Build a Moat in Your Portfolio - news.morningstar.com
Transcript of Build a Moat in Your Portfolio - news.morningstar.com
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Build a Moat in Your Portfolio
× Matthew Coffina, CFAEditor, Morningstar StockInvestor
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Disclosure
× I own many of the stocks that will be discussed today, both personallyand in StockInvestor’s Tortoise and Hare portfolios.
× None of this presentation is intended as investment advice.× Please consult a financial advisor for questions about the suitability of
any investment strategy or product for your particular circumstances.
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Morningstar’s Strategy
Invest in companies with strong and growing competitiveadvantages, trading at reasonable prices.
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× Economic Moats× Moat Trends× Stewardship× Price/Fair Value Ratios× Uncertainty/Star Ratings
Five Morningstar Ratings Drive Stock Selection
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Why Moats Matter
× Wide-moat firms’ ability to invest incremental capital at high rates ofreturn = faster earnings growth and/or higher free cash flow.
× Wide-moat firms are able to sustain excess returns longer than firmswithout moats.
× Morningstar’s fair value estimates are more accurate for wide-moatfirms because future cash flows are more predictable.
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Star Ratings Performance*
Wide Moat Narrow Moat No Moat
All 11.0% 11.6% 12.9%
QQQQQ 19.7% 15.8% 19.3%
QQQ 8.1% 10.6% 12.4%
Q -2.3% 6.1% 15.3%
*Annualized Returns, 6/26/2002-2/28/2014
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The Tortoise and Hare Strategy
× Real-money portfolios focused on buying wide- and expanding-moatstocks at discounts to Morningstar’s fair value estimates.
× Tortoise Portfolio invests in more conservative stocks.× Hare Portfolio takes on greater risk for higher total-return potential.× About 20 stocks in each portfolio.× Inception date of June 18, 2001.
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Tortoise and Hare Performance
Combined Tortoise &Hare S&P 500
Trailing 1-Year 27.4% 25.4%
Trailing 5-Year 23.4% 23.0%
Trailing 10-Year 9.7% 7.2%
Since Inception 9.4% 5.5%
Annualized Total Returns as of 2/28/14
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Other Benefits to a Wide-Moat Approach*
× The Tortoise and Hare have experiencedlow turnover (18% per year versus 89%for the average equity mutual fund).
× Standard deviation of returns (14.1%)below the S&P 500 (15.2%).
× Beta below one (0.87).× Greatest outperformance realized during
down markets.*All figures represent averages since inception for the combined Tortoise and Hare.
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Definition of a Moat
× Sustainable competitive advantage(s).× Enables a company to earn positive
economic profits (ROIC>WACC).× At least one identifiable moat source.
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Moat Ratings: Wide/Narrow/None
× Width of moat determined byduration of competitive advantage.
× Narrow moats: Excess returnsmore likely than not in 10 years.
× Wide moats: Excess returns nearlycertain in 10 years, more likelythan not in 20 years.
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Wide Moats Are Rare
× We assign a wide moat rating to 14%of our global coverage universe.
× However, we intentionally try to coverhigh-quality companies.
× The share of wide moats in the overalleconomy/market would be much lower.
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Prevalence of Moats by Sector
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The Five Sources of a Moat
× Network Effect× Intangible Assets× Cost Advantage× Switching Costs× Efficient Scale
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The Network Effect
× The value of a company’s service increases as more people use it.
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Intangible Assets
× Patents, brands, or regulatory licenses that protect excess returns.
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Cost Advantage
× Economies of scale, access to a unique asset, etc.
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Switching Costs
× It is too expensive/troublesome for customers to stop using a product.
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Efficient Scale
× A niche market is effectively served by one or a small handful of firms.
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Prevalence of Moat Sources
× Firms often have multiple moat sources, which can reinforce one another.
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Other Evidence of a Moat
× High barriers to entry.× Strong/improving market share.× Ability to raise prices.× High customer retention.× Few competitors, low competitive rivalry.× Margins ahead of peers and/or sustainable margin expansion.
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Quantitative Evidence of a Moat: ROIC>WACC?
× In contrast to return on equity, return on invested capital isn’t affected bythe capital structure (the degree of leverage).
× ROIC is compared against the weighted average cost of capital,reflecting the cost of both equity and debt capital.
× ROIC>WACC is the ultimate test of shareholder value creation.
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Basic Example: A Lemonade Stand
× Jill needs $100 for a table, sign, pitcher, lemons,sugar, ice, and cups.
× She borrows $50 from Mom and promises topay her 5% interest ($2.50).
× Dad has a higher risk tolerance and buys $50worth of common stock in Jill’s lemonade stand.
× Dad expects a 10% return (his cost of equity).
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Jill’s Weighted Average Cost of Capital
× (Cost of Debt) x (Debt Weighting)+(Cost of Equity) x (Equity Weighting).× Jill’s capital structure includes 50% debt and 50% equity.× WACC = 5% x 0.5 + 10% x 0.5= 7.5%.
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Jill’s Return on Invested Capital
× (Earnings Before Interest) ÷ (Invested Capital).× After a hard day’s work, Jill has earned a $10 profit after paying herself
a reasonable wage and replenishing her supplies.× Her invested capital was $100.× ROIC = $10/$100 = 10%.× 10%>7.5%, so ROIC>WACC and Jill has earned excess returns.
