those investors?
Let's start with the most basic example imaginable, the most basic business model there is: a lemonade stand. Imagine that Jill needs $100 for a table, a sign, pitchers, lemon, ice, sugar, and cups. She goes to her mom and borrows $50 and promises to pay her 5% interest, so $2.50.
Dad has a higher risk tolerance, so he buys $50 worth of common stock in Jill's lemonade stand. Jill has a $100 in invested capital funded 50% with equity, 50% with debt. And now Dad expects a 10% return. That's what's called his cost of equity. It's the required return for the equityholders.
Jill's weighted average cost of capital is relatively easy to calculate, again 50% equity, 50% debt. We multiply each of those by the relative cost of debt. In this case, it was 5% cost of debt, 10% cost of equity, and Jill's WACC is 7.5%. What is Jill's return on invested capital? We take earnings before interest and divide that by invested capital.
After a hard day's work, Jill has paid herself a reasonable wage. She has replenished her supplies and she has $10 in profit left over. Again, her invested capital is $100. The return on invested capital is the $10 profit divided by the $100 of invested capital, that's a 10% ROIC, which compares to her 7.5% WACC and Jill has indeed earned excess returns on capital.
Now let's take a look at Dad's return on equity. Mom receives her $2.50 in interest as she was promised, the other $7.50 belongs to Dad, and this is why it can be great to own a common stock at least when things are going well. Dad's achieved a 15% return on equity, so $7.50 in profits divided by his $50 investment and that's above his 10% cost of equity.
However, this also demonstrates why you need to be careful with the ROE metric, because it's affected by leverage. For example, if Jill had decided instead to fund her lemonade stand with $80 in debt and only $20 of equity, Mom would have been owed $4 in interest and Dad would receive the other $6, which would have been a return on equity of 30%, $6 divided by the $20 investment. So ROE, again, can be affected by the degree of leverage, whereas ROIC is not.
What are some real-world challenges when calculating ROIC? One, starting with the earnings before interest number, is it normalized? Companies are affected by cyclicality. There can be one-time charges in play, noneconomic costs. Sometimes it's hard to get at the company's actual cash taxes, so a lot of complication in calculating earnings before interest.
Second, what should be included in invested capital? For example, the company's past acquisitions, the goodwill, and other intangibles generated by those, should that be counted in invested capital? How about deferred taxes? Sometimes our analysts will adjust for lease expenses, which don't show up on the balance sheet, but in many ways represent a form of investment, and the same with R&D, which flows through the income statement but doesn't show up on the balance sheet.
You can make adjustments for all these things. And depending on the assumptions that you make, you can reach very different conclusions. It's important to know what's going into those ROIC metrics before drawing any conclusions.
Now we're going to move on to a real-world example. This is ITC Holdings. This is a company that we own in StockInvestor's Tortoise portfolio, and I also own it personally. It's an independent electricity transmission utility. Basically, what ITC does is, it owns the power lines that bring power over long distances from point A to point B and related infrastructure. It has an efficient scale advantage, since it isn't cost effective in general to build multiple competing sets of transmission lines across the same routes.
ITC also has an attractive set of investment opportunities. These are mostly aimed at improving the reliability of the electricity grid, encouraging the development of wind power. Wind power often--the best places for that are far away from population centers, and you need to get the electricity from where it's windy, maybe high up in mountains and in unpopulated areas, to where the people are and they can use the electricity.
And last, to enable cross-regional, electricity pricing arbitrage. What I mean by that is power prices can be very high in one market, say New York, and they could be much cheaper in another market, say the Midwest, and those differences can persist largely because of a lack of transmission infrastructure.
If you had transmission lines between the two markets, you'd be able to generate the electricity in lower-cost regions, transport it to the places where it's more expensive, and everyone benefits.
The most important distinguishing factor of ITC, though, because a lot of utilities have the same basic advantage, right? They have a natural geographic monopoly. They have an efficient scale advantage. But the difference about ITC is that it's regulated at the federal level. It's not regulated at the state level like most utilities, at least its returns aren't regulated at the state level. And so the company receives very favorable allowed returns from the Federal Energy Regulatory Commission. So the FERC is their primary regulator, and we'll see in a minute why that is.
