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Moats Matter: How to Identify Businesses With Competitive Advantages

- By Robert Abbott

In 2014, Morningstar Inc. (MORN), which rates corporate moats, published a book explaining its methods and rationale. Members of the equity research team contributed to "Why Moats Matter: The Morningstar Approach to Stock Investing."

Lead authors were Heather Brilliant, chartered financial analyst and co-CEO of Morningstar Australasia, and Elizabeth Collins, CFA and director of equity research for Morningstar North America. Other contributors were Joel Bloomer, Matthew Coffina, Stephen Ellis, Gareth James, Warren Miller, Josh Peters and Todd Wenning.


The authors wrote, "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 is one that can fend off competition and earn high returns on capital for many years to come."

More specifically, the company wants businesses that can withstand competition for many years into the future, all the while increasing earnings, returning cash to shareholders and compounding existing value.

And, the authors confirm the value investing approach by stating they especially like great businesses when they are available at great prices. They take an owner's, rather than a trader's, perspective and emphasize cash flow over stock prices.

The book has two main objectives:

  1. Identifying "great" businesses.
  2. Determining the best time to buy such businesses for maximum returns.



In addition, it spells out the three main thrusts of the firm's analytical work:

  1. Competitive advantages that are sustainable.
  2. Valuation.
  3. Margin of safety.



On the first objective, finding great businesses, the authors note that "economic moats protect the high returns on capital enjoyed by the world's best companies." They also highlight the idea that an economic moat must be more than short-term execution, cyclical improvements or good management--it must be a structural element, built into the company or product.

There is also a relationship between a moat and value creation. The relationship is built on two factors: First, the amount of value now being produced, as determined by examining the financial statements, and second, "the magnitude and duration of future excess returns."

Moats come in three categories: Wide, narrow and none, as shown in this illustration from the book:

Morningstar moat widths

The existence or width of a moat is based on the number of years a company is expected to have a competitive advantage over its peers. For 10 years or less, it's no moat, for 10 to 20 years, it's a narrow moat and for at least 30 years, it is a wide moat.

For an example of a moat in action, the authors pointed to ITC Holdings (ITC), an electrical utility and transmission business. It's hardly as exciting as a tech stock, but at the time of publication, it had turned out double-digit earnings increases and strong returns on capital. Behind those robust fundamentals were a dominant market position and government-imposed regulations, both of which discouraged new entrants. Morningstar gave it a "wide" economic moat rating because ITC should be able to enjoy continuing high returns for many years.

The authors said they identified five sources of competitive advantage that add up to an economic moat:

  1. Intangible assets, including brands, patents and government restrictions.
  2. A cost advantage, which allows businesses to either sell for less or sell at the same price as rivals while enjoying bigger margins.
  3. Switching costs, which mean customers are not able to change to another provider without serious inconveniences or costs.
  4. Network effect: The value of a product or service increases as more people use it; think, for example, of social media platforms such as Facebook (FB).
  5. Efficient scale means a situation in which one or a few companies serve a market of limited size.



These five criteria, all qualitative, provide the first screen, if you will, of a company's eligibility for a narrow or wide moat rating. To that is added a quantitative criterion, a business' ability to generate excess returns on invested capital. But the authors added the spread between the cost of capital and ROIC is less important than the expected duration of those excess returns.

Companies that are expected to retain their competitive advantage for at least 10 years are given a "narrow" moat rating, while those expected to keep it for at least 20 years receive a "wide" rating. Anything less than 10 years is consider a "no" moat. When the book was published in 2014, Morningstar reported that only about 200 companies worldwide qualified for a wide rating.

The second major objective of the book, as noted, was to identify the best time to buy companies with wide moats. Despite their relative scarcity, wide-moat companies should not be bought on that basis alone--they should also be available at a discount to their intrinsic value.

To know if a stock is selling at a discount, it's necessary to know its fair market value. That, in turn, is based on estimating future cash flows. Morningstar uses a fundamental approach to valuation and, thus, creates a discounted cash flow model for each company.

Analysts estimate revenue, earnings, balance sheet and cash flows for five to 10 years. The cash flows are then discounted back to the present based on the estimated cost of capital. Since there are many variables in these models, they use scenario analysis to create a range of potential outcomes, and they look for a margin of safety.

To try to quantify the margin of safety to some extent, they created the Morningstar Uncertainty Rating; it is based on the "perceived difficulty" of forecast future cash flows. It takes in variability of revenues, operating income and financial leverage throughout full economic cycles.

The rating also includes company-specific variables. For example, the authors compared Cemex (CX), a cement maker with wide revenue swings, high fixed costs and extensive leverage, to Nestle (NESN), a steady, conservatively managed business.

Most importantly, though, are the ideas that moats are based on specific criteria, and that even companies with wide moats should be bought at a discount to their intrinsic value.

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This article first appeared on GuruFocus.