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7/23/2019 PPT Morningstar Economic Moats III_Excellent
http://slidepdf.com/reader/full/ppt-morningstar-economic-moats-iiiexcellent 1/22
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© 2008 Morningstar, Inc. All rights reserved.
Durable Competitive Advantages: Using
Economic Moats to Improve Investment Returns
×
Pat Dorsey, CFADirector of Equity Research
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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
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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.
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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
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Sources of Economic Moats
×
Intangible Assets
×
Brands
×
Patents
×
Approvals & Licenses
×
Customer Switching Costs
×
The Network Effect
×
Cost Advantages
×
Process
×
Scale
×
Low-cost resources
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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
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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Sources of Economic Moats
×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
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Sources of Economic Moats
×
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
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Sources of Economic Moats
×
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.
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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.
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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.
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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),
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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
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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.
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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.
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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?
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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.
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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.
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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%
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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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)
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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More on Moats
×
The Little Book that Builds Wealth, by Pat Dorsey (John Wiley, 2008)
7/23/2019 PPT Morningstar Economic Moats III_Excellent
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Durable Competitive Advantages: Using
Economic Moats to Improve Investment Returns
×
Pat Dorsey, CFADirector of Equity Research
+1 312 696 6560