Why Moats Matter

Incorporate economic moat analysis for profitable investing

Why Moats Matter is a comprehensive guide to finding great companies with economic moats, or competitive advantages. This book explains the investment approach used by Morningstar, Inc., and includes a free trial to Morningstar's Research.

Economic moats—or sustainable competitive advantages—protect companies from competitors. Legendary investor Warren Buffett devised the economic moat concept. Morningstar has made it the foundation of a successful stock-investing philosophy.

Morningstar views investing in the most fundamental sense: For Morningstar, investing is about holding shares in great businesses for long periods of time. How can investors tell a great business from a poor one? A great business can fend off competition and earn high returns on capital for many years to come. The key to finding these great companies is identifying economic moats that stem from at least one of five sources of competitive advantage—cost advantage, intangible assets, switching costs, efficient scale, and network effect. Each source is explored in depth throughout this book.

Even better than finding a great business is finding one at a great price. The stock market affords virtually unlimited opportunities to track prices and buy or sell securities at any hour of the day or night. But looking past that noise and understanding the value of a business's underlying cash flows is the key to successful long-term investing. When investors focus on a company's fundamental value relative to its stock price, and not where the stock price sits today versus a month ago, a day ago, or five minutes ago, investors start to think like owners, not traders. And thinking like an owner will makes readers better investors.

The book provides a fundamental framework for successful long-term investing. The book helps investors answer two key questions: How can investors identify a great business, and when should investors buy that business to maximize return?

Using fundamental moat and valuation analysis has led to superior risk-adjusted returns and made Morningstar analysts some of the industry's top stock-pickers. In this book, Morningstar shares the ins and outs of its moat-driven investment philosophy, which readers can use to identify great stock picks for their own portfolios.

Preface ix

Acknowledgments xi

Chapter 1 Guiding Principles of Morningstar’s Equity Research 1

Question 1: How Can We Identify Which Businesses Are Great? 2

Question 2: When Is the Best Time to Invest in Great Businesses? 6

Chapter 2 What Makes a Moat? 11

Moat Sources 13

Notes 33

Chapter 3 Why Moat Trends Matter 35
Contributed by Stephen Ellis, a member of Morningstar’s Economic Moat Committee and head of Financial Services equity research at Morningstar

Moat Trends and Fundamental Performance 37

Five Key Considerations for Moat Trends 38

Intangibles 41

Cost Advantage 44

Switching Costs 47

Network Effect 51

Efficient Scale 54

Best Practices for Moat Trend Analysis 57

Chapter 4 How Stewardship Affects Economic Moats 61
Contributed by Todd Wenning, who oversees Morningstar’s equity stewardship methodology

Meet Our Stewardship Methodology 62

Drilling Down 63

Chapter 5 Applying Moats to Dividend Investing 81
Contributed by Josh Peters, director of equity-income strategy for Morningstar and editor of the Morningstar® DividendInvestorSM newsletter

Why Dividends Matter 83

Which Dividends? 87

Chapter 6 The Importance of Valuation 93
Contributed by Joel Bloomer, Matt Coffina, and Gareth James, members of Morningstar’s Moat Committee and contributors to Morningstar’s valuation methodology

Valuation Concepts 95

Cost of Capital and Returns on Capital 96

Morningstar’s Valuation Approach 97

Example: Calculating ROIC 99

Forecasting Future Free Cash Flows 102

The Morningstar RatingTM for Stocks 106

Fair Value Uncertainty and Cost of Equity 107

Notes 111

Chapter 7 Do Moat Ratings Predict Stock Returns? 113
Contributed by Warren Miller, head of quantitative research at Morningstar