First, let's calculate ITC's ROIC. We're going to start on the income statement. Here, I've circled ITC's interest expense and net income, and to do a very basic calculation of EBI, that's all we're really going to need. ITC's EBI, earnings before interest, would be its net income plus interest expense times 1 minus the tax rate. We need to adjust the interest expense for taxes. In our lemonade example, we were assuming that Jill wasn't paying taxes, but we want net income and after-tax interest expense to be stated on a consistent basis without the after-tax.
You'll see last year, ITC reported $233.5 million in net income. So all figures in the slide here are in thousands, but that's $233.5 million. We're going to assume a marginal tax rate of 36.5%. And the interest expense was $168 million, which gives us tax-adjusted interest expense, so again using that 36.5% tax rate, $106.9 million. EBI very simply, is adding net income plus after-tax interest expense, and that gets us to EBI, earnings before interest, of $340.4 million.
What about adjustments to EBI? I said there are all sorts of reasons that EBI could not be normalized for whatever reason. In ITC's case, the biggest factor affecting why these figures are not normalized is that ITC tried to acquire the transmission assets of a different utility named Entergy last year, and this deal actually ended up falling through. Regulators in Mississippi didn't approve of the deal, so it didn't go through. ITC in the meantime incurred $25 million of nonrecurring transaction costs, after tax, related to this attempted merger that didn't go through.
If we add these items back, as I think would clearly be appropriate in this case, assuming that ITC isn't going to do a failed merger every year, the normalized earnings, or the operating earnings, are $258.6 million, and that gets us to adjusted EBI. Adding back the transaction costs, it's $365.5 million of EBI, which compares to $340.4 million if we include the transaction costs.
Next, we're going to move to ITC's balance sheet. This is the asset side of the balance sheet. Here we have the liabilities and equities side, and we're going to use the relatively simpler method of calculating invested capital. We're going to take average debt from this year and last year and average equity balances and we're going to add those up. There are two ways in general that you can calculate invested capital.
The slightly more complicated way would be to take operating assets minus operating liabilities and in that case it's really a judgment call on the part of the analyst to determine what counts as an operating asset, or an operating liability, versus nonoperating assets and liabilities. Or the simpler method would be just to add debt plus equity.
We usually, again, use an average of the current and preceding years' balance sheets, and that gets us to an average debt balance of about $3.4 billion over the last two years and an average equity balance of $1.5 billion. Add those together, and we get invested capital of $4.9 billion.
Again, the analysts may make adjustments based on their own discretion. In this case, ITC has done some acquisitions over time, and that's created $950 million of goodwill on the balance sheet. Whether or not to include that, again, is really up to your discretion or the analyst's discretion.
If we want to get at the earnings power of the core underlying business, in other words ignoring the price that ITC paid to buy these businesses, but what's the moat of the actual underlying businesses, we might consider excluding goodwill of $950 million, which would get us a total invested capital of $3.9 billion.
What's ITC's return on invested capital? We can calculate these in different ways and you can take your pick based on personal preferences of whether you should include or exclude the one-time costs, whether you should include or exclude the goodwill. There is any number of other adjustments we could have potentially made, but to keep it simple let's just stick with these two adjustments.
You see, again, the conclusion can be very different depending on the methodology that you're using. So including one-time costs and including goodwill on invested capital, we see that ITC's ROIC was 7%. If we exclude both the one-time costs and the goodwill, we get to 9.3% ROIC and that's a pretty significant difference, a 30% difference. But in any case, ITC's ROIC is at least 7% and maybe as high as 9.3% depending on how you want to calculate it. Nothing to write home about, but it's actually, as you'll see, not bad for a utility.
The next question is what is ITC's weighted average cost of capital? Calculating the WACC involves its own complications. First and foremost, the cost of equity can't be observed. This is a key input. But we can't tell what investors' required returns are from the equity. We have to make some assumptions and take our best guess of it.
Also, interest rates change over time, so you don't necessarily want to use current interest rates, particularly in a time like now when interest rates are arguably artificially low. Lastly, should we use a market or book capital structure weighting? As you'll see, this can be very important when calculating WACC.
