At Morningstar, we believe economic moats are one of the keys to investing success. We're suggesting finding companies that have carved a moat around their business that keeps competitors at bay.
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Narrator: Individual investors may assume that the deck is stacked against them compared with sophisticated institutions. They see these large investors piling money into private equity deals and getting in on the ground floor on the next hot IPO. But individuals with a long-term time horizon can have some distinct advantages over those that are more focused on the near term.
Instead of being worried about what is going to happen next quarter or even next year, individuals can truly take a long-term view of the world and this gives them a distinct perspective.
Heather Brilliant, CEO, Morningstar Australasia: We really like to think like owners of the businesses that we're investing in. I would liken this to the way Warren Buffett thinks about investing. Buffett has had a lot of influence on our philosophy over the years, but generally speaking we really like to think about buying a stock as owning a piece of the underlying business.
Narrator: The stock market gives you a chance to own great businesses from Johnson & Johnson to Amazon to McDonald's and, yes, even to Berkshire Hathaway. But how do you identify firms that are truly going to be able to withstand competition for years to come. At Morningstar, we've developed a framework to help investors find these companies, figure out the best time to buy them, and help investors build wealth over time.
Brilliant: We're really looking for a couple of factors when we're trying to find businesses that have an economic moat.
The first is that we look at a qualitative list of different factors or sources of moat that we've identified over our research over the past decade or so.
The other is really on the quantitative side; we're looking for literally a calculation of return on invested capital to exceed the cost of capital in the future.
We have found over our decade-plus of experience in studying moats that companies with wide moats literally have lower risk than companies with no moats. They have a structural advantage to their business itself that helps them compete effectively against other companies in their industry and all of those things really help set them up for establishing a very long track record of strong cash flow generation.
Matt Coffina, Editor and Portfolio Manager, Morningstar StockInvestor: You take a company like Coca-Cola, people enjoy Coca-Cola's products about as much now as they did 20 years ago or 50 years ago even, and we're pretty confident that people are going to still enjoy Coca-Cola products just as much 20 years from now, maybe even 50 years from now.
When you think about a company that wouldn't have an economic moat, let's take Crocs for example. Crocs was a very hot product a couple of years ago and very trendy for a while, but the company never had an economic moat. It was just a fashion that quickly went out of fashion. And that's the kind of company that's much harder to predict how much sales they can generate in the short run and what people are really going to think of that product over the long run, versus something that's has a lot more history and is a lot more engrained in our society like Coca-Cola.
We have identified five major sources of competitive advantage or economic moat.
1) Intangible assets
This includes brands, patents, or government licenses that explicitly keep competitors away from that same business.
Brilliant: We see that for example with companies like Tiffany where customers are willing to pay 25% to 30% more for a Tiffany diamond than one available on any Jeweler's Row in America.
Elizabeth Collins, Morningstar's Director of Equity Research, North America: We see these in health care, for example, where a company develops a drug and then they have really a protected monopoly for the period of the patents that matter. And competitors are legally barred from entering the market.
2) Customer switching costs
Those are one-time inconveniences or expenses that a customer incurs to change from one product to another. Customers facing high switching costs often won't change providers unless they are either offered a large improvement in price or performance, and even then, the risk associated with making a change may still prevent switching in some industries.
Coffina: A good example might be Oracle. They have database software that's very essential to their customers' businesses, and if anyone tried to switch away from using Oracle's database, they risk a huge amount of disruption to their core business.
3) Cost advantage
Firms that have the ability to provide goods or services at lower costs, have an advantage because they can undercut their rivals on price. They may also sell products or services at the same prices as rivals, but achieve fatter profit margins. We also consider economies of scale to be a type of cost advantage.
Collins: A good example of a company with, let's say, a natural-resource-based cost advantage would be Compass Minerals. It's a producer of salt and specialty fertilizer. They have access to the world's largest salt mine and access to one of the world's three only solar evaporation facilities on the Great Salt Lake for the production of specialty fertilizer. This means that they're able to produce these commodities at a cost much lower than their competitors, and these are ultimately irreplaceable because you can't create a salt mine or a salt deposit that's underground, and the Great Salt Lake is one of three similar lakes in the world.
4) The network effect
This occurs when the value of a particular good or service increases for both new and existing users, as more people use that good or service. That can create a virtuous cycle that allows strong companies to become even stronger.
Coffina: A network effect occurs in a situation like MasterCard, where the more merchants accept MasterCard, the more valuable it is to cardholders. The more cardholders use MasterCard, the more merchants have to accept it. Both sides benefit as more people use the service.
5) Efficient scale
Efficient scale describes the dynamic in which a market of limited size is effectively served by one or just a few companies. The companies involved generate economic profits, but potential competitors are discouraged from entering because doing so would result in insufficient returns for all players.
