How an Economic Moat Can Help You Find

Great Stocks
Paul Larson
Chief Equities Strategist
Editor, Morningstar StockInvestor
Twitter: @StockInvestPaul
Mike Tian
Equities Strategist
Co-Editor, Morningstar Opportunistic Investor

2011 Morningstar, Inc. All rights reserved.

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Whats An Economic Moat?

Economic Moats Concept

Basic premise: Capitalism works

High profits attract competition
Competition reduces profitability

But some firms stay very profitable for a long time by creating economic
moats to protect profits

Economic moats are structural business attributes that help companies

generate high returns on capital for an extended period.
Structural = inherent to the business
Structural a smart manager
Sustainable returns on capital are much more important than high returns on
capital.
Crocs CROX or Valero VLO vs. Kinder Morgan KMI or Union Pacific UNP

Why Moats Matter

Imagine

two companies with similar growth rates, returns on capital,

and reinvestment needs:
The moaty company has a higher value
Moats provide a margin of safety
Companies with moats likely to continue to compound in value
Overestimating a moat = paying for unlikely value creation
Companies with higher ROICs deserve premium valuation multiples
Waiting for wide moat firms to get cheap pays off

Why Moats Matter

add intrinsic value!
Narrow Economic
Moat

ROIC

ROIC

Wide Economic
Moat

Time
Horizon

No Economic
Moat

ROIC

Moats

Time
Horizon

Time
Horizon

Sources of Economic Moats

Network

Cost

Effect

Advantage

Intangible

Assets

Switching

Costs

New!

Efficient Scale

Sources of Economic Moats: The Network Effect

The

network effect is present when the value of a service grows as

more people use a network.
With each additional node, the number of potential connections in a
network grows exponentially.
MasterCard MA, Visa V
eBay EBAY
Apps Apple AAPL iOS, Google GOOG Android
Financial Exchanges Deutsche Borse DB1.DE, CME CME
Facebook

Sources of Economic Moats: Cost Advantages

Allows

firms to sell at same price as competition and gather excess

profit and/or have the option to undercut competition.
Economies of Scale
Distribution UPS UPS, Stericycle SRCL, Sysco SYY
Manufacturing Intel INTC
Low-Cost Resource Base
Ultra Petroleum UPL, Compass Minerals CMP

Sources of Economic Moats: Intangible Assets

Things

that block competition and/or allow companies to charge more

Brands
Sony

SNE vs. Tiffany TIF

Procter & Gamble PG and Colgate CL
Patents
Pharmaceuticals
Licenses & Government Approvals
Waste, aggregates, casinos (kind of)

Sources of Economic Moats: Switching Costs

Time

= money, and vice versa

Consumers and Banks
Oracle ORCL, Autodesk ADSK
Otis (United Technologies UTX), GE GE
Jack Henry JKHY, Fiserv FISV
Intuit INTU

Sources of Economic Moats: Efficient Scale

When

a company serves a market limited in size, new competitors may

not have an incentive to enter. Incumbents generate economic profits,
but new entrants would cause returns for all players to fall well below
cost of capital
Natural geographic monopolies
Airports, racetracks, pipelines
Niche markets
Defense companies, Lubrizol, Graco GGG, etc.
Rational oligopolies
Canadian banks

Whats Not An Economic Moat

Size

/ Dominant Market Share: High market share does not give a

firm a moat. (Ask Compaq or GM.)
Technology: What one smart engineer can invent, another engineer
can make even better.
Hot Products: Can generate high returns on capital for a short period
of time, but sustainable returns are what make a moat.
Krispy Kreme KKD, Crocs CROX
Process: Can be imitated with time. Witness Dell DELL, Southwest
LUV

Whats Not An Economic Moat

Management:

CEOs can create (or destroy) a moat, but management

is not a moat by itself.
Go

for a business that any idiot can run because sooner or

later, any idiot probably is going to run it.
Peter Lynch
When management with a reputation for brilliance tackles a
business with a reputation for poor economics, it is the reputation
of the business that remains intact. Buffett

History of Moat Rating

Warren

Buffett in a 1999 Fortune magazine article writes:

The

key to investing is not assessing how much an industry is going

to affect society, or how much it will grow, but rather determining the
competitive advantage of any given company and, above all, the
durability of that advantage. The products or services that have wide,
sustainable moats around them are the ones that deliver rewards to
investors.