Here are some considerations in estimating the COE. Morningstar has its own proprietary system for assigning cost of equity ratings to companies. We assign a rating for companies in the U.S. at least of 8%, 10%, 12%, or 14%, depending on the level of systematic risk. Systematic risk is this concept that comes from finance theory. This is basically risk that can't be eliminated through diversification. The idea is that investors will only be systematically compensated for risk that they can't reduce through diversification. There'll be no systematic rewards for risk that could be eliminated just by owning a diversified portfolio.
This is basically our version of the capital asset pricing model, or CAPM. Except instead of using the market-based estimates of beta, we're using the company's fundamentals of its revenue cyclicality, its operating leverage, and its financial leverage. The key point for ITC is that the company has formula-based rate regulation from its regulator.
Basically, this means the company is more or less guaranteed to earn its allowed return on equity. It passes costs directly through to customers. There's no exposure to fuel costs. Even interest expense at the subsidiary level is passed directly through to customers. So the company at the subsidiary level is basically guaranteed to earn its ROE, which creates very low uncertainty, very low risk.
The primary source of uncertainty is FERC policy. It's always possible that the regulator could come back and lower the company's allowed returns. It's actually a controversy that's going on right now. A lot of people are worried that the FERC is going to do that. That they're going to come and slash allowed returns for transmission, particularly in light of the low interest-rate environment.
That is a risk and it is an uncertainty, but it's not correlated with the market in any way. It's really up to the whims of the regulatory process. And so we wouldn't consider this a form of systematic risk. In other words, ITC has very low systematic risk, and it deserves the cost of equity in our view of 8%, at the low end of our 8% to 14% range.
Here are our analyst's assumptions in calculating ITC's weighted average cost of capital: We use an 8% cost of equity; we use a 5% cost of debt, which given our marginal tax-rate assumption, comes to 3.2% after tax; and we use a market-based weighting of equity and debt in the capital structure. So this would actually be 62% equity, 28% debt.
You'll notice this is very different than the book value weighting, capital structure weighting, and the reason is that the company we think we use a fair value as our proxy for the market value of the equity. And the fair value of the equity in our view is at a significant premium to the book value of the equity. So our capital structure--and this is the right way to do it for valuation purposes--we could debate whether it's the right way to do it for moat purposes, but our weighting to our equity, is 62%, again based on the fair value of the equity.
If you wanted to again get more at the underlying assets or in other words, what was ITC's cost of capital when it took on this capital in the first place, when it first issued the equity, first issued the debt, then you might want to use more of a book capital structure weighting, in which case, a 31% equity, 69% debt would be more appropriate, and that would get the WACC all the way down to 4.7%.
Regardless, though, you'll notice that there's a spread between the ROICs, which again we estimated are at least 7%, if we include the goodwill and include the one-time cost, at least 7%. And our high-case WACC assumption of 6.2%, so there is a modest spread there, more importantly, a very sustainable spread. The spread would be even greater if we use the book capital structure weighting and a 4.7% WACC.
ITC's economic moats: Under most assumptions, ROIC exceeds WACC by a slim, but we think very sustainable, margin. The wide moat in particular is based on our belief that FERC policy, the Federal Energy Regulatory Commission, policy will continue to favor independent transmission operators.
The key insight here I think is that FERC is less subject to local political pressures than state-based regulators. State-based regulators need to be much more concerned about whether or not the governor is going to get re-elected and they are much more concerned about consumer utility bills than federal regulators are.
In our view, federal regulators' first priority is maintaining reliability of the electricity grid. If FERC did decide to lower ITC's allowed returns, the savings would be very, very modest. Transmission is only in the neighborhood of 10% of customers' utility bills. A lot of that goes to operating costs, so ITC's actual return on capital would be a relatively small fraction of that.
And given the realistic possibilities, a 1 or 2 percentage point reduction in the allowed returns, which would matter a lot for ITC, but it would only save at most, maybe 1% of consumers' utility bills. We think that FERC is going to realize that the current low interest-rate environment is a temporary phenomenon and probably not reflective of long-run interest rates, but most importantly that the savings are very modest compared to the potential cost of blackouts and other issues of grid reliability.
Let's take a little side note here to talk about ITC's return on equity. ITC has very stable cash flows, which in our view allow the parent company to safely leverage equity at the parent company level.
