Wide Moat Investing - CFA Institute · of revenue Southern Company Utilities have natural geographic monopolies, but regulations ... AT&T and Verizon eliminates economic ... or dissipate

©2016 Morningstar, Inc. All rights reserved.

Heather Brilliant, CFA

May 2016

Wide Moat Investing

2

Morningstar® Economic Moat™ Rating

Sustainable competitive advantages that allow a company to generate positive economic profits for the benefit of its owners for an extended period of time.

Morningstar Equity Research

Wide 15%

Narrow 45%

None 40%

Wide Narrow None

3

Sources of Economic Moat

There are five sources of economic moats.


Intangible Assets

Switching Costs

Network Effect

Cost Advantage

Efficient Scale

4

Measuring an Economic Moat

Duration of excess returns is far more important than absolute magnitude.


Ret

urn

on In

vest

ed C

apita

l (R

OIC

)

No Moat Narrow Moat Wide Moat

Time Horizon:

Weighted

Average

Cost of Capital

10 Years 20 Years


5

Sustainable competitive advantage drives value creation.

Growth Profitability Invested Capital Free Cash Flow

Competitive Advantage Economic Profit

Why Moats Matter

6

Why Moats Matter: Moats Increase Intrinsic Value


0.0%

20.0%

40.0%

60.0%

80.0%

2016 2021 2026 2031 2036 2041 2046 2051 2056 2061

Wide Economic Moat Stage I Stage II STAGE III WACC

0.0%

5.0%

10.0%

15.0%

20.0%

2016 2021 2026 2031 2036 2041 2046 2051 2056 2061

Narrow Economic Moat Stage I Stage II STAGE III WACC

7

Research Methodology

Our award-winning analysts rely on a proven methodology.


8

Examples of Wide, Narrow, and No Moat Companies


Intangible Assets

Switching Costs

Network Effect

Cost Advantage

Efficient Scale

Coca Cola

It’s just sugar water,

but consumers pay

a premium

Oracle

Switching from

Oracle’s tightly

integrated databases

could cause massive

disruptions

MasterCard

Each additional user of

the MasterCard brand

increases its value to

others.

Novo Nordisk

Entering insulin market

requires significant

upfront costs, and

Novo controls more

than 1/4 of the market.

Canadian National

Cost advantages,

efficient scale, and

network effect form

a steep barrier to entry

Adidas

Has strong and well-

recognized brand in

athletic footwear.

Workday

Switching costs with

initial product set, but

still need to see

success integrating a

large number of

products.

United Health

Sizable membership

and solid provider

network allows firm to

scale its fixed costs

FedEx

The high fixed-cost air

express segment

is still a large portion

of revenue

Southern Company

Utilities have natural

geographic

monopolies, but

regulations

restrain returns

United Continental

Name recognition

doesn’t result in

sufficient pricing

power

Macy’s

Consumers easily

pick and choose

among many retailers

Deutsche Telekom

Despite its scale, it has

not been able to

generate returns above

its cost of capital

Alcoa

Low-cost bauxite

resources can’t offset

industry oversupply

Sprint

Lacking scale versus

AT&T and Verizon

eliminates economic

profit

9

Morningstar® Economic Moat™ Trend


10

Moat Trend is a detectable direction of change in the competitive position of a company’s businesses.


gPositive Trend The underlying sources (or potential sources) of an economic moat must be materially strengthening for an identifiable reason

gNegative Trend The underlying sources (or potential sources) of an economic moat must be materially weakening or face a substantial and identifiable threat that is growing

No Moat Narrow Moat Wide Moat

Positive Trend

Negative Trend

Stable

Ret

urn

on In

vest

ed C

apita

l (R

OIC

)

Time Horizon: 10 Years 20 Years

11


A change in moat trend doesn’t indicate a change in moat rating. It’s an alert that competitive advantages could extend further into the future, or dissipate sooner than we initially forecast.


