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Durable Competitive Advantages: Using Economic Moats to Improve Investment Returns,Pat Dorsey, CFA Director of Equity Research,2,Agenda,Our Approach to Competitive Analysis What is an Economic Moat Whats Not Where Morningstar Finds Moats Why Moats Matter Using Economic Moats in the Investment Process,3,Whats A Moat?,Capital seeks the areas of highest potential return, so all firms face competition 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 allows a 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, but theyre not structural attributes.,4,Whats a Moat?,The key to having an economic moat is the sustainability of excess returns, rather than the absolute level of return on capital. A company with 40% returns on invested capital (ROIC) due to a hot product has no moat. The returns cannot be forecasted with any level of confidence. Fashion stocks (Crocs, Heelys), Motorola Razr A company with 12% ROIC and a low cost of capital that is structurally protected from the competition may have a wide 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 Location Unique Assets Scale,6,Sources of Economic Moats,Intangible assets Brands: Does it increase the consumers 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,Sources of Economic Moats,Switching Costs: Do the costs in time or money of switching to a competing product/service outweigh the benefits? Monetary/Labor Costs -Oracle -Autodesk -Data processors Low or uncertain benefits from switching -Amazon -Asset managers,8,Sources of Economic Moats,The Network Effect One of the most powerful types of competitive advantage, which occurs when the value of a good or service increases with the number of users. Examples of the Network Effect eBay Western Union MasterCard, American Express, Discover, Visa Microsoft Financial Exchanges,9,Sources of Economic Moats,Cost Advantages Not necessarily tied to size Process Invent a cheaper way of delivering a good or service that rivals cannot (or will not) replicate. Dell, Nucor, Steel Dynamics, Southwest/other LCCs. Low-cost resource base Ultra Petroleum, Compass Minerals. Scale -Distribution Stericycle, Cintas, Sysco, UPS -Manufacturing Intel -Niche Markets/Single-Scale Efficiency Graco, Blackbaud,10,Whats 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 be irrelevant bigger is not necessarily better. Technology: What one smart engineer can invent, another can improve upon. (Exception: Creating a standard thats widely adopted.) Easily-replicable cost advantages (lean manufacturing, outsourcing.) Hot Products: Krispy Kreme, Tommy Hilfiger, Crocs, Iomega, etc. Can generate high returns on capital for a short period of time, but sustainable returns are what make a moat.,11,Whats Not An Economic Moat,Management: Smart managers may create a moat over time, but great management is not a moat by itself. Go for a business that any idiot can run because sooner or later, any idiot probably is going to run it. Peter Lynch “When management with a reputation for brilliance tackles a business with a reputation for poor economics, it is the reputation of the business that remains intact.” Buffett Management matters, but moats 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 2100 companies that we follow have wide economic moats. (169, to be precise.) Moats vary by sector & industry. Fewer moats in highly commoditized or competitive sectors like computer hardware, consumer services (retail/restaurants), or industrial materials. Only 1/3 of the companies 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 many years is worth more today than a company which isnt.,Wide Economic Moat,No Economic Moat,Narrow Economic Moat,ROIC,ROIC,ROIC,Time Horizon,Time Horizon,Time Horizon,14,Why Moats Matter,When comparing two companies with similar growth rates, returns on capital, and reinvestment needs, the company with the moat has a higher intrinsic value. Underestimating a moat results in opportunity cost, while overestimating a moat can cause you to pay for value creation which never materializes. Some fast-growing companies are worth the premium, because the excess 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 many years, what looks expensive may actually be quite a bargain.,15,Why Moats Matter,“Time is the friend of the wonderful business, affording it the opportunity to reinvest incremental capital at favorable rates and increase the value of the enterprise. Over time, the price you paid for a terrific company looks cheaper and cheaper. For the inferior business at the cheap price, time may turn out to be the fell destroyer.“ Bob Goldfarb, Sequoia Fund,16,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 to the mean is fast and painful. But a few generate excess returns for many years, and moats give us an analytical framework for selecting them.,17,Why Moats Matter,Companies with moats have greater resilience. If a firm can fall back on a structural competitive advantage, its more likely to recover from temporary troubles. This is a great psychological backstop for the investor whos buying when everyone else is screaming “sell!” If youre confident in the moat, its easier to average down if you initiate a position too early.,18,Isnt the Moat Already Priced In?,Short answer: Sometimes, but less frequently than you might think. Long answer: Most market participants own securities for short time periods, and moats matter much more in the long run than over the short term. (Time-horizon arbitrage.) Recency bias causes most investors to assume that the current state of the world (good or bad) persists for longer than it usually does. Our performance record suggests that waiting for wide moats to become cheap is a compelling strategy.,Wide + Cheap,Returns through 9/18/2009 * Annualized returns Source: Morningstar,The Wide Moat Focus is an index of our 20 most undervalued wide-moat stocks. Holdings are equally-weighted and rebalanced quarterly.,20,More on Moats,Competitive Strategy, by Michael Porter (Free Press, 1998) The Essays of Warren Buffett, compiled by Lawrence Cunningham (John Wiley, 2002) . Berkshire letters are also free at Competition Demystified, by Bruce Greenwald (Penguin, 2005) Annual Reports The more, the better. Build that mental database! The Halo Effect, by Phil Rosenzweig (Free Press, 2007),21,More on Moats,The Little Book that Builds Wealth, by Pat Dorsey (John Wiley, 2008),Contact Information,Patrick Dorsey Director of Research Morningstar, Inc. +1 312.696.6560 ,Durable Competitive Advantages: Using Economic Moats to Improve Investment Returns,Pat Dorsey, CFA Director of Equity Research,
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