Chapter 8 Putting Moat and Valuation to Work: Portfolio Strategies 121

Wide Moat Focus Index 121

The Tortoise and Hare Portfolios 124

Chapter 9 Basic Materials 129

Commodity Manufacturers 130

Commodity Processors 133

Metals and Mining 135

Chapter 10 Consumer 139

Beverages 140

Consumer Products 141

Tobacco 143

Restaurants 144

Retail Defensive 146

Specialty Retail 148

Lodging 149

Notes 151

Chapter 11 Energy 153

Oil and Gas Drilling 154

Oil and Gas Exploration and Production 156

Oil and Gas Midstream 158

Refining 159

Oil and Gas Integrateds 161

Engineering Services 163

Chapter 12 Financial Services 167

Banks 168

Capital Markets 170

Credit Services 172

Financial Exchanges 173

Insurance 174

Chapter 13 Healthcare 177

Pharmaceuticals 178

Biotechnology 180

Medical Devices 182

Medical Instruments and Supplies 184

Diagnostics and Research 185

Chapter 14 Industrials 187

Railroads 188

Airport Operators 190

Aerospace and Defense 191

Trucking and Marine Shipping 192

Waste Management 193

Heavy Equipment 195

Diversified Industrials 197

Chapter 15 Technology 199

Consumer Technology 200

Enterprise Hardware Systems 202

IT Services 203

Semiconductors 205

Software 207

Telecom Services 209

Chapter 16 Utilities 211

Regulated and Diversified Utilities 212

Independent Power Producers 214

About the Authors 217

Index 221

Heather E. Brilliant, CFA, Co-Chief Executive Officer, Morningstar Australasia
Prior to assuming her current role, Brilliant led Morningstar's global equity and corporate credit research teams, consisting of more than 120 analysts, strategists, and directors. Brilliant is a member of the CFA Institute Board of Governors and is a past chair of the CFA Society of Chicago.

Elizabeth Collins, CFA, Director of Equity Research, North America, Morningstar
Collins is responsible for leading Morningstar's team of North American-based equity research analysts. She has served as chair of Morningstar's Economic Moat committee, a group of senior members of the equity research team responsible for reviewing all Economic Moat and Moat Trend ratings issued by Morningstar.

Morningstar is a leading provider of independent investment research in North America, Europe, Australia, and Asia. We offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.
To find out more about Morningstar’s approach to stock investing and receive a free trial of our research, visit: www.global.morningstar.com/whymoatsmatter

Just as physical moats protect castles from enemies, economic moats—or sustainable competitive advantages—protect companies from competitors. Legendary investor Warren Buffett devised the economic moat concept. Morningstar has made it the foundation of a successful stock-investing philosophy.

At Morningstar, we've always viewed investing in the most fundamental sense: We want to hold shares in great businesses for long periods of time. How can you tell a great business from a poor one? A great business can fend off competition and earn high returns on capital for many years to come. The key to finding these great companies is identifying economic moats that stem from at least one of five sources of competitive advantage—cost advantage, intangible assets, switching costs, efficient scale, and network effect—each of which we explore in great depth.

Even better than finding a great business is finding one at a great price. The stock market affords virtually unlimited opportunities to track prices and buy or sell securities at any hour of the day or night. But looking past that noise and understanding the value of a business' underlying cash flows is the key to successful long-term investing. When you focus on a company's fundamental value relative to its stock price, and not where the stock price sits today versus a month ago, a day ago, or five minutes ago, you start to think like an owner, not a trader. And thinking like an owner will make you a better investor.

As you've probably guessed, this book won't tell you how to get rich quick by juggling stocks. What it will give you is a fundamental framework for successful long-term investing. The book will help you answer two key questions: How can I identify a great business, and when should I buy that business to maximize my return? If you get these two things right more often than not, you're well on your way to investing success.

Ours is not the only valid method for investing in stocks, but it's one that has worked well over the years. Using fundamental moat and valuation analysis has led to superior risk-adjusted returns and made Morningstar analysts some of the industry's top stock-pickers. In this book, we share all the ins and outs of our moat-driven investment philosophy, which you can use to identify great stock picks for your own portfolio.

To find out more about Morningstar's approach to stock investing and receive a free trial of our research, visit: www.global.morningstar.com/whymoatsmatter

"The search for the enduring economic moat is the holy grail of value investing. These modern-day protected business castles allow their owners to earn high returns on capital, the ultimate goal for any long-term investor. In Why Moats Matter, Heather Brilliant and Elizabeth Collins provide a wonderfully detailed map to help both small and large investors find these great companies."
—John W. Rogers Jr., founder, chairman, and chief investment officer, Ariel Investments

"Morningstar's Economic Moat framework is a useful complement to Michael Porter's five forces model, as it approaches the issue of franchise quality from an investor's perspective. Armed with Morningstar's moat framework, I've been able to make better assessments of companies' competitive positions, which is a critical element of my stock-picking process."
—Michael Luciano, investment analyst and U.K. pilot fund manager, Fidelity Worldwide Investment