Morningstar

initiates economic moat rating in late 2002, subdividing

entire coverage universe into three moat buckets: none, narrow,
wide. This system remains in place today.
Moat ratings have always required sign-off of committee. Acts as
quality control measure and improves consistency.

Measuring a Moat
First,

assume company does not have a moat.

Key Test: Does ROIC > WACC?
If yes is positive spread sustainable for at least next decade-plus?
If yes Company has at least narrow moat
Is spread sustainable for two decades?
If yes Company has wide moat
If company does not currently have positive economic profit
(ROIC>WACC), will it in the near future? Do positive economic profits in
future outweigh near-term negative economic profits?
Duration of economic profits matters, not absolute magnitude.

Who Has a Moat?

~10% of companies = Wide

~ 50% = Narrow

~ 40% = None

are not equally distributed across the market

Fewer moats in highly commoditized or competitive sectors
More moats in areas with durable brands, patents or switching costs
Our coverage universe skews toward larger, successful firms. In overall
economy, most firms do not have any economic moat.
Moats

Ba
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Percent Composition

How Are Moats Distributed?

Composition of Sectors by Moat
Equal-Weighting

100%

90%

80%

70%

60%
None

50%
Narrow

40%
Wide

30%

20%

10%

0%

As of Oct. 2011

The Payoff: Wide + Cheap = Alpha

Example:

Real-world Tortoise and Hare Portfolios

Total Returns Since Inception (6/18/01)

Cumulative

Annualized

Tortoise

115.0%

7.4%

Hare

103.5%

6.9%

S&P 500

38.3%

3.1%

Since

inception, the Hare has outperformed 98.4% of large-growth

mutual funds, while the Tortoise has bested 99.4% of large-blend
mutual funds.

Returns through 2/29/2012

Even Better: The Wide Moat Focus Index

Growth of $10,000

The Payoff: Wide + Cheap = Alpha

Example:

Wide Moat Focus Index

Total Returns Since Inception (9/30/02)

Cumulative

Annualized

Wide-Moat Focus

270.3%

14.9%

S&P 500

99.4%

7.6%

Created

in Sept. 2007, index takes universe of U.S.-based

corporations rated by Morningstar as wide-moat, then takes the 20
cheapest when sorted by the price/fair value ratio. Index is equalweighted (all positions = 5%), and then reconstituted and rebalanced
quarterly.
Returns through 2/29/2012

Whats A Moat Trend?

Moat Trend Concept

Moats

are not constant

Moats go through a lifecycle just like a company
Where in the cycle you invest can have major investment implications

Why Moat Trends Matter

Investment 101 Math goes something like:
Firm makes profit
Firm reinvestment part of profit in business to make more money
Firm returns what it doesnt need to shareholders
The power of compounding = wealth creation for shareholders
This math works fantastically for companies that are growing, investing wisely,
and building an economic moat
But math can break down with firms in trouble or decline
Investment opportunities dry up
Management deworsify, buy into growth, hoard resources, repeated
restructuring
Incremental returns on investments in core business are low or even negative
Firms generally dont decline gracefully!

History of Moat Trends

Started

formally tracking in September 2009

Assign all companies to three buckets:
Positive : Companies with expanding economic moats
Stable
Negative : Companies with eroding economic moats
Litmus Test:
Evaluate the companys economic moat today
Close your eyes for three years. Is the moat wider or narrower?

Common Characteristics of Positive Trend Firms

You

can reverse these characteristics for Negative trends

Sustained, higher than GDP revenue growth
Stable or rising operating margins
Stable or rising returns on invested capital (ROIC)

Moat Trend Investment Performance

Investment Returns for Positive and Negative Moat Trending Stocks
75%
65%

61.6%

55%

45.9%

45%

40.8%

35%

29.3%

25%
15%
5%
-5%

Aug 09

Nov-

09

Fe b10

M ay-

10

Aug -

10

Nov-

10

Fe b11

Positive Moat Cumulative

Negative Moat Cumulative

S&P 500 Cumulative

Russell 2000 Cumulative

M ay-

11

Aug 11

Nov -

11

Positive and Negative trends each make up about 15% of our U.S. coverage universe.

Fe b12

How do Moats Expand and Shrink?