Collins: Imagine a pipeline that transports oil from City A to City B. It wouldn't make sense for another pipeline company to build a similar pipeline along the same corridor because the capacity utilization for both pipelines would be substandard, and neither company would generate suitable economic profits.
Brilliant: In addition to the qualitative elements of the sources of moats that we've identified, we also will look quantitatively for businesses that can generate returns for shareholders well into the future. Now there's many different ways to measure returns, and the way we like to look at it would be to look at what we call return on invested capital, which is really just the idea that we want to look at the return a business can generate relative to the investments the business needs to make in order to generate that return.
So if you have a company that has to invest $1 billion just to make $100,000 every year, that's probably not worth it at the end of the day because that return that you're getting on that incremental dollar invested is not very high. But on the other hand, some businesses have to invest very, very little in order to generate tremendous returns, and we see that in what we would call asset-light businesses, or businesses that don't require a lot of high capital or a lot of capital intensity in order to function well.
Narrator: But there is no magic level of returns on invested capital that automatically means a company has a moat.
Brilliant: The persistence of excess returns is much, much more important than the magnitude of excess returns.
Narrator: Railroads are an example of an industry where the persistence of returns is more important than the level of returns. We assign a wide moat rating to all of the North American Class 1 railroads due to their cost advantage over other forms of long-haul shipping across land as well as the railroads' efficient-scale advantage since building a new railroad would be virtually impossible today.
Keith Schoonmaker, Director of Industrial Equity Research and Equity Analyst at Morningstar: When it comes to long-haul shipping of freight or goods across the land, railroad is hard to beat. Certainly barging is less expensive if there's a river handy, but for routes where there is not a convenient river transporting the goods from origin to destination, railroading is going to be the most economical for any kind of long haul. Its advantage over trucking are obvious; it has quadruple the fuel efficiency per ton mile, and as far as use of manpower per container, for example, the railroads have a tremendous advantage over trucking.
Canadian Pacific has recently made changes that the rest of the industry made earlier in the past decade. However, the velocity and magnitude of changes that CP has made in the past year and a half have been simply breathtaking. The new CEO, Hunter Harrison, who came in about 18 months ago, continues to aggressively reduce assets. In fact, he has identified about $2 billion worth of assets that can be liquidated for cash that the railroad no longer needs. We would expect him to continue to press CP operations to increase velocity, thereby reducing the number of locomotives and cars it needs, and in general to continue to escalate operations.
Hunter Harrison, President and CEO, Canadian Pacific Railway : If you ask the competition, they'd say that we're very good at cost control. You've got to keep some balance with that issue of cost control, but clearly it's an advantage to be the low-cost carrier. As we started this journey, when we were 10 or 12 points on a margin behind the competition, it's very, very tough. There is business they can handle that we can't touch. So, as your costs come under control, it opens up your markets and expands it.
At the same time, we have always seen, contrary to conventional wisdom, compatibility between low-cost and good service. If you understand and recognize that and can put those two together, it's a pretty simple agenda, but it's pretty successful. I've always been a believer that we don't set the price; the market does. We effectively say whether we want to play or not. Here's the market, here's where we go to be to be competitive, and can we get our costs down to where we can be effective and competitive there. When it gets to the point that you either can become efficient or effective, or else you lose the market, then it inspires people to control costs better and to maintain that status of low-cost carrier.
Narrator: Another firm that earns a wide moat is Facebook. FB has over 1.2 billion monthly active users, making it by far the largest social network on the Web.
Rick Summer, Sr. Product Manager, Mobile Solutions at Morningstar: I think FB really truly has a wide moat because it is a network. It has that social network, and you think of the old-line phone system where everyone has to connect to some sort of interchange to be able to connect to other people.
FB is very unique with the fact that you've got to sign up for it and you create these friends and you create a network maybe even of professional friends or family and you can do different things with that.
I think it has to go a little bit beyond that, though. So, it has to be repeatable; it has to be something that's really almost indispensable, not necessarily as part of your daily life, but at least some sort of recurring fashion, as well. So it's something that's not going to be easily replaced, whatever you're doing out there. Clearly the way folks are messaging back and forth, sharing pictures, sharing comments, and sharing news stories, it ends up being very interesting how that dialog happens. But most important, you've got to make money from it. And the ability for FB to actually monetize that network, to turn those people into eyeballs that advertisers are very excited about, primarily because they know so much about each individual user, all of that together really creates quite a compelling economic moat.
Narrator: As you may suspect, these great businesses are rare, but even the greatest company can be a bad investment if you overpay. So how do you decide when it is the right time to buy? We shall tackle that in the next article.
