The Makings of a Wide Moat

This analyst blog is part of our coverage of the 2015 Morningstar Investment Conference.

Moats are structural barriers that keep competitors at bay, said Elizabeth Collins, Morningstar's North America director of equity research. When Morningstar stock analysts try to gauge a company's moat--or lack thereof--they look for sustainable competitive advantages and the ability to generate profits for a decade or more. Sources of moat, or competitive advantage, come from a network effect, customer switching costs, intangible assets, efficient scale, and cost advantage.

Morningstar's narrow economic moat rating signifies that a company has at least one source of competitive advantage and the ability to generate profits for at least 10 years. If a company's moat is deemed wide, that signifies an ability to generate profits for at least 20 years.

During a panel discussion at the 2015 Morningstar Investment Conference, Collins, co-author of "Why Moats Matter: The Morningstar Approach to Stock Investing," discussed moat investing with two managers--Parnassus Investments' Todd Ahlsten and Bruno Paulson from Morgan Stanley Investment Management--who put moats to work in their own portfolios.

Ahlsten, manager of Silver-rated

But even wide-moat companies face adversity. Collins asked the panelists about their tolerance for instability. "We want downside protection," Paulson said. "We don't want the earnings to go away."

Ahlsten named

Both Ahlsten and Paulson agreed that management is a key consideration when analyzing a company's moat. "What we look at with management is not just how well you're managing the company's assets but also whether you're removing the negative," Paulson explained.

When examining management's future goals, Ahlsten said he looks for a sense of urgency and tries to gauge the likelihood that the company will succeed. Paulson said he often asks management to identify a strong part of their business. "If they name a fast-growing but small part of their business, that's bad; if they name a solid, sturdy part of their business, the manager gets good marks from us."

Collins then asked how the company track record fits into the equation.

"We're very fussy. We want the business model to be proven," said Paulson. "We're nervous about paying up too much."

Ahlsten agreed that track record is key but added that he liked companies with "a tradition and a mindset to unlock value." He listed a recent addition to his portfolio as an example:

Paulson cautioned that those types of investments are something good for a company "to have on top" but that the focus should be on reinforcing the moat around the core business.