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Two New Wide Moat Firms, Two Downgrades

Pat Dorsey, CFA

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar.

If you're familiar with Morningstar's research, you'll know the importance we place on competitive analysis, thinking about the structural competitive advantages or what we call economic moats that surround companies and keep them protected from the competition.

In particular, we pay special attention to our group of wide-moat businesses, businesses that in our view would be almost impossible to kill--very, very difficult for a competitor to move in on and destroy their returns on invested capital.

Our wide-moat universe of about 170 companies is less than 10 percent of our coverage universe, and so it's a group that we monitor very carefully, and we tend to not initiate coverage on new wide-moat companies very frequently or, we think carefully when we downgrade a company from wide-moat.

We've had a few changes recently that I thought would be fun to talk about, a couple of companies that are new to our wide-moat list and a couple that have left. I'll start with the ones that have left because of changes in their business.

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We recently downgraded Marsh & McLennan from wide-moat to narrow-moat. Still a good business, just perhaps not a phenomenal business anymore.

Our original wide-moat rating on Marsh Mac was partially based on its ownership of Putnam, the large mutual fund family, which it sold to Canada's Power Financial a couple of years ago. We retained the wide-moat rating because the Marsh insurance brokerage unit had global scale and some interesting competitive advantages, but as we dug into the industry and looked at competitors like Aon trying to basically compete with Marsh on a global scale, well, Marsh's returns in that unit haven't been that much better than Aon's, and so we don't see any huge advantage to Marsh relative to other global insurance brokerage competitors, so we took the moat rating from wide to narrow.

Cintas, the largest provider of uniform rental services and other business services in the country, is another company we recently downgraded from wide to narrow, largely because of what we view as misguided capital allocation by management. The uniform rental business is not growing very quickly, so Cintas management has begun plowing capital into new businesses such as document destruction, which competes with Iron Mountain and other businesses, which we don't think are frankly as good a business. They're not ones where the company is likely to have the same scale, they're ones where the economics, we think, are less attractive than its core business. Management has indicated that it really wants to continue plowing capital into what we view as less competitively advantaged areas instead of, say, returning capital to shareholders. We don't view that as a good idea; we think that's going to harm overall returns on invested capital, so we took the moat from wide down to narrow.

Now, on the flip side, we recently upgraded MSCI to wide-moat from narrow-moat. MSCI owns the Barra risk management business, but you're perhaps most familiar with it as the provider of MSCI indexes. The company dominates the market for international indexes with over 90 percent of the market, and with the proliferation of, say, single-country ETFs, really has been able to grow its business by providing indexes to those ETFs and getting a licensing fee for doing so.

Now, the index business is truly a phenomenal business because once an index becomes an industry standard, such as the S&P 500 or the MSCI EAFE or the MSCI Emerging Markets, it really is almost impossible to displace. There's a network effect that occurs where as more and more people use that index as the standard, it becomes more and more attractive for others to use it also as the standard, sort of a virtuous circle, very, very difficult to break. MSCI is a phenomenally profitable business, one that we now think has a wide economic moat.

Finally, a French company that we recently initiated coverage on with a fascinating business called Essilor. This is the world's largest manufacturer of eyeglass lenses. They're about three times larger than the closest competitor. You don't think of eyeglass lenses as a great business, but when you think about it for a moment, it really is. Think about your local optician. It's a very fragmented business. And so basically Essilor has about 300 optical labs around the world selling to over 300,000 independent opticians. They have no bargaining power over Essilor, which allows Essilor to get better margins. As the largest player in the industry, Essilor is able to have the greatest variety of lenses. Think about all the different varieties of lenses there can be, different shapes for different frames, different types of prescriptions, different coatings. And, of course, since Essilor has the largest number of stock-keeping units, or SKUs, in the business, they're able to attract more and more customers with that wide selection of lenses.

It's a phenomenal business; the company's begun to vertically integrate by buying manufacturers of precision lens equipment. And it's really just one of these little businesses you kind of find and go you know, I wish I had thought of that. They've been buying up independent labs across the world for the past several years. And it's a phenomenal business that we think would be almost impossible to replicate, which is one of the reasons why we put our wide-moat rating on it.

So there you have it, some interesting developments recently in our wide-moat universe, a group that we track very, very carefully. I'm Pat Dorsey, and thanks for watching.