PPT Morningstar Economic Moats II_Excellent
description
Transcript of PPT Morningstar Economic Moats II_Excellent
<#>
© 2011 Morningstar, Inc. All rights reserved.
How an Economic Moat Can Help You Find Great Stocks
Paul LarsonChief Equities StrategistEditor, Morningstar StockInvestorTwitter: @StockInvestPaul
Mike TianEquities StrategistCo-Editor, Morningstar Opportunistic Investor
What’s An Economic Moat?
Economic Moats Concept
× Basic premise: Capitalism works× High profits attract competition× Competition reduces profitability
× But some firms stay very profitable for a long time – by creating economic moats to protect profits
× Economic moats are structural business attributes that help companies generate high returns on capital for an extended period.
× “Structural” = “inherent to the business”× “Structural” ≠ a smart manager
× Sustainable returns on capital are much more important than high returns on capital.
× Crocs CROX or Valero VLO vs. Kinder Morgan KMI or Union Pacific UNP
Why Moats Matter
× Imagine two companies with similar growth rates, returns on capital, and reinvestment needs:
× The “moaty” company has a higher value× Moats provide a margin of safety
× Companies with moats likely to continue to compound in value× Overestimating a moat = paying for unlikely value creation× Companies with higher ROICs deserve premium valuation multiples
× Waiting for wide moat firms to get cheap pays off
Why Moats Matter
× Moats add intrinsic value!
ROIC
Time Horizon
Wide EconomicMoat
ROIC
Time Horizon
No EconomicMoat
ROIC
Time Horizon
Narrow EconomicMoat
Sources of Economic Moats
× Network Effect
× Cost Advantage
× Intangible Assets
× Switching Costs
× New! Efficient Scale
Sources of Economic Moats: The Network Effect
× The network effect is present when the value of a service grows as more people use a network.
× With each additional node, the number of potential connections in a network grows exponentially.
× MasterCard MA, Visa V× eBay EBAY× Apps – Apple AAPL iOS, Google GOOG Android× Financial Exchanges – Deutsche Borse DB1.DE, CME CME× Facebook
Sources of Economic Moats: Cost Advantages
× Allows firms to sell at same price as competition and gather excess profit and/or have the option to undercut competition.
× Economies of Scale× Distribution – UPS UPS, Stericycle SRCL, Sysco SYY× Manufacturing – Intel INTC
× Low-Cost Resource Base× Ultra Petroleum UPL, Compass Minerals CMP
Sources of Economic Moats: Intangible Assets
× Things that block competition and/or allow companies to charge more× Brands
× Sony SNE vs. Tiffany TIF× Procter & Gamble PG and Colgate CL
× Patents× Pharmaceuticals
× Licenses & Government Approvals× Waste, aggregates, casinos (kind of)
Sources of Economic Moats: Switching Costs
× Time = money, and vice versa× Consumers and Banks× Oracle ORCL, Autodesk ADSK× Otis (United Technologies UTX), GE GE× Jack Henry JKHY, Fiserv FISV× Intuit INTU
Sources of Economic Moats: Efficient Scale
× When a company serves a market limited in size, new competitors may not have an incentive to enter. Incumbents generate economic profits, but new entrants would cause returns for all players to fall well below cost of capital
× Natural geographic monopolies× Airports, racetracks, pipelines
× Niche markets× Defense companies, Lubrizol, Graco GGG, etc.
× Rational oligopolies× Canadian banks
What’s Not An Economic Moat
× Size / Dominant Market Share: High market share does not give a firm a moat. (Ask Compaq – or GM.)
× Technology: What one smart engineer can invent, another engineer can make even better.
× Hot Products: Can generate high returns on capital for a short period of time, but sustainable returns are what make a moat.
× Krispy Kreme KKD, Crocs CROX× Process: Can be imitated with time. Witness Dell DELL, Southwest
LUV
What’s Not An Economic Moat
× Management: CEOs can create (or destroy) a moat, but 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
History of Moat Rating
× Warren Buffett in a 1999 Fortune magazine article writes:× The key to investing is not assessing how much an industry is going
to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
× Morningstar initiates economic moat rating in late 2002, subdividing entire coverage universe into three moat buckets: none, narrow, wide. This system remains in place today.
× Moat ratings have always required sign-off of committee. Acts as quality control measure and improves consistency.
Measuring a Moat
× First, assume company does not have a moat.× Key Test: Does ROIC > WACC?
