What Makes A Moat
What Makes A Moat
What Makes A Moat
To make money in todays dynamic market environment, one Mr. Buffett, Morningstar has taken the economic moat concept
needs to invest in companies that will perform in the face of a step further and developed a comprehensive moat-based
sustained competitive pressure. But how can you accurately analytic framework that can be applied consistently across a
identify companies that are great today and likely to remain broad, global list of companies.
great for many years to come? The answer to this question lies
in competitive advantages, or economic moats. Just as moats Whenever a company develops a profitable product or service,
were dug around medieval castles to keep the opposition at bay, it isnt long before other firms try to capitalize on that oppor-
economic moats protect the high returns on capital enjoyed by tunity by producing a similar version, or even improving upon
the worlds best companies. the original version. We know from microeconomics that in
a perfectly competitive market, rivals will eventually compete
Moats 101 away any excess profits earned by a successful business.
In a famous 1999 Fortune article, legendary investor Warren Nokia boasted the majority share of the mobile phone market
Buffett wrote, The key to investing is determining the from the late 1990s until the early 2000s, but the introduction
competitive advantage of any given company and, above all, of Apples iPhone in 2007 and the subsequent evolution of the
the durability of that advantage. The products or services smartphone market left Nokia behind. A similar shift has
that have wide, sustainable moats around them are the ones occurred in the gaming industry, where longtime powerhouse
that deliver rewards to investors. With gratitude to Nintendo has seen its iconic, family-friendly franchises
overtaken by powerful new consoles boasting high-end third- for itself over the coming years. In Figure 2, the company
party software, such as Microsofts Xbox and Sonys PlayStation. with the widest moat and the longest advantage period has the
Meanwhile, mobile devices and social gaming have begun to greatest value creation (area under the curve). In a nutshell,
erode Nintendos dominant position in the handheld gaming companies that have moats can create value for longer periods
market. In other words, profits attract competitors, and competi- of time and are worth more, all else being equal.
tion makes it difficult for firms to generate strong growth and
margins over the long term. Moat Sources
Over the years of looking at companies, Morningstar has
But looking at the history of firms, many companies earn high identified five major sources of competitive advantage:
returns on capital for an extended period of time. Such
companies are able to withstand the relentless onslaught of 1. Switching CostsSwitching costs are those one-time inconve-
competition for long periods, and these are the wealth- niences or expenses a customer incurs to change from one
compounding machines. The explanation lies in structural product to another. Customers facing high switching costs often
characteristics known as economic moats. wont switch unless they are offered a large improvement in
either price or performance. Companies whose customers have
Moats Determine the Size of Value Creation switching costs can charge higher prices (and reap more profits)
How much value a company will create for itself and its share- without the threat of losing business. Consider a firm like
holders depends on two things: the amount of value currently Oraclethe massive software giant that sells database
being created and the business ability to continue to create programs to companies that store and retrieve vast amounts
value well into the future. The first factor is widely known by of data. Oracles databases are generally connected to
the market because its easy to calculate using basic financial other software programs, so if a company wants to change
statements. Its the second factor, the magnitude and duration from an Oracle database, it would not only need to move all its
of future excess returns, that is harder to determine but is data, but also reattach all the different programs that pull
ultimately more important for successful long-term investing. from Oracle. Therefore, companies tend not to switch, which is
why businesses like Oracle have extraordinarily high
Figure 2. Moats Add Intrinsic Value renewal rates.
Return on invested capital (ROIC) will diminish to weighted
average cost of capital (WACC) over time. Companies with the widest
moats have the potential to create value for longer periods of time. 2. Network EffectThe network effect occurs when the value of
a particular good or service increases for both new and
Wide Moat Narrow Moat No Moat existing users as more people use that good or service, often
creating a virtuous circle that allows the strong to get
stronger. Take eBay as an exampleit has the most buyers on
its platform, so it attracts the most sellers. Meanwhile,
because it has the most sellers, it is the most compelling source
for buyers looking for nonstandard goods.
4. Cost AdvantageFirms that can figure out ways to provide Union Pacifics wide moat is partially based on efficient scale.
goods or services at lower cost have an advantage because On all but the busiest lanes, generally a single railroad serves
they can undercut their rivals on price. Alternatively, they an end-of-the-line shipper, and only two railroads operate in
may sell their products or services at the same prices as rivals, most regions in North America. Meanwhile, Medtronic benefits
but achieve a fatter profit margin. Wal-Mart is a textbook from efficient scale in the cardiac area, with roughly three
example of a low-cost producer because it can use its size competitors in total across its heart-related portfolio. The mar-
to acquire and distribute merchandise on the cheap, passing kets for pacemakers, implantable cardioverter defibrillators
part of the savings to its customers. (ICDs), coronary stents, and neuromodulation devices generally
operate as rational oligopolies.