Again, this gets back to why the company's book weighting toward equity is much lower than its market-based weighting toward equity. Operating earnings, again, excluding the transaction cost related to the failed Entergy merger, operating earnings last year of $258.6 million compared to average equity of $1.5 billion, that's a return on equity of 17.1% for ITC.
Better still, the company invested incremental equity, so this would be comparing this year's average equity balance to the prior year's average equity balance and invested incremental equity in the last year of $177 million and on that investment it earned incremental earnings, operating earnings, of $42 million. That's an incremental ROE of 23.7%, not bad at all for a regulated utility.
Lastly, just a summary of the considerations between a wide-moat company, a narrow-moat company, and no-moat company. Here you see the five sources of moat and some company examples along each of the sources. For example, Coca-Cola, best-in-class beverage brands and unmatched global distribution system, we think the company has a wide moat.
If you move over to Dr Pepper Snapple Group, they have second-tier brands and a lack of global distribution scale, which in our view gives them a narrow moat. On the other hand, United Continental, very well-known brand in airline travel, but it doesn't allow them to actually charge higher prices than any other airline, so the branding advantage is basically no value for investors and we don't think the company has an economic moat at all.
Let's move on to switching costs: Oracle, its enterprise software customers face massive disruption risk, if they change database vendors, for example. Salesforce.com on the other hand is a very popular product. Everybody's in love with cloud software right now. But we think that switching costs are less significant than at Oracle, which is why Salesforce only gets a narrow moat.
Then you have Macy's or any retailer, really, for the most part, switching costs are nonexistent. You can choose on any given shopping trip, are you going to go to Macy's, Sears, wherever it may be.
The network effect: CME Group. There's a clearinghouse function involved with futures trading that keeps volumes captive. In other words, trades that are initiated on CME have to stay on CME.
NYSE Euronext, in contrast, is more of an equities exchange, and equities can be bought on one exchange and sold on a different exchange, which greatly lowers the network effect.
Archer-Daniels Midland, on the other hand, an agriculture company, has a very broad network, but the products are so commoditized that the company is not able to earn excess returns despite having that network.
Cost advantage: UPS. Route density gives it a very significant cost advantage in delivering packages. On the other hand, FedEx is bigger in the air express category, where its cost advantage is not nearly as significant. Network density isn't as much of a factor. So maybe FedEx's ground delivery business would have a wide moat, but the balance of the business we think has a narrow moat.
Then you have a company like Alcoa, a low-cost producer of aluminum and related products, but the industry is so oversupplied that the company is not realistically able to earn excess returns over a sustained period.
Lastly, efficient scale. ITC, as we've just been talking about. It's too expensive to build competing transmission lines, but most importantly, the regulatory framework is favorable and we expect it to remain favorable. Compared to a company like Southern Company, which also has a national geographic monopoly, but much more heavily regulated, the returns are less favorable, and so we think the company only has a narrow moat, which is the case for most utilities.
Lastly, you have Aeroports de Paris, which severe regulation completely offsets its geographic monopoly. The company may have a great competitive position and basically a geographic monopoly, but regulators in France prevent it from even earning its cost of capital, which gives it no economic moat.
With that, I'll be happy to take your questions, and I'm going to turn it back to Jeremy to facilitate that.
Glaser: Matt, thanks for the presentation. We have a lot of good questions. The first is, would you rather buy a no-moat, 5-star stock, one that's trading at a big discount to that fair value estimate, or would you rather buy a wide moat that maybe is more fairly valued?
Coffina: Maybe I'm not the best person to answer that question, because our strategies completely ignore the no-moat companies. As I showed on one slide, our analysts have not been particularly good historically at assigning star ratings to no-moat companies, and it's not their fault--we shouldn't blame them for it. It's just that it's very difficult to predict their future cash flows.
If you've got a deep enough discount, maybe in my personal portfolio I would consider a no-moat company if it was really trading at a very steep discount to fair value. But I think even say a 10% discount to fair value for a wide moat company can be more meaningful or we can have a higher confidence that that company is actually trading at less than intrinsic value than say a 30% discount for a no-moat company where the fair value itself is so uncertain that we just can't have that much faith in it.
Glaser: Someone asks that you seem to not have a lot of cash in your Tortoise and Hare portfolios right now. Why are you fully invested? Is it because you're finding lots of values or you just don't see the value in that cash right now?
