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What's the Real Value of an Economic Moat?

Pat Dorsey, CFA

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

As those of you who are familiar with Morningstar's equity research probably know, we are big fans of what we think of as competitive advantage or economic moats in the way we look at stocks here at Morningstar.

And one of the things people often ask me is, so why do you care, Pat. What is so important about economic moats? Why should they be an important part of your analytical process? And I think the answer is pretty simple.

Well, first of all, moats add intrinsic value. A company that's able to compound cash at a very high rate of return for many years into the future is simply worth more today in present value terms than a company that's not.

You can imagine three triangles, if you think about returns on capital starting very high and then fading down low over a long period of time, all that area is value creation. All that time is opportunity where the company can basically reinvest capital at a high rate of return, protect itself from the competition, and thus increase its value and thus make it more valuable to you today as a shareholder.

Whereas the no moat business where you might see returns on capital starting high, but then coming down very, very quickly as competition comes in and pulverizes it--well, all else equal, that's just worth less today in present value terms. So, it's reasonable to pay up a little bit for a wide moat business versus a no moat business.

Now, does that mean a wide moat business is worth two times a no-moat business? Hardly, but it is worth a bit more and this is why you often hear, this company deserves to trade at a premium, a quality company is trading at a premium, that's sort of jargon on Wall Street. And what that is, is basically getting at this intuition that a business that is able to compound cash at a high rate of return for many years is worth more today in present value terms.

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Because the bottom line is that over-estimating a moat, thinking there is a moat when there isn't one, results in basically you paying for value creation that never materializes. If you over-estimate a moat, if you think there is a moat there and its not, well you pay up a lot for the stock because it's priced as if it can generate high returns on capital for many, many years, but it doesn't, and your investment winds up frankly turning out pretty poorly--ass anybody who invested say in say, Crocs at the top found out, or anybody who invested in Motorola, when people thought the RAZR – if you remember the RAZR, a very thin flip phone – people thought that it was going to save the company's bacon. At the end of the day, it was just another phone. It wasn't a moat, even though this stock was priced like one.

But on the flipside here, underestimating a moat, probably results in opportunity cost. If you underestimate the moat, you don't think the company has one, but it really does, and you don't pay up a little bit for the stock. You don't actually think it's worth paying a little bit more for the stock, because you don't appreciate the potential value creation of the company.

Buffett actually brought this up in his 2001 or 2002 shareholder meeting, when he talked about Berkshire Hathaway starting to buy Wal-Mart in that early 1990s and saying that they had set out to buy so many million shares of Wal-Mart, and the price moved up an eighth and they stopped buying. And then he went on to say that that mistake cost Berkshire Hathaway quite a lot of money in forgone profits--money they didn't make on the stock because they say didn't buy very much Wal-Mart. And he went on to say at that annual meeting that it was because they didn't fully appreciate the strength and durability of Wal-Mart's competitive advantages. So, that's what happens when you underestimate the moat.

You say, when we're going to pay this much for the stock, when really its probably worth paying a little bit more, and then being able to participate in that value creation that occurs for many, many years.

Companies with economic moats we find are also more resilient to challenges. They are more likely to bounce back when there are troubles and able to fall back on that competitive advantage and retool.

You might think of McDonald's back in 2002, 2003, when the company was suffering from very poor sales, a menu that was out of touch with consumer tastes, poor customer service--just about all the problems that a quick-service restaurant chain could face.

And you know, restaurants are very, very competitive industry. If you don't like the food here, you walk next door and go somewhere else. Switching costs, in our jargon, are quite low. Most restaurants that have the travails that McDonald's did back in 2002 or so, they don't come back. They just go down into oblivion. McDonald's, however, had advantages that other restaurants did not.

They had an iconic 40-, 50-year-old brand. They had more units, more branches across the world than just about any other restaurant chain, which meant that small changes in marketing or in the menu or in customer service processes could be propagated out across many more units, thus getting the company more operating leverage, and that's what enabled McDonald's, with what we would think of as actually having a wide moat, to be able to bounce back from troubles that would have leveled most other restaurant companies.

So, that's really the value of an economic moat as an investor. It results in more value creation over time, and it's a fall-back position for the company. It's something that the company can use to help rebuild itself when it hits temporary troubles that would level a no moat business.

So, at the end of the day, moats do matter, we think, in the investment process. They are not the end all, be all, but they're, we think, another important component to selecting good-quality stocks.

I'm Pat Dorsey and thanks for watching.