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By Jeremy Glaser and Elizabeth Collins, CFA | 10-18-2013 12:00 PM

Moats Widen for Railroads, Luxury Goods, and More

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.

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