Coffina: That's a great question. In our Tortoise portfolio, we hold very little cash at this point, we're at about 1%. We actually hold more cash than I would ideally like in the Hare portfolio, more than 11% cash position, and that's because it's been very difficult in the current environment to find these growthier kind of companies that are actually trading at reasonable prices. At the moment, I think investors are very much willing to pay up for growth even if it's very uncertain or lies in the distant future.
Growth company investing has become very difficult, and we're holding more cash than I really would like. Getting to the broader point of why do we stay even at 11% cash more or less fully invested at all times. I think it is very rare that you get a circumstance where the market is very obviously overvalued. I would say the 1999 to 2000 period with the Internet bubble, it was fairly obvious that the market was just ridiculously overpriced.
On the other side, during the financial crisis, 2008-09, maybe it didn't feel like it at the time, but really, companies were very, very deeply undervalued. I think at that point we had some 850 5-star stocks across our entire coverage universe. That number now is more like 15 5-star stocks.
There are some extreme market dislocations where it can make sense to load up on equities, in 2008-09, really cut back on equities, in 1999-2000. But other periods like 2007, for example, right before the latest crash, I don't think it was obvious that all the stocks were significantly overpriced. And really after we've come through this financial crisis and you could have even got a halfway decent return starting in 2007. I don't think it was obvious that the stocks were so overpriced, and I don't think it's so obvious now. I do think the market is relatively fully valued, but I wouldn't say that we're anywhere near massively overvalued.
The other really important thing to keep in mind is that stocks tend to go up over time. Companies tend to grow earnings, they tend to compound their intrinsic values, they're paying dividends over time. So time is not on your side if you're holding cash as an investor in common stocks. If you assume maybe an 8% to 10% normal historical return for the market and say the market's 5% overvalued right now, you would expect that a year from now the market will be 5% undervalued, a year from now after that it'll be 15% undervalued and so on.
To a certain extent, it's really just a matter of time. Especially when you invest in the kinds of companies that we do, companies with strong and growing competitive advantages, those companies really tend to compound their intrinsic values over time. And the longer you wait, the more intrinsic value is likely to start to run away from you.
Glaser: Like you mentioned, these companies don't really sit still. Their competitive advantage can change over time. And we have a question about that moat trend, which is something that you talk about in your newsletter. How do you think about comparing a stock that maybe is narrow moat now, but they're making investments that maybe is widening that moat, has a positive moat trend, versus a company that's already wide, but maybe it's on the decline?
Coffina: Moat trend is very important to our strategy with the Tortoise and Hare. In the Hare, we particularly look for companies with positive moat trends, and they're hard to find ones that are undervalued especially in the current market. But ideally, we own companies whose competitive positions are getting stronger over time.
In the Tortoise portfolio, we tend to lean more on the wide-moat, stable-trend kind of companies. But in both cases, we try, at all costs, to avoid companies with negative moat trends or companies with deteriorating competitive advantages, because I think this is really where investors get themselves in the most trouble.
We've had some recent examples, where even our Morningstar analyst didn't anticipate the extent to which competitive advantages were deteriorating. Some cases that come to mind would be Weight Watchers, Boardwalk Pipeline Partners, and ADT. All three of these companies, their economic moats have been eroded over time for various reasons, increasing competition, assets poorly placed, failure of management to adapt, and so on. And investors have done very, very poorly.
I think the number-one priority of investors should be to avoid companies with deteriorating moats, and in general, I look for stable moat trends in the Tortoise and ideally positive moat trends in the Hare. My personal preference, I'd rather own a narrow-moat company with a positive moat trend, where I think the competitive advantage is going to be getting stronger and stronger over time than a wide-moat company with a negative moat trend that might not even have that wide moat five years from now.
Investing is very much a forward-looking exercise. I think investors need to think five and 10 years ahead, and what kind of situation is this company going to be in. And you certainly want that to be better five years from now, rather than worse, unless the company is really ridiculously cheap and already baking that in.
I'd say in general, I think moat trends are less likely to be incorporated in valuations than economic moats are. It's fairly obvious that Johnson & Johnson or Google or MasterCard, these are great businesses, great wide-moat businesses. It's maybe less obvious that a company like Baidu, for example, a Chinese version of Google, has a positive moat trend, that we think the competitive advantage is actually strengthening over time.