Changes
The

in competitive landscape

firms investment strategy or business mix

Changes

in consumer behavior or preferences

Changes

in technological landscape

Changes

in regulatory / political landscape

Demographics

A Moat Based on Any Source May Evolve

Network

Effects
The number of nodes and interconnections in the network is key

VS

Cost Advantage
Focus

on the cost differential between the firm and competitors

VS

Intangible Assets
Brands

and intellectual property need constant reinvestment to

remain relevant

VS

Switching Costs
Higher

switching costs usually translate into pricing power on top of

customer stickiness

VS

Efficient Scale
Almost

by definition, its difficult to grow a moat based on efficient

scale.
But its much easier for an efficient scale moat to be eroded
Irrational competitor
Changing marketplace

??

What is NOT a Moat Trend

Cyclical

improvements / harm to business

A hot product with little assurance of repeat success
A really good management team
We are looking for structural improvements / deterioration to a
firms business

Paul Larson Pick: Western Union WU

In

both Hare Portfolio and current Wide Moat Focus Index

Stock Price (03/26/12): $17.93
Fair Value Estimate: $29
P/FV: 0.62
Economic Moat Rating: Wide
Fair Value Uncertainty: Medium
Benefits from both network effect and low costs. Concerns about
technological disruption appear overblown.
Expectations priced into the stock are very low. Trades at just 10
times earnings with a 9% free cash flow yield. Company both pays a
dividend (2.2% yield) and has active share repurchase program.

Paul Larson Pick: Oracle ORCL

In

both Hare Portfolio and current Wide Moat Focus Index

Stock Price (03/25/12): $28.55
Fair Value Estimate: $38
P/FV: 0.75
Economic Moat Rating: Wide
Fair Value Uncertainty: Medium
Database behemoth benefits from both economies of scale as well as
enormous switching costs. Customers will not risk interrupting core
operations just to save a buck or two.
Company trades at 11 times forward earnings estimates, about half of
10-year average PE.

Paul Larson Pick: Compass Minerals CMP

In

both Hare Portfolio and current Wide Moat Focus Index

Stock Price (03/25/12): $69.42
Fair Value Estimate: $93
P/FV: 0.75
Economic Moat Rating: Wide
Fair Value Uncertainty: Medium
Company has two world-class, advantaged assets: Goderich, Ontario
(worlds largest salt mine) and the Great Salt Lake (lost-cost specialty
fertilizer). One of few wide-moat firms with a positive moat trend.
Weather has been abysmal for Compass over the last year, but
weather is the ultimate mean-reverting phenomenon.

Mike Tian Pick: Covance CVD

Stock Price (03/23/12): $47.50
Fair Value Estimate: $60
P/FV: 0.79
Market Cap: $2.1B
Economic Moat Rating: Narrow
Moat Trend Rating: Positive
Fair Value Uncertainty: Medium
Benefits from increasing outsourcing of clinical trial operations by pharmas
Leader in signing strategic relationships that increase switching costs
Near term margin pressure keeping margins low. But firm should grow at
GDP+ for many years with opportunity to expand margins

Mike Tian Pick: Charles Schwab SCHW

Stock Price (03/23/12): $15
Fair Value Estimate: $23
P/FV: 0.65
Market Cap: $19B
Economic Moat Rating: Narrow
Moat Trend Rating: Positive
Fair Value Uncertainty: High
World class asset gatherer. Relentlessly pushing costs down.
Offerings of banking services, financial advisory services increasing
stickiness.
Low interest rates keeping earnings down. But earnings will rocket up once
Fed Funds go above 1%.

Mike Tian Pick: Autoliv ALV

Stock Price (03/23/12): $66
Fair Value Estimate: $80
P/FV: 0.82
Market Cap: $6B
Economic Moat Rating: None
Moat Trend Rating: Positive
Fair Value Uncertainty: High
Largest R&D budget in industry drives innovation, consistent taking of market
share for decades
Mix shift to emerging markets positive for moat and margins
Economic fears keeping stock relatively cheap (10x PE). Lots of exposure to
Europe

Full Disclosure
The chefs are eating the cooking!
Disclosure: Paul Larson personally owns nearly all the stocks in the Tortoise and Hare
model portfolios, including the following stocks explicitly mentioned in these slides:
ADSK, CME, CMP, EBAY, GOOG, ISCA, MA, MSFT, ORCL, PFE, PG, SYY, WMT, WU
Disclosure: Mike Tian personally owns stocks in the Mosaic model portfolio, including
the following stocks explicitly mentioned in these slides:
ALV, SCHW, CVD
2011 Morningstar, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc.

The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and
therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the
date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading
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herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written
consent of Morningstar.

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