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Durable Competitive Advantages: Using Economic Moats to Improve Investment Returns. Pat Dorsey, CFA Director of Equity Research. Agenda. Our Approach to Competitive Analysis What is an Economic Moat What’s Not Where Morningstar Finds Moats Why Moats Matter

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Durable Competitive Advantages: Using Economic Moats to Improve Investment Returns

  • Pat Dorsey, CFA
  • Director of Equity Research
agenda
Agenda
  • Our Approach to Competitive Analysis
    • What is an Economic Moat
    • What’s Not
  • Where Morningstar Finds Moats
  • Why Moats Matter
  • Using Economic Moats in the Investment Process
what s a moat
What’s A Moat?
  • Capital seeks the areas of highest potential return, so all firms face competition that seeks to force down high returns on capital.
    • But some firms generate high returns for a very long time.
    • How? By creating economic moats around their businesses.
  • An economic moat is a structural business characteristic that allows a firm to generate excess economic returns for an extended period.
    • Note that “structural” means “inherent to the business.”
    • Smart managers and great execution are important, but they’re not structural attributes.
what s a moat1
What’s a Moat?
  • The key to having an economic moat is the sustainability of excess returns, rather than the absolute level of return on capital.
    • A company with 40% returns on invested capital (ROIC) due to a hot product has no moat. The returns cannot be forecasted with any level of confidence.
        • Fashion stocks (Crocs, Heelys), Motorola Razr
    • A company with 12% ROIC – and a low cost of capital – that is structurally protected from the competition may have a wide economic moat, because we can forecast those returns with a high degree of confidence.
        • Pipelines, Railroads
sources of economic moats
Sources of Economic Moats
  • Intangible Assets
    • Brands
    • Patents
    • Approvals & Licenses
  • Customer Switching Costs
  • The Network Effect
  • Cost Advantages
    • Process
    • Location
    • Unique Assets
    • Scale
sources of economic moats1
Sources of Economic Moats
  • Intangible assets
    • Brands: Does it increase the consumer’s willingness to pay, or reduce search costs?
        • Sony vs. Tiffany
        • Doublemint & Juicy Fruit
    • Patents: Valuable, but subject to expiration & challenge.
        • Big pharma vs specialty pharma
    • Licenses & Government Approvals.
        • Waste haulers, aggregate companies
sources of economic moats2
Sources of Economic Moats

×Switching Costs: Do the costs – in time or money – of switching to a competing product/service outweigh the benefits?

  • Monetary/Labor Costs
    • -Oracle
    • -Autodesk
    • -Data processors
  • Low or uncertain benefits from switching
    • -Amazon
    • -Asset managers
sources of economic moats3
Sources of Economic Moats
  • The Network Effect – One of the most powerful types of competitive advantage, which occurs when the value of a good or service increases with the number of users.
  • Examples of the Network Effect
    • eBay
    • Western Union
    • MasterCard, American Express, Discover, Visa
    • Microsoft
    • Financial Exchanges
sources of economic moats4
Sources of Economic Moats
  • Cost Advantages – Not necessarily tied to size
    • Process – Invent a cheaper way of delivering a good or service that rivals cannot (or will not) replicate. Dell, Nucor, Steel Dynamics, Southwest/other LCCs.
    • Low-cost resource base – Ultra Petroleum, Compass Minerals.
    • Scale
      • -Distribution – Stericycle, Cintas, Sysco, UPS
      • -Manufacturing – Intel
      • -Niche Markets/Single-Scale Efficiency – Graco, Blackbaud
what s not an economic moat
What’s Not An Economic Moat

Size / Dominant Market Share: High market share does not give a firm a moat. (Ask Compaq – or GM.) In fact, market share may be irrelevant – bigger is not necessarily better.

Technology: What one smart engineer can invent, another can improve upon. (Exception: Creating a standard that’s widely adopted.)

Easily-replicable cost advantages (lean manufacturing, outsourcing.)

Hot Products: Krispy Kreme, Tommy Hilfiger, Crocs, Iomega, etc.