Or a Charles Schwab would be another example, a narrow-moat company that we think is growing its competitive position over time. I think moat trend in general is less likely to be priced into stocks, which means, in general, negative moat trend companies tend to underperform, positive moat trend companies tend to outperform, and the challenge is really just identifying these companies when other investors are missing it.
Glaser: We have two related questions here. The first is how a company can lose that wide moat? You know what that process is? How often it happens? And the related question is asking about the accuracy of the moat ratings, or how often is Morningstar making changes? How do you quantify that?
Coffina: Those are great questions. In general, if we think of a wide moat lasting 20 years on average, then you would expect that in any given year, 5% of wide-moat companies are going to lose their wide moats, right? Because then, by the end of 20 years, you would have turned over the whole group. Now the reality is that some companies sustain their wide moats for 50 years, and other companies, either the moat gets eroded or we were wrong about it in the first place and it tends to lose it more quickly.
Looking back historically, in the period after the financial crisis, at least, starting in 2010 or so, through last year, I believe something like 6.5% of wide-moat companies have been downgraded in any given year, and that would imply an average moat life of something like 15 years, a little short of our 20-year target. But again, some amount of deterioration of moats is normal and to be expected over time. Whether we upgrade moats at the same rate, I'd say that more or less we have.
These things tend to run in cycles depending on our analysts' views. For example in the last two years we've added a lot more wide-moat companies than we've downgraded, and this has been due to our more positive take on some specific industries like midstream energy, railroads, for example, where we've upgraded a large group of companies all at once.
There have been other periods, certainly, like during the financial crisis, when a lot of wide-moat companies were getting downgraded at the same time. Banks being a great example, where we used to think that most banks had wide moats and then the financial crisis made that blatantly obvious that that wasn't the case.
Some amount of moat turnover is normal and natural. The other thing to keep in mind is that, basically what we're doing is predicting the future and that's not an easy task to look five and 10 years ahead and determine, maybe this company has great returns on invested capital historically, but are those going to be sustained five years in the future? You asked about ways that moats can be eroded. I'll go back to those three companies that I mentioned.
Boardwalk Pipeline Partners: We thought it used to have a moat, but the problem is that the company's assets are in the wrong place for the energy boom that's occurring in North America. Basically, its main assets bring natural gas up from the Gulf Coast to the Midwest. This huge boom in natural gas production in the Marcellus Shale has made it so that it doesn't really make sense anymore to bring gas up from the Gulf Coast to the Midwest.
You can meet a lot of the Midwest gas needs with locally produced Marcellus Shale gas and that has eroded the moat, and ideally, we would've anticipated that, but certainly that's the kind of situation that you want to prevent going forward.
Another case would be Weight Watchers. This is a company that, its unique approach to weight loss would be very difficult to replicate. They have these meetings. They're led by people that have been in the program before. The company has built the brand advantage over the course of 50 years. But now mobile devices have come out and there are all sorts of mobile apps that deliver basically the same experience as Weight Watchers.
Now they help you track calories, they help you track your fitness. I see articles in The Wall Street Journal every day about new fitness tracker devices that are coming out, and this has really eroded Weight Watchers' value proposition. So people are no longer willing to pay $20 a month for something when a free app can basically do the same thing.
Another example being ADT, in that case, cable and telecom companies have started to get into the business of home security. They have existing relationships with customers. They have a lot of costs that are leverageable. They're already sending people out to these houses. They have the customer lists and so on.
And in general, they've been willing and able to significantly undercut ADT on price. Any situation where you have somebody else willing to do the same service as you for a significantly lower cost, you could say the same thing about Weight Watchers. That's a situation to be concerned about.
Glaser: You had a slide that showed the prevalence of moats in various industries, and we have a question asking that in the future, where do you think there are going to be the most moats? What companies are the best positioned. Would you expect that graph to look the same 10 years from now?
Coffina: I think some sectors are definitely more prone to economic moats than others. Utilities, the business model hasn't really changed in 100 years and probably won't change over the next 100 years. Most utilities are going to have a geographic monopoly and a competitive advantage from that, but the returns are going to be capped by regulators, and definitely into the future. So most utilities, domestic utilities are going to be narrow moat. I think they probably have been for the last 100 years. They probably will be for the next 100.