12

Examples of Positive, Stable, and Negative Moat Trend Companies


Wide Moat Narrow Moat No Moat

Salesforce.com

Switching costs continue to grow, as

companies increase their spending

with the firm faster than other

vendors.

FedEx

Enjoying a strengthening network

effect, driving by growth, better

margins, and market share gains.

Panera Bread

Increasing pricing power evidence of

an improving intangible asset.

3M

Ongoing investment in support of

intangible assets perpetuates a self-

sustaining new product development

cycle.

Ross Stores

Competition likely to increase, but

continued growing scale at Ross

should offset major threats.

Marathon Oil

High-quality U.S. portfolio increasing

in contribution, but the company’s

overall relative competitive position is

likely to remain unchanged.

Wal-Mart

Shift to e-commerce will likely take

share and make large Wal-Mart stores

less productive at the margin.

Nasdaq

Still a major player, but competition in

the trading space remains fierce.

Ford Motor Co

Excess capacity will probably become

even worse going forward given

minimal barriers to entry.

13

Moat Committee Members

Adam Fleck, CFA Consumer Chicago

Allen Good, CFA Energy Amsterdam

Alex Morozov, CFA Healthcare Amsterdam

Dan Baker Telecom Hong Kong

Elizabeth Collins, CFA Materials Chicago

Gareth James Technology Sydney

Mathew Hodge Materials Sydney

Joel Bloomer Consumer Sydney

Matthew Coffina, CFA Healthcare Chicago

Michael Hodel, CFA Telecom Chicago

Michael Holt, CFA Technology Chicago

Michael Waterhouse, CFA Healthcare Chicago

Phil Gorham, CFA Consumer Amsterdam

Rick Summer, CFA, CPA Technology Chicago

Stephen Ellis Financials Chicago

14

Valuation

15

The Effectiveness of Our Ratings Over Time


Data as of December 31, 2015

70%

80%

90%

100%

110%

120%

2002/06 2003/07 2004/07 2005/07 2006/07 2007/07 2008/07 2009/07 2010/07 2011/07 2012/07 2013/07 2014/07 2015/07

Aggregate Market Price to Fair Value

16

Aggregate Price to Fair Value By Industry

As of January 2016, Energy, Financial Services, and Industrials are among our most undervalued sectors.


Undervalued Overvalued

74

77

88

90

90

91

92

95

96

101

108

70 75 80 85 90 95 100 105 110 115

Energy

Financial Services

Industrials

Basic Materials

Communication Services

Healthcare

Real Estate

Technology

Utilities

Consumer Defensive

Consumer Cyclical

17



97

97

96

94

92

92

91

91

91

89

88

84

80 85 90 95 100 105 110 115 120


Utilities

Consumer Defensive

Industrials

Real Estate

Technology

Consumer Cyclical

Healthcare

Market Aggregate

Basic Materials

Energy

Financial Services


Data as of September 30, 2015

Sector Valuations as of 30 Sept 2015: Financial Services, Energy, and Basic Materials were among our most undervalued sectors.

18


Sector Valuations from 30 Sept 2014: S&P declined more than 300 basis points after this period.


110

110

110

106

104

103

101

101

99

98

96

92

80 85 90 95 100 105 110 115 120

Technology


Healthcare

Utilities

Industrials

Real Estate

Consumer Defensive

Market Aggregate

Basic Materials

Consumer Cyclical

Financial Services

Energy



19

The Effectiveness of Morningstar Ratings for All Stocks


From 2002-2015, 5-star rated stocks outperformed stocks of all other star ratings.

Appendix

21


Morningstar institutional equity research services is a global and independent research provider. Our long-term outlook and emphasis on economic moats, or sustainable competitive advantages, differentiate our research and have proven to drive long-term outperformance.

22

Global Analyst Team

Our accomplished team of award-winning analysts apply one consistent methodology across our global coverage universe.


Equity Analysts Companies Covered Globally

Methodology

23

Comprehensive Equity Coverage

Our coverage spans the globe and all major market sectors.