× If yes is positive spread sustainable for at least next decade-plus?If yes Company has at least narrow moat
Is spread sustainable for two decades?If yes Company has wide moat
× If company does not currently have positive economic profit (ROIC>WACC), will it in the near future? Do positive economic profits in future outweigh near-term negative economic profits?
× Duration of economic profits matters, not absolute magnitude.
Who Has a Moat?
× Moats are not equally distributed across the market× Fewer moats in highly commoditized or competitive sectors × More moats in areas with durable brands, patents or switching costs× Our coverage universe skews toward larger, successful firms. In overall
economy, most firms do not have any economic moat.
~ 50% = Narrow~10% of companies = Wide ~ 40% = None
How Are Moats Distributed?
As of Oct. 2011
Composition of Sectors by MoatEqual-Weighting
0%10%
20%30%
40%50%
60%70%
80%90%
100%
Basic M
aterial
s
Commun
icatio
n Serv
ices
Technol
ogy
Consumer
Cyclica
l
Consumer
Defensiv
eEne
rgyFin
ancia
l Serv
ices
Real Esta
teHeal
thcare
Industria
lsUtilit
ies
Coverag
e Univ
erse
Perc
ent C
ompo
sitio
n
None
Narrow
Wide
The Payoff: Wide + Cheap = Alpha
Returns through 2/29/2012
× Example: Real-world Tortoise and Hare Portfolios
× Since inception, the Hare has outperformed 98.4% of large-growth mutual funds, while the Tortoise has bested 99.4% of large-blend mutual funds.
Total Returns Since Inception (6/18/01)
Cumulative Annualized
Tortoise 115.0% 7.4%
Hare 103.5% 6.9%
S&P 500 38.3% 3.1%
Even Better: The Wide Moat Focus Index
Growth of $10,000
The Payoff: Wide + Cheap = Alpha
Returns through 2/29/2012
× Example: Wide Moat Focus Index
× Created in Sept. 2007, index takes universe of U.S.-based corporations rated by Morningstar as wide-moat, then takes the 20 cheapest when sorted by the price/fair value ratio. Index is equal-weighted (all positions = 5%), and then reconstituted and rebalanced quarterly.
Total Returns Since Inception (9/30/02)
Cumulative Annualized
Wide-Moat Focus 270.3% 14.9%
S&P 500 99.4% 7.6%
What’s A Moat Trend?
Moat Trend Concept
× Moats are not constant× Moats go through a “lifecycle” just like a company× Where in the cycle you invest can have major investment implications
Why Moat Trends Matter
× Investment 101 Math goes something like:× Firm makes profit× Firm reinvestment part of profit in business to make more money× Firm returns what it doesn’t need to shareholders× The power of compounding = wealth creation for shareholders
× This math works fantastically for companies that are growing, investing wisely, and building an economic moat
× But math can break down with firms in trouble or decline× Investment opportunities dry up× Management “deworsify”, buy into growth, hoard resources, repeated
“restructuring”× Incremental returns on investments in core business are low or even negative× Firms generally don’t decline gracefully!
History of Moat Trends
× Started formally tracking in September 2009× Assign all companies to three buckets:
× Positive : Companies with expanding economic moats× Stable× Negative : Companies with eroding economic moats
× Litmus Test: × Evaluate the company’s economic moat today× Close your eyes for three years. Is the moat wider or narrower?
Common Characteristics of Positive Trend Firms
× You can reverse these characteristics for Negative trends× Sustained, higher than GDP revenue growth× Stable or rising operating margins× Stable or rising returns on invested capital (ROIC)
Moat Trend Investment Performance
-5%
5%
15%
25%
35%
45%
55%
65%
75%
Aug-09Nov-09
Feb-10May-10
Aug-10Nov-10
Feb-11May-11
Aug-11Nov-11
Feb-12
Positive Moat Cumulative Negative Moat Cumulative
S&P 500 Cumulative Russell 2000 Cumulative
61.6%
45.9%
40.8%
29.3%
Investment Returns for Positive and Negative Moat Trending Stocks
Positive and Negative trends each make up about 15% of our U.S. coverage universe.
How do Moats Expand and Shrink?
× Changes in competitive landscape
× The firm’s investment strategy or business mix
× Changes in consumer behavior or preferences
× Changes in technological landscape
× Changes in regulatory / political landscape
× Demographics
A Moat Based on Any Source May Evolve
× Network Effects× The number of nodes and interconnections in the network is key
VS
Cost Advantage
× Focus on the cost differential between the firm and competitors
VS
Intangible Assets
× Brands and intellectual property need constant reinvestment to remain relevant
VS
Switching Costs
× Higher switching costs usually translate into pricing power on top of customer stickiness
VS
Efficient Scale
× Almost by definition, it’s difficult to grow a moat based on efficient scale.
