At the Morningstar Investment Conference held in Mumbai in October 2015, Sanjoy Bhattacharyya, Managing Partner, Fortuna Capital, moderated a session on moats and equity investing. Here is an extract of him in conversation with Lorraine Tan, Morningstar's director of equity research for Asia.
What are your thoughts on a shrinking moat? There are fads and cycles. Do you tweak to the franchise investing approach to deal with it when it goes out of fashion or do you need to be a purist?
When the Morningstar Equity Research teams look at moats, it's one of the various things we look at.
Obviously, valuation plays a role as well.
We look at situations concerning where you jump ship; for example, if the moat is going to disappear. That's why we put a particular emphasis on looking at moat trends as well.
You could have a company that has no moat and if it's doing things and has got a positive moat trend, it puts that company on your radar screen.
You could have a situation where the moat disappears.
Take the example of PetroChina, a huge state-owned enterprise in China. Probably 10-20 years ago it definitely had a moat.
This is a heavily regulated company, protected by the government. Naturally, you think that's very defensive. But Morningstar currently does not have a moat on this company. Because PetroChina's key oil and gas field in China is actually maturing and the cost of deriving oil from that field is actually rising.
So we look at the direction in which the company is headed and whether it's going to be vulnerable, and if it’s moat is vulnerable. We ensure that we drill down to the qualitative aspect of their assets.
Microsoft, Apple and Samsung are all highly regarded brands. Everybody knows Apple, probably one of the most popular brands at the moment. Morningstar has assigned Apple a narrow moat, Microsoft a wide moat and Samsung has no moat. The premise for Microsoft’s wide moat is that when you look at its business, it's in the enterprise space where the switching costs are very high.
Antitrust is something that has dodged Microsoft constantly, both in Europe and in the U.S. Antitrust strikes at the heart of that wide moat….
Regulatory issues are always going to present a risk.
Can a company which has tremendously high regulatory risk have a wide moat?
It can still. In the case of Microsoft – I believe most of us are running Microsoft at our workplace. Nowadays, even if it doesn't necessarily come bundled with our hardware, we're still going to end up using it and I think that's where it's very sticky.
Obviously the financial returns are there as well.
The key to the sustenance of moats is stewardship or capital allocation, often referred to as corporate governance. Rational, sensible capital allocation and high-quality stewardship is important to extend the longevity of the moat. How do you identify that and seek it out?
We've got three rankings for stewardship: exemplary, standard and poor. The majority fall into standard category. There's very few percentage-wise that are exemplary, similar to wide moats.
What we're looking at is the history of really any aspects that sort of protect the minority shareholder. First and foremost, to look after the interest of the minority shareholders, could be through a history of dividend payouts. You want to get the returns if there's excess cash to give it back to the shareholders.
All the decisions made are essentially to ensure that the minorities get a fair deal. Those are the aspects we look at, decisions that the company makes. There are moaty companies, however, who may have poor stewardship.
So you can have a company which has an incredibly strong franchise and poor stewardship.
We do have a resource company in India which has a narrow moat because its assets are very low costs. However, its parent has a tendency to try and inject things at a higher level. So, that's an example of poor stewardship but a moaty company. This company could remain with a narrow moat for a period of time.
In India, how do you deal with the challenge of the fact that the companies with the strongest franchises demand that you pay a pitiful and often an aggressive price to own them?
First and foremost, we would look at the valuation. There is going to be a range of premiums you're looking at. I would focus definitely on those that are trading more fair.
Your time horizon is important as well. The moats, as Morningstar has noted, work best when you've got a 3-5 year time horizon. We're really looking at companies that have these characteristics for at least 10 years anyway. So, what we're saying is that you can still pay a slight premium if you have a longer time horizon.
Can a franchise investor ever be contrarian?
I think he can.
For example, a contrarian sector. At the moment you have energy, definitely out of favour, oil and gas. So, at this point in time we have stocks that we do like in energy space - basically they are low-cost operators.
With oil prices this low, obviously their margins have come down. In some cases, their ROIC may not even be above their WACC at this stage. But when we look at moats we take a 5-year perspective and we want to know whether this company is going to still be ROIC positive or over its WACC at the mid-cycle point. The main thing is what we think are going to be the sustainable returns.
This is where the uncertainty creeps in: How do you figure out where oil prices are going to be two years from now?
You trust your research on that. You could do a scenario if you want. So, at the moment we're saying $50 for the next few years, but we're taking mid-cycle price $65-70…
So, you're relying on history, mean reversion, a bunch of other things….
Yes mean reversion, supply-demand……
You're saying that it's got to get back to $50 or else we'll have chaos in certain parts of the world and that won't be tolerated.
Exactly. So, you could do a stress test if you wanted to.
Unidentified Speaker: Do you think a moat is relevant in the case of technology? Is technology changing the way the moat has been defined? Take Walmart for example…..
That's why it’s important to look not just at moats but the moat trend. See whether there are any developments there that is going to create a negative bias to the moat and so, if that's the case, the premium that you want to pay should not be there.
Another example of a sector that was kind of sleepy but does have a nice moat is analog chips and analog chips are now getting growth because they are increasingly put into cars and sensors, electronics…
And it's a great moat story because there are very high switching costs, it's a very design-specific and they are very cheap to make. So, you won't have a Chinese company trying to undercut you on that. It doesn't make sense for your customer to buy cheap. So, that goes both ways I think in terms of what's going on with technology.