Regional Coverage

Asia 136

Australia/New Zealand 223

Europe 257

Latin America 32

Middle East/Africa 46

North America 763

Total Global Coverage 1,457

Sector Coverage

h Cyclical

r Basic Materials 133

t Consumer Cyclical 213

y Financial Services 207

u Real Estate 58

j Sensitive

i Communication Services 60

o Energy 123

p Industrials 191

a Technology 158

k Defensive

s Consumer Defensive 98

d Health Care 133

f Utilities 83

Market Cap Coverage

! Large-cap Stocks 731

@ Mid-cap Stocks 409

# Small-cap Stocks 317

The market caps were broken down by the following breakpoints: Large cap: 10+ Billion USD Mid-cap:2-10 Billion USD Small-cap: 0-2 Billion USD

*Institutional coverage numbers


24

Moat Rating Distribution

Our analyst coverage universe skews toward companies with economic moats, though in the overall economy, most firms do not have an economic moat.


15%

45%

40%

Analyst Coverage

Morningstar Coverage Universe Moat Rating Distribution Wide Moat Narrow Moat No Moat

1%

29%

70%

Quantitative Research Coverage

Data as of March 31, 2016

25


Moats are not equally distributed across sectors. Highly commoditized or competitive industries will have fewer companies with moats.



0%

20%

40%

60%

80%

100%

Basic

Materials

Comm.

Services

Consumer

Cyclical

Consumer

Defensive

Energy Financial

Services

Healthcare Industrials Real

Estate

Technology Utilities

Wide Moat Narrow Moat No Moat

26


The sources of competitive advantage are widely distributed across our moat companies.



0%

10%

20%

30%

40%

50%

60%

70%

Intangible Assets Cost Advantage Switching Costs Efficient Scale Network Effect

Wide Moat Narrow Moat

201

104

1,149

0

200

400

600

800

1,000

1,200

Negative Positive Stable

27

Morningstar® Economic Moat™ Trend Distribution

The number of companies with negative, positive, and stable moat trend ratings.


Data as of March 31, 2016.

28


The Morningstar Rating for Stocks shows significant predictive power in our regression analysis.


29

The Effectiveness of Our Ratings Over Time

Morningstar® Wide Moat Focus IndexSM vs. S&P 500


Trailing Annualized Returns (%)

Index 1-Year 3-Year 5-Year 10-Year

Since Inception

(09/30/2002)

Morningstar® Wide Moat Focus IndexSM 4.3 11.7 12.7 10.9 14.3

S&P 500 Index (cap-weighted) 1.9 11.8 11.6 7.0 9.2

Data from September 30, 2002 through March 31, 2016. Indexes are unmanaged and not available for direct investment.

1.00

2.00

3.00

4.00

5.00

6.00

7.00

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Wide Moat Focus S&P 500

30

The Effectiveness of Morningstar Ratings for Wide Moat Stocks

Wide Moat stocks sorted by Morningstar Rating for stocks vs. S&P 500



Morningstar Rating™ for Wide Moat stocks 1-Year 3-Year 5-Year 10-Year

Since Inception

(06/26/2002)

QQQQQ 17.0 17.5 17.7 14.6 18.6

QQQQ -3.5 10.5 12.0 8.3 10.3

QQQ -3.5 9.0 11.1 7.6 7.6

QQ -0.2 7.5 11.2 7.4 8.9

Q -8.5 1.8 9.2 -3.7 -2.8

Morningstar Coverage Universe -3.3 8.89 7.8 9.0 —

S&P 500 Index (cap-weighted) 1.9 11.8 11.6 7.0 —

Source: Morningstar Time-weighted returns through: March 31, 2016

31


All stocks sorted by Morningstar Rating for stocks vs. S&P 500



Morningstar Rating™ for stocks 1-Year 3-Year 5-Year 10-Year

Since Inception

(08/06/2001)