Consumer defensive sector, a lot of consumer staples companies like the Coca-Colas or Philip Morris Internationals or Unilevers of the world. Again, people have been loyal to those brands, in a lot of cases for 50 or 100 years and I don't really see any reason to think that they won't be loyal to them 50 or 100 years from now.
In a sector like health care, you tend to have a lot of wide moats, but those wide moats can definitely erode over time if you're not careful. A patent only lasts 20 years, and we're talking about a 20-year life for a wide moat. By the time you actually bring a lot of these drugs to market you might only have 10 years left on that patent life. So a pharmaceutical company needs to constantly innovate and constantly add new drugs.
I think health care is an example where you will probably still have a lot of wide-moat companies in the future, but they won't necessarily be the same companies that are wide moat today. Unless these companies really stay on top of their game and make sure that they're constantly replenishing their product portfolios with new drugs and extending that patent life further and further out into time.
On the other hand, sectors like basic materials, I think, they're just not prone to having economic moats. It's an extractive industry in general. Their costs tend to go up the more of whatever it is you take out of the ground, which can really erode your competitive advantage over time. They're subject to commodity prices, which can be influenced by all sorts of factors, relative economic positions, discoveries in other regions, and so on.
I think in general, basic materials and a lot of energy, at least on the exploration and production side, it's very difficult to carve a moat and very unlikely that they'll be doing that in the future. Broadly speaking, I would expect that chart to look pretty similar. There are just some sectors that are much more prone to economic moats or much more friendly to economic moats than other sectors.
Glaser: What do you think the impact of rising rates will be on fair value estimates? Would you expect that as rates rise fair value estimates are naturally going to come down?
Coffina: In general, the reason you would think that that would be the case is that, your cost of equity assumption includes an implicit assumption about interest rates, and the cost of debt also includes an assumption about future interest rates. The reason that fair value estimates I don't expect to change materially as a result of rising interest rates, is that we haven't really adjusted those discount-rate assumptions, the cost of equity, and the cost of debt to the current interest-rate environment.
We haven't been assuming that companies are going to be able to raise debt at 3% and 4% forever into the future. We haven't been lowering our cost of equity assumptions. In some cases, we have lowered cost of equity, but that's really because of a new assessment of the systematic risk of the company. Companies like Coca-Cola, we've determined, deserve a lower cost of equity regardless of the interest-rate environment. And I don't see any reason why that would go up with a higher rate environment.
Furthermore, I would say that if you look historically in the market's history, stocks tend to do very well in a rising rate environment and they tend to do very poorly in a falling rate environment. I think the conventional wisdom that rising interest rates are bad for stocks really has its limits. If interest rates rise to the point where they really start to hurt the economy, then you have to be concerned.
But if rates are rising because the economy is already so strong, or even somewhat strong or stronger than it was, then rising rates could actually be a favorable sign for stocks. I'd say the time to really worry about rates is, once the economy starts to turn south and the Fed feels compelled to start lowering rates. I think we're quite far from that.
Glaser: And just finally, you mentioned ITC, went through that example. Do you think it's advisable to invest in their shares today given that it's trading for around its fair value estimate?
Coffina: The problem with ITC, as you mentioned, is it's now trading for actually a slight premium to its fair value estimate. We bought the shares for the Tortoise portfolio at the time it was trading at maybe a 10% discount to fair value. I think with ITC, you need a very modest discount to fair value because of the nature of the regulation, its formula-based rates. Its future cash flows are very, very predictable.
The main source of uncertainty is whether or not the Federal Energy Regulatory Commission is going to change its policies on allowed returns for transmission operators, which, by the way, we should find out sometime in the middle of this year. There is a rate case that's going to be decided that should shed some light on that.
That is a real risk and I think that we should demand some margin of safety before investing in ITC. I probably wouldn't be adding new money now, but for the Tortoise's position, I'm very happy to continue holding the company at even a modest, call it a 5% or less, discount to fair value. I think that that would be a fine time to buy that stock.
Glaser: Matt, thank you very much for your insights today.
Coffina: Thanks for having me, Jeremy.