Seven Questions about Our Moat Ratings

We write a lot about moats at Morningstar, and for good reason. As we explained in our last stock star rating performance update, high-quality companies with sustainable competitive advantages have outperformed since we launched our moat ratings seven years ago. The most significant period of wide-moat outperformance has occurred during the current economic crisis. Over the trailing 12 months, wide-moat companies have outperformed the S&P 500 by nearly 800 basis points.

We often receive questions about our moat ratings, several of which we answer below. First, it's important to understand what it means for a company to have a moat. Our moat rating is meant to describe both the durability and magnitude of the competitive advantages that protect a company's ability to earn an economic profit. Our equity analysts assign a moat rating after careful competitive analysis and approval by Pat Dorsey, Morningstar's director of equity research, and Paul Larson, editor of Morningstar StockInvestor. This ensures that our moat ratings remain consistent across our entire coverage universe. A more detailed look at our moat rating methodology can be found here.

Are Wide-Moat Stocks a Good Store of Value?
Historically, we have found that the market assigns a premium to stocks with no moat. Their median price/fair value has, more often than not, exceeded that of wide-moat and narrow-moat firms. However, we've recently seen a convergence in the median price/fair value ratios of our wide-, narrow-, and no-moat stocks as wide-moat companies have retained significantly more of their value in the current economic downturn. In fact, from the local peak in June 2007 to the current trough in January 2009, the median wide-moat stock lost 33 percentage points of value compared to 33 and 40 percentage points for the median narrow- and no-moat stocks, respectively. We saw a similar phenomenon during the previous bear market in 2002 when all three moat ratings were nearly equally undervalued. Currently, the median price/fair value ratios of our wide-, narrow-, and no-moat stocks are 0.63, 0.70, and 0.71, respectively, and a higher percentage of wide-moat stocks are undervalued than at any time since we've been publishing moat ratings.*

What Are the 'Moatiest' Sectors?
Each sector in the Morningstar universe has its own competitive dynamics that surface in our moat ratings. Health care is our moatiest sector with 68% of its market cap rated wide moat. Intuitively, this makes sense because large health-care companies like  Johnson & Johnson (JNJ) and  Pfizer (PFE) benefit from significant research and development infrastructures, as well as patent protection on their drug portfolios. Their size allows them to develop diversified pharmaceutical development pipelines and gives them access to the best and brightest human capital. The telecommunication sector, on the other hand, is intensely competitive and asset-heavy, and it's highly dependent on technological advances. As a result, it finds itself at the bottom of our list with no wide-moat companies. Only 15% of the market cap of Morningstar's coverage universe has a wide moat.

Moatiest Sectors by % Wide Moat
	Wide	Narrow	None
Health Care	68%	23%	8%
Software	51%	43%	7%
Consumer Services	46%	32%	22%
Financial Services	44%	35%	21%
Consumer Goods	43%	44%	13%
Business Services	38%	42%	19%
Hardware	35%	46%	19%
Media	31%	66%	2%
Industrial Materials	18%	48%	34%
Energy	15%	77%	8%
Utilities	5%	87%	7%
Telecommunication	0%	89%	11%
Total Morningstar Coverage Universe	8%	39%	53%
Data through 2-16-09.

Do Moats Correlate with Uncertainty Ratings?
While we examine moats and fair value uncertainty as separate, independent ratings, there is a correlation between the two. A vast majority of low uncertainty stocks have a wide moat, just as a vast majority of our high, very high, and extreme uncertainty stocks have no moat. This makes logical sense because wide-moat companies face less uncertainty due to competitive threats, and they have greater power to control their own future via power over suppliers and customers.  Wal-Mart (WMT) is an excellent example of a company that exercises its power over suppliers to minimize costs and price its merchandise lower than competitors do, leaving little uncertainty that the company will prosper in good times and bad.

Correlation between Moats and Uncertainty Ratings
Uncertainty	Wide	Narrow	None
Low	72%	28%	0%
Medium	17%	64%	19%
High	5%	38%	57%
Very High	1%	23%	76%
Extreme	7%	16%	77%
Data through 2-16-09.

1  2  |  Next Page >>