QQQQQ -11.5 11.9 8.0 13.5 10.9

QQQQ -4.9 6.7 6.8 8.1 10.8

QQQ -2.2 10.5 8.7 8.5 8.9

QQ -5.8 6.2 4.9 4.0 4.9

Q -8.1 7.4 4.6 10.6 8.8

Morningstar Coverage Universe -3.3 8.89 7.8 9.0 —

S&P 500 Index (cap-weighted) 1.9 11.8 11.6 7.0 —


32

The Effectiveness of Morningstar Indexes and Portfolios

Morningstar Indexes and Portfolios vs. S&P 500



1-Year 3-Year 5-Year 10-Year

Morningstar® Wide Moat Focus IndexSM 4.3 11.7 12.7 10.6

Morningstar Tortoise Portfolio 1.3 11.1 12.9 8.1

Morningstar Hare Portfolio 0.8 15.1 13.3 10.8

Morningstar Dividend Select Portfolio 12.7 11.8 14.4 —

Buy at 5-Star/Sell at 3-Star -12.9 1.6 3.6 7.5

Morningstar Large-Cap Blend Mutual Fund Cat. -2.2 9.2 9.0 5.5

S&P 500 Index (cap-weighted) 1.8 11.8 11.6 7.0


33


Be careful with what you are measuring. The number of stocks in each star-rating buck fluctuate from year to year.


Data as of October 31, 2015

22 7 30 78 78 373 396 33 31 128 48 16 40 59

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

1 Star 2 Star 3 Star 4 Star 5 Star

34

Data as of September 30, 2015.

Morningstar Rating™

We assign the Morningstar Rating for stocks by comparing the market price to our fair value estimate, adjusted for uncertainty.


Low Medium High Very High

Q

QQ

QQQ

QQQQ

QQQQQ

—125%+

—105%

—80%

—95%

—135%+

—110%

—70%

—90%

—155%+

—115%

—60%

—85%

—175%+

—125%

—50%

—80%

35

Stewardship Analysis

36


The purpose of stewardship analysis is to identify managers that are acting in the best interest of shareholders. A focus on capital allocation decisions best identifies managers who focus on widening their moats and improving shareholder returns.

Investment Strategy

Investment Valuation

Execution Dividend and Buy Back

Management Incentives

Financial Leverage

Ownership Structure

37

Key Stewardship Considerations

A focus on capital allocation decisions informs the Stewardship Rating.


92 137

1,227

0

200

400

600

800

1,000

1,200

1,400

Poor Exemplary Standard

Distribution of Poor, Exemplary, and Standard Stewardship Ratings Across Companies

Data as of March 31 2016

38

Examples of Exemplary and Poor Stewardship


Exemplary Stewardship Poor Stewardship

Deere

Stock ownership requirements for a broad set of employees,

combined with disciplined investment processes and

accretive share repurchases.

AT&T

Poor capital allocation decisions, such as paying a premium

price for DirecTV, enacting a questionable strategic move

into Mexico, and overpaying for operating assets.

Nike

Strong brand management, and executive focus on

maximizing returns on invested capital.

Carlsberg

Shareholders face potentially substantial dilution in the event

of a major acquisition, owing to the Carlsberg Foundation’s

ownership of 75% of voting rights.

O’Reilly Automotive

Well-executed acquisitions that has transformed the firm into

a highly profitable national player.

Zions Bancorp

Growth at the expense of risk controls leading up to the

2008/09 financial crisis led to heavy losses.

39

Alphabet (GOOGL)

Alphabet – Conviction in growth potential allowed us to look past near term challenges and increase our valuation.


40

General Electric (GE)

Focusing on the durability of GE’s economic moat allows us to see past near term concerns over exposure to China and energy.


Documents

Wide Moat Investing - CFA Institute · of revenue Southern Company Utilities have natural geographic monopolies, but regulations ... AT&T and Verizon eliminates economic ... or dissipate