ppt morningstar economic moats iii_excellent

7/23/2019 PPT Morningstar Economic Moats III_Excellent

http://slidepdf.com/reader/full/ppt-morningstar-economic-moats-iiiexcellent 1/22

<#>

© 2008 Morningstar, Inc. All rights reserved.

Durable Competitive Advantages: Using

Economic Moats to Improve Investment Returns

×

Pat Dorsey, CFADirector of Equity Research



2

Agenda

×Morningstar’s 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



3

What’s A Moat?

×

Capital seeks the areas of highest potential return, so all firms facecompetition 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 allowsa 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, butthey’re not

structural attributes.



4

What’s a Moat?

The key to having an economic moat is the sustainability of excessreturns, rather than the absolute level of return on capital.

A company with 40% returns on invested capital (ROIC) dueto a hot product has no moat. The returns cannot beforecasted with any level of confidence.

Fashion stocks (Crocs, Heelys), Motorola RazrA company with 12% ROIC – and a low cost of capital – that

is structurally protected from the competition may have awide economic moat, because we can forecast those returns

with a high degree of confidence.

Pipelines, Railroads



5

Sources of Economic Moats

×

Intangible Assets

×

Brands

×

Patents

×

Approvals & Licenses

×

Customer Switching Costs

×

The Network Effect

×

Cost Advantages

×

Process

×

Scale

×

Low-cost resources



6


×

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



7


×Switching Costs: Do the costs –

in time or money –

of switching toa competing product/service outweigh the benefits?

×

Monetary/Labor Costs

-Oracle-Autodesk

-Jack Henry

×

Low or uncertain benefits from switching

-Amazon

-Asset managers



8


×

The Network Effect

–

One of the most powerful types of competitiveadvantage, which occurs when the value of a good or serviceincreases with the number of users.

×

Examples of the Network Effect×

MasterCard, American Express, Visa

×

iPhone apps

×

Microsoft

×

Financial Exchanges



9


×

Cost Advantages

–

Not necessarily tied to size

×

Process

–

Invent a cheaper way of delivering a good or servicethat rivals cannot (or will not) replicate.

×

Dell, Nucor, Steel Dynamics, Southwest/other LCCs.

×

Scale

×

Distribution –

Stericycle, Cintas, Sysco, UPS

×

Manufacturing –

Intel

×

Niche Markets/Single-Scale Efficiency –

Graco,

Blackbaud

×

Low-cost resource base –

Ultra Petroleum, Compass Minerals.



10

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 beirrelevant –

bigger is not necessarily better.

×

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

×

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

Hot Products: Can generate high returns on capital for a short periodof time, but sustainable

returns are what make a moat.



11

What’s Not

An Economic Moat

×

Management: Smart managers may create

(or destroy) a moat overtime, but great management is not a moat by itself.

×

"Go for a business that any idiot can run –

because sooner orlater, any idiot probably is going to run it." –

Peter Lynch

×

“When management with a reputation for brilliance tackles abusiness with a reputation for poor economics, it is thereputation of the business that remains intact.”

–

Buffett

×

Management matters, but moats often matter more.



12

Where Morningstar Finds Economic Moats

×Three groups: Wide, Narrow, and None.

×Wide moats are tough to find. Less than 10% of the 1800 companiesthat we follow have wide economic moats. (165, to be precise.)

×Moats vary by sector & industry.

×

Fewer moats in highly commoditized or competitive sectorslike computer hardware, consumer services(retail/restaurants), or industrial materials. Only 1/3 of thecompanies in these three sectors are wide/narrow moat.

×

More moats in areas with high switching costs (data

processors) and durable brands (consumer products),



13

Why Moats Matter

×

Moats add intrinsic value!

×

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

Wide Economic Moat No Economic MoatNarrow Economic Moat

R O I C

R O I C

R O I C

Time HorizonTime Horizon Time Horizon



14

Why Moats Matter

×

When comparing two companies with similar growth rates, returnson capital, and reinvestment needs, the company with the moat has a

higher intrinsic value.×

Underestimating a moat results in opportunity cost, whileoverestimating a moat can cause you to pay for value creation which

never materializes.×

Some fast-growing companies are worth the premium, because theexcess 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 manyyears, what looks expensive may actually be quite a bargain.



15

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 tothe mean is fast and painful.

×

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



16

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’sbuying when everyone else is screaming “sell!”

×

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

×

Key question to ask yourself when negative news hits

is simple: Does the information affect the company’scompetitive advantage?



17

So, I Should Only Buy Wide Moat Stocks?

×Short answer: Well, that depends.

×Long answer:

×

There’s nothing “wrong”

with no-moat stocks –

if purchasedat a sufficiently cheap price, they can be great investments.

×

Wide moat companies are neither better nor worse than no

moat companies –

they’re just different.

×

Understanding which companies in your portfolio havecompetitive advantages and which don’t can improve

portfolio management in two important ways:×

Valuation

×

Position sizing & making good sell decisions.



18

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 timeperiods, and moats matter much more in the long run thanover the short term. (Time-horizon arbitrage.)

×

Recency

bias causes most investors to assume that thecurrent state of the world (good or bad) persists for longerthan it usually does.

×

Empirical evidence suggests that waiting for wide moats tobecome cheap is a compelling strategy.



Performance: Wide + Cheap

Returns through 6/08/2010

* Annualized returns

Source: Morningstar

YTDTrailing

1-YearTrailing

3-Year*Trailing

5-Year*

Morningstar Wide Moat FocusIndex -6.3% 15.5% 0.6% 6.5%

S&P 500 Index -3.9% 15.4% -9.0% -0.3%



20

More on Moats

×

Competitive Strategy, Michael Porter (Free Press, 1998)

×

The Essays of Warren Buffett, compiled by Lawrence Cunningham (JohnWiley, 2002) .

×

Berkshire letters are also free at www.berkshirehathaway.com

×

Competition Demystified, Bruce Greenwald (Penguin, 2005)

×

Annual Reports –

The more, the better. Build that mental database!

×

The Halo Effect , Phil Rosenzweig

(Free Press, 2007)



21

More on Moats

×

The Little Book that Builds Wealth, by Pat Dorsey (John Wiley, 2008)



Durable Competitive Advantages: Using

Economic Moats to Improve Investment Returns

×

Pat Dorsey, CFADirector of Equity Research

[email protected]

+1 312 696 6560

mailto:[email protected]



ppt morningstar economic moats iii_excellent

Documents