5. Efficient ScaleThis is a dynamic where there is a limited
market size that is being effectively served by one or a Assigning Moat Ratings
small handful of companies. The companies that benefit from When assigning moat ratings, we first consider the five qualita-
this phenomenon are efficiently scaled to fit a market tive factors outlined above. But we also look for quantitative
that only supports one or a few competitors, limiting rivalry. evidence of a moat, namely, a companys ability to earn excess
No No
Morningstar Morningstar
Security Selection Morningstar Wide Moat Focus Index
US Market Index Moat Assignment Process
3 A broad market index, representing 3 Morningstar equity analyst assigns: 3 The 20 securities with the lowest
97% of U.S. equity market cap. Wide moat rating current market price/fair value
Fair value estimate estimate are selected for inclusion
3 Company cannot be under review at in the index.
time of stock assignment.
Source: Morningstar
returns on invested capital. The size of the spread between While many investors get caught up in daily stock price move-
ROIC and cost of capital is actually far less important than the ments, we prefer to think about valuation in the same way as
expected duration of the excess profits. When we believe you would a real asset, such as the house in the example above.
that a company will more likely than not benefit from a competi- There is a fair market value of any business, and opportunities to
tive advantage and earn excess returns for a period of at least purchase great businesses at less than that fair market value
10 years, we assign it a narrow moat rating. When were give investors an advantage in generating future returns.
near-certain that a firm will earn excess returns for the next
10 years, and likely for the next 20 years, we assign the Morningstar Wide Moat Focus Index
firm a wide moat rating. Clearly, the hurdle is high for earning In 2007, we introduced the Morningstar Wide Moat Focus Index
a wide moat rating. Despite scouring the universe of to capture the systemic sources of active returns resulting
listed companies, we have assigned wide moat ratings to from our Economic Moat Rating, outlined here. When construct-
approximately 200 companies globally. ing the Wide Moat Focus Index, we start with all U.S.-based
and U.S.-traded corporations with a wide moat rating (excluding
Importance of Valuation master limited partnerships), yielding approximately 150
Valuation is an incredibly important aspect of investingyou companies eligible for the index. Then the companies are sorted
could argue, the most important. It makes sense when you think by market price relative to Morningstar fair value estimates
about it: You wouldnt want to pay $650,000 for a house thats and to include the 20 securities trading at the largest discount
worth $500,000, because even if it were a great house, it would to fair value. The holdings are equally weighted, and the
take many years for the market to recognize the value of the index is rebalanced and reconstituted quarterly.
house as $650,000. At that point, you would have likely lost pur-
chasing power in real terms after inflation. Even if you bought Based on actual moat ratings assigned over the previous decade,
that same house for $500,000, or fair market value, you would the Wide Moat Focus Index has back-tested results starting in
see it appreciate only at the market rate of return. Ideally, youd mid-2002. As illustrated in Figure 6, the index has posted excep-
get an even better price on the house, perhaps buying it for tionally strong performance, beating approximately 95% of
$450,000, so you could benefit not only from the future market large-cap active funds since inception.
rate of return, but also from having the price converge from your
discounted price to the fair market value. Using Morningstars differentiated economic moat framework
in combination with the stock valuations that are based
on long-term projected cash flow, our process has produced
5 Morningstar Indexes 2014 15
Figure 6. Growth of a $10,000 Investment and Risk/Return (Sept. 20, 2002March 23, 2014)
Morningstar Wide Moat Focus Index Morningstar US Market Index U.S. Open-End Large-Blend Active Managers
60,000
54,743
50,000
40,000
31,224
26,158
20,000
10,000
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Total Returns
Standard Max
3-Years 5-Years 10-Years Deviation Sharpe Beta Drawdown
(%) (%) (%) (%) Ratio (%) (%)
Morningstar Wide Moat Focus Index 18.25 26.10 12.70 19.03 0.76 1.14 -42.43
Morningstar US Market Index 6.52 5.92 16.27 14.94 0.61 1.03 -50.76
U.S. Open-End Large-Blend Active Managers 5.88 6.16 14.96 14.63 0.52 1.01 -50.79
* Index performance data prior to October 2007 is hypothetical, but was calculated using the same methodology that has been in use by Morningstar since the index was first launched. As a result of the risks
and limitations inherent in hypothetical performance data, hypothetical results used in the above chart may differ from the actual index performance. Investors cannot directly invest in the index.
Source: Morningstar
Figure 7. Morningstar Wide Moat Focus Index Style Trail excess returns that have persisted through varying market
The index is plotted with each quarterly portfolio on the Morningstar environments. The strategies focused on economic moats have
Style Box. The February 2014 portfolio is circled in white. Given that performed well over the last decade, which has seen two
wide-moat companies tend to have larger capitalizations, the index
back-to-back commodity booms, a major financial crisis, a Great
has generally landed in the large-cap row over the past decade.
Recession, a boom-bust cycle in the housing markets, and
Morningstar Wide Moat Focus Index (Oct. 2002Feb. 2014) a surprisingly strong rebound in corporate earnings. If a pre-
requisite to properly evaluating an investment strategy is
looking at it across a variety of market environments, the past
Giant
Source: Morningstar