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Dad’s Return on Equity
× Mom receives her $2.50 in interest.× The other $7.50 belongs to Dad, who has achieved a 15% return on
equity—above his 10% cost of equity.× ROE is affected by leverage.× For example, if the lemonade stand were funded with $80 in debt and
$20 in equity, Mom would be owed $4 in interest and Dad wouldreceive $6, for an ROE of 30%.
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Real-World Challenges
× Is Earnings Before Interest normalized?× Cyclicality, one-time charges, noneconomic costs, cash taxes.
× What should be considered invested capital?× Goodwill, other intangibles, deferred taxes, capitalized lease
expense, capitalized R&D.× Changing assumptions can result in very different conclusions.
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Example: ITC Holdings (ITC)
× Independent electricity transmission utility.× Efficient scale advantage—it isn’t cost-effective to
build multiple competing transmission lines.× Attractive set of investment opportunities to ensure
grid reliability, encourage wind-power development,and enable cross-regional electricity pricing arbitrage.
× Favorable allowed returns from the Federal EnergyRegulatory Commission are a key differentiator.
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Calculating ITC’s Earnings Before Interest
× Net Income + (Interest Expense) x (1 - Tax Rate).× ITC reported $233,506 in net income last year (all figures in thousands).× Assume a marginal tax rate of 36.5%.× Interest expense was $168,319; tax-adjusted interest expense of
$106,883.× EBI = $233,506 + $106,883 = $340,389.
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Adjustments to EBI
× However, last year ITC Holdings tried to acquire Entergy’s (ETR)transmission assets—a deal that failed to receive regulatory approval.
× Earnings in 2013 include $25,096 of nonrecurring transaction costs andother items (after tax).
× Adding these items back, operating earnings were $258,602.× Adjusted EBI = $258,602 + $106,883 = $365,485.
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Calculating ITC’s Invested Capital
× Operating Assets - Operating Liabilities or Debt + Equity.× Use an average of current and preceding year’s balance sheet.× Average debt of $3,379,670 and average equity of $1,514,294.× Invested Capital = $4,893,964.× If we exclude $950,163 of goodwill, invested capital would be
$3,943,801.
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ITC’s Return on Invested Capital
× Divide EBI by Invested Capital.
Invested Capital
With Goodwill Without Goodwill
EBI
Including One-Time Costs 7.0% 8.6%
Excluding One-Time Costs 7.5% 9.3%
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Weighted Average Cost of Capital
× Calculating WACC involves its own complications:× The cost of equity can’t be observed.× Interest rates change over time.× Should we use a market or book capital structure weighting?
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Considerations in Estimating COE
× For U.S. companies, Morningstar assigns a cost of equity of 8%, 10%,12%, or 14% depending on the level of “systematic risk.”
× Systematic risk = risk that can’t be eliminated through diversification.× Our version of CAPM, using fundamentals of revenue cyclicality,
operating leverage, and financial leverage in place of beta.× ITC’s formula-based rate regulation creates exceptionally low risk.× Primary uncertainty is FERC policy, which isn’t correlated with the
market.
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Calculating ITC’s WACC
× Morningstar’s cost of capital assumptions:× 8.0% cost of equity.× 5.0% cost of debt, 3.2% after tax.× 62% equity/28% debt capital structure.× WACC = 6.2%.
× Using a book capital structure (31% equity/69% debt):× WACC = 4.7%.
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ITC’s Economic Moat
× Under most assumptions, ROIC>WACC by a slim but sustainablemargin.
× Wide moat based on our belief that FERC policy will continue to favorindependent transmission operators.
× Compared with state regulators, FERC is less subject to local politicalpressures (less focused on consumer utility bills).
× Grid reliability trumps modest savings that could be achieved fromlower allowed ROEs.
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ITC’s Return on Equity
× Stable cash flows allow ITC to safely leverage returns at the parentcompany level.
× Operating earnings of $258,602 last year relative to average equity of$1,514,294.
× Return on equity = 17.1%.× Incremental earnings of $42,086 on incremental equity of $177,420.× Incremental ROE of 23.7% in 2013—not bad for a regulated utility!
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Moat Trend: Positive, Stable, Negative
× Is the competitive position strengthening or weakening?× The moat trend is independent of the moat.× Moat trend is less likely to be incorporated in current stock prices.
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Stewardship: Exemplary, Standard, Poor
× We assign Stewardship Ratings based on the quality ofmanagement’s capital-allocation decisions and strategic execution.
× Exemplary stewardship characterized by:× Moat-widening investments and execution.× Prudent financial leverage and accounting decisions.× Effective dividend and share-repurchase policies.× Avoids conflicts of interest that could harm shareholders.
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Fair Value Estimates
× We use discounted cash flow analysis to assign fair value estimatesto stocks.
× Analysts make detailed assumptions about future revenue, costs,working capital investments, capital expenditures, and so on.
× Moats reflected in duration of excess returns.× Free cash flows are discounted back to the present using the WACC.
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Uncertainty/Star Ratings
× Greater uncertaintyrequires a larger marginof safety.
× Star ratings adjustautomatically based onmarket prices.
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Questions?