Opportunistic Investor's Moat Philosophy

A subject familiar to almost all Morningstar readers is the concept of moats. The message is simple: If a company can consistently invest at returns higher than its cost of capital, it has a moat. The longer the company can do this before competition eats away its advantages, the wider the moat. All else equal, the wider the moat, the more attractive the company is.

One can get a decent sense of a company's moat simply by cracking open its historical financial statements and performing some simple computations. In general, high returns on equity or assets, high and consistent margins, and ample free cash flows are great signs that a moat is present. A battery of computers and some simple algorithms can figure this much out. Morningstar goes a step deeper and looks qualitatively at the company's business model, competition, industry, regulatory environment, and so on. This tends to work well over time. For example, on Feb. 28, 2009, companies with wide moat ratings returned about negative 3.9% annually over the last five years, versus negative 6.6% for the S&P 500 and about negative 22.2% for those companies we rate as having no moat.

This performance is pretty impressive, but the Opportunistic Investor can improve on the formula. Instead of "we buy wide moats," one of our investment pillars will be "we buy growing moats."

This may sound like anathema, but it isn't at all when you think about it. We want the wide moats of the future, not the wide moats of today. This is not easy. Most moats--almost by definition--are not growing. We exist in a fiercely competitive economy, and companies are constantly jostling for some edge that will allow them to earn higher returns on their capital. Overtime, edges dull and chip against the ever-advancing vanguard of the competition.

An eroding moat can be ugly. One of the best-known examples is  Dell . This company built an enviable business based on its lean operations and "direct-to-consumer" business model. It made millionaires out of paupers as its fortunes soared in the 1990s. But over the last decade, that slowly changed. Overseas (Asian) manufacturers became much more efficient, and the computer business shifted from PCs, where Dell had its core advantages, to notebooks and other mobile devices. Dell has been struggling ever since.

Margins constantly shrank, sales growth slowed, and returns sagged. The company's moat rating was downgraded from wide to narrow in early 2008, and unless the business is fundamentally changed, we suspect that it will eventually head to "none." Stockholders fared badly--losing about 22% per year for the last five years, significantly worse than the S&P 500.

Dell is a worse business than it was, but is it a terrible business? The objective answer is "no." Even in its emaciated state, it earns decent returns on capital and generates ample cash flows, qualifying it for a moat. This may go on for years to come. However, would we buy it? The unequivocal answer is also "no."

An exact opposite example is  Monsanto . In 2001, Monsanto generated 70% of its revenues from its Roundup insecticide and herbicide franchise, which had recently lost patent protection. The future looked bleak. However, hidden away was a seed of potential in its genetically modified crop division. The story of the next seven years reads like a Charles Dickens rags-to-riches epic. Leveraging its best-in-class technology, the genomics segment grew roughly 20% a year* over this period, and it now accounts for more than half the company's sales and even more of the profits. And as it turned out, Roundup is still going strong. The stock has more than quintupled over this time period.

Today, we think Monsanto's moat is stable, if not growing. Its R&D capabilities are still huge and unparalleled, and its technology is generations ahead of its rivals. It's able to incrementally improve its products and develop new tangential products to maintain or widen that lead. The stock's moat was slowly upgraded, beginning at none in 2001 to wide in 2008.

These examples are somewhat exceptional in that these businesses changed so dramatically so quickly. But aside from that, stories like these are playing out every day. From our observations, a declining moat signals poor stock returns, even if the company has been wonderful historically and is still generating strong cash flows. In these cases, cash often piles up on the balance sheet, while growth, margins, and return on capital all shrink and possibly become more volatile. At this point, it may become irresistible for management to do something "transformational"--buying a major competitor, entering a new business, financial engineering, or a major restructuring. Investors often never see a penny of all that wonderful cash. Or, even worse, the company can simply become steadily less profitable until it collapses under its obligations--think newspaper companies for the last few years.

At this point, you may be asking, "The theory is all great, but what does this mean for us?" Obviously, we would love to buy only growing moats for great prices. In fact, if these companies started with no moats, so much the better. But, unfortunately, situations like that are incredibly rare. Often, moats are created more by accident than design: perhaps brought on by a lucky technical discovery, or a company's largest competitor going bust, or some other fluke of history. Even Monsanto's early days were filled with peril and uncertainty--the company probably didn't have an identifiable moat until its products gained acceptance by markets and consumers (but there was plenty of money to be made once the moat became evident). In all fairness, the company could have flamed out like just another speculative biotech.

The point is, before the fact, moats are very difficult to identify. It's even more difficult to identify one that the market isn't excited about. We'll do our best, and I'm sure we'll catch a few attractive picks, but we probably won't be able to build a portfolio around them. But what we can do is avoid declining moats like the plague and try to upgrade our portfolio with growing moats whenever possible. Occasionally, we will own a company whose moat, perhaps through no fault of its own, starts to decline. In these cases, we think it's smart to admit that we were wrong and sell, even if the company "looks cheap." We'll also try to highlight firms whose moats are declining as potential short ideas.

A version of this article originally appeared on March 13, 2009 in Opportunistic Investor.

*Exact data on Monsanto is hard to pin down because of the changing composition of the genomics segment, a fiscal-year-end date change a few years ago, and asset sales on the fringe. But our data are in the ballpark.

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