A Look at How Our Moat Ratings Have Performed through 2017

Andrew Lane: Within Morningstar's global equity research group, we assign an economic moat rating to each of the more than 1,500 companies that we cover. The economic moat rating determines if a company possesses a sustainable competitive advantage that will help it fend off competitors that might otherwise eat away at its economic profits. Only 16% of the companies we cover have a wide economic moat rating, while 43% have a narrow moat, and the remaining 43% have no moat.

We recently published a report titled "Not All Moats Are Created Equal" that takes a closer look at various profitability and performance metrics across each of these three moat rating cohorts. Across a number of different metrics--including returns on invested capital, returns on equity, and operating margins--wide-moat firms outperformed narrow-moat firms, and, in turn, narrow-moat firms outperformed no-moat firms. Let's focus for a moment on returns on invested capital, which is the primary metric we consider when assessing quantitative evidence for the presence of an economic moat.

Over the trailing three-year period, wide-moat firms reported a nearly 14% return on invested capital; narrow-moat firms reported just shy of a 10% return on invested capital; and no-moat firms reported just shy of a 5% return on invested capital. We also confirmed that wide-moat firms, on average, trade at higher price/earnings multiples than narrow-moat firms which, in turn, trade at higher multiples than no-moat firms. On current trailing P/E multiples, wide-moat firms are trading at nearly 26 times; narrow-moat firms are trading closer to 22 times; and no-moat firms are trading just below 19 times.

A wide or narrow economic moat rating also requires the presence of at least one out of the five moat sources. These moat sources include intangible assets, cost advantage, switching costs, efficient scale, and network effect. With these moat sources in mind, we also analyzed our coverage across moat source cohorts. Over the last decade, companies to which the network effect moat source is currently assigned have delivered the highest returns on equity and operating margins, in addition to the highest total returns with regard to stock performance. Efficient scale companies, on the other hand, generated the lowest profitability across nearly every metric we analyzed, as well as the lowest total stock returns.

In summary, our findings were largely consistent with what we expected to see. This provides us with even more conviction that we have been effective in identifying economic moats and that our methodology is working as it should.