Can generate high returns on capital for a short period of time, but sustainable returns are what make a moat.

what s not an economic moat1
What’s Not An Economic Moat
  • Management: Smart managers may create a moat over time, but great 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
    • Management matters, but moats matter more.
where morningstar finds economic moats
Where Morningstar Finds Economic Moats
  • Three groups: Wide, Narrow, and None.
  • Wide moats are tough to find. Less than 10% of the 2100 companies that we follow have wide economic moats. (169, to be precise.)
  • Moats vary by sector & industry.
    • Fewer moats in highly commoditized or competitive sectors like computer hardware, consumer services (retail/restaurants), or industrial materials. Only 1/3 of the companies in these three sectors are wide/narrow moat.
    • More moats in areas with high switching costs (data processors) and durable brands (consumer products),
why moats matter
Why Moats Matter

Moats add intrinsic value!

A company that is likely to compound cash flow internally for many years is worth more today than a company which isn’t.

Wide Economic Moat

Narrow Economic Moat

No Economic Moat

ROIC

ROIC

ROIC

Time Horizon

Time Horizon

Time Horizon

why moats matter1
Why Moats Matter

When comparing two companies with similar growth rates, returns on capital, and reinvestment needs, the company with the moat has a higher intrinsic value.

Underestimating a moat results in opportunity cost, while overestimating a moat can cause you to pay for value creation which never materializes.

Some fast-growing companies are worth the premium, because the excess returns are more likely to persist. If a firm has a wide moat that will allow it to reinvest cash flow at a high rate of return for many years, what looks expensive may actually be quite a bargain.

why moats matter2
Why Moats Matter

“Time is the friend of the wonderful business, affording it the opportunity to reinvest incremental capital at favorable rates and increase the value of the enterprise. Over time, the price you paid for a terrific company looks cheaper and cheaper. For the inferior business at the cheap price, time may turn out to be the fell destroyer.“

– Bob Goldfarb, Sequoia Fund

why moats matter3
Why Moats Matter

Moats enforce investment discipline.

High returns on capital will always be competed away – eventually.

For most companies (and their investors), the regression to the mean is fast and painful.

But a few generate excess returns for many years, and moats give us an analytical framework for selecting them.

why moats matter4
Why Moats Matter

Companies with moats have greater resilience.

If a firm can fall back on a structural competitive advantage, it’s more likely to recover from temporary troubles.

This is a great psychological backstop for the investor who’s buying when everyone else is screaming “sell!”

If you’re confident in the moat, it’s easier to average down if you initiate a position too early.

isn t the moat already priced in
Isn’t the Moat Already Priced In?
  • Short answer: Sometimes, but less frequently than you might think.
  • Long answer:
    • Most market participants own securities for short time periods, and moats matter much more in the long run than over the short term. (Time-horizon arbitrage.)
    • Recency bias causes most investors to assume that the current state of the world (good or bad) persists for longer than it usually does.
    • Our performance record suggests that waiting for wide moats to become cheap is a compelling strategy.

18

wide cheap
Wide + Cheap
  • The Wide Moat Focus is an index of our 20 most undervalued wide-moat stocks. Holdings are equally-weighted and rebalanced quarterly.

Returns through 9/18/2009 * Annualized returns Source: Morningstar

more on moats
More on Moats
  • Competitive Strategy, by Michael Porter (Free Press, 1998)
  • The Essays of Warren Buffett, compiled by Lawrence Cunningham (John Wiley, 2002) .
    • Berkshire letters are also free at www.berkshirehathaway.com
  • Competition Demystified, by Bruce Greenwald (Penguin, 2005)
  • Annual Reports – The more, the better. Build that mental database!
  • The Halo Effect, by Phil Rosenzweig (Free Press, 2007)
more on moats1
More on Moats
  • The Little Book that Builds Wealth, by Pat Dorsey (John Wiley, 2008)
contact information
Contact Information

Patrick Dorsey

Director of Research

Morningstar, Inc.

+1 312.696.6560

[email protected]

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Durable Competitive Advantages: Using Economic Moats to Improve Investment Returns

  • Pat Dorsey, CFA
  • Director of Equity Research
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