× But it’s much easier for an efficient scale moat to be eroded× Irrational competitor× Changing marketplace
??
What is NOT a Moat Trend
× Cyclical improvements / harm to business× A hot product with little assurance of repeat success× A really good management team× We are looking for structural improvements / deterioration to a
firm’s business
Paul Larson Pick: Western Union WU
× In both Hare Portfolio and current Wide Moat Focus Index× Stock Price (03/26/12): $17.93× Fair Value Estimate: $29× P/FV: 0.62× Economic Moat Rating: Wide× Fair Value Uncertainty: Medium× Benefits from both network effect and low costs. Concerns about
technological disruption appear overblown.× Expectations priced into the stock are very low. Trades at just 10
times earnings with a 9% free cash flow yield. Company both pays a dividend (2.2% yield) and has active share repurchase program.
Paul Larson Pick: Oracle ORCL
× In both Hare Portfolio and current Wide Moat Focus Index× Stock Price (03/25/12): $28.55× Fair Value Estimate: $38× P/FV: 0.75× Economic Moat Rating: Wide× Fair Value Uncertainty: Medium× Database behemoth benefits from both economies of scale as well as
enormous switching costs. Customers will not risk interrupting core operations just to save a buck or two.
× Company trades at 11 times forward earnings estimates, about half of 10-year average PE.
Paul Larson Pick: Compass Minerals CMP
× In both Hare Portfolio and current Wide Moat Focus Index× Stock Price (03/25/12): $69.42× Fair Value Estimate: $93× P/FV: 0.75× Economic Moat Rating: Wide× Fair Value Uncertainty: Medium× Company has two world-class, advantaged assets: Goderich, Ontario
(world’s largest salt mine) and the Great Salt Lake (lost-cost specialty fertilizer). One of few wide-moat firms with a positive moat trend.
× Weather has been abysmal for Compass over the last year, but weather is the ultimate mean-reverting phenomenon.
Mike Tian Pick: Covance CVD
× Stock Price (03/23/12): $47.50× Fair Value Estimate: $60× P/FV: 0.79× Market Cap: $2.1B× Economic Moat Rating: Narrow× Moat Trend Rating: Positive× Fair Value Uncertainty: Medium× Benefits from increasing outsourcing of clinical trial operations by pharmas× Leader in signing strategic relationships that increase switching costs× Near term margin pressure keeping margins low. But firm should grow at
GDP+ for many years with opportunity to expand margins
Mike Tian Pick: Charles Schwab SCHW
× Stock Price (03/23/12): $15× Fair Value Estimate: $23× P/FV: 0.65× Market Cap: $19B× Economic Moat Rating: Narrow× Moat Trend Rating: Positive× Fair Value Uncertainty: High× World class asset gatherer. Relentlessly pushing costs down.× Offerings of banking services, financial advisory services increasing
stickiness.× Low interest rates keeping earnings down. But earnings will rocket up once
Fed Funds go above 1%.
Mike Tian Pick: Autoliv ALV
× Stock Price (03/23/12): $66× Fair Value Estimate: $80× P/FV: 0.82× Market Cap: $6B× Economic Moat Rating: None× Moat Trend Rating: Positive× Fair Value Uncertainty: High× Largest R&D budget in industry drives innovation, consistent taking of market
share for decades× Mix shift to emerging markets positive for moat and margins× Economic fears keeping stock relatively cheap (10x PE). Lots of exposure to
Europe
40
The chefs are eating the cooking!
Disclosure: Paul Larson personally owns nearly all the stocks in the Tortoise and Hare model portfolios, including the following stocks explicitly mentioned in these slides:
ADSK, CME, CMP, EBAY, GOOG, ISCA, MA, MSFT, ORCL, PFE, PG, SYY, WMT, WUDisclosure: Mike Tian personally owns stocks in the Mosaic model portfolio, including the following stocks explicitly mentioned in these slides:ALV, SCHW, CVD
© 2011 Morningstar, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc.
The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar.
Full Disclosure
Expert Stock Analysis and Recommendations from Morningstar
Investing in Companies with Growing Economic Moats× Download a free Opportunistic Investor report:
× www.morningstar.com/goto/WebOPP× Subscribe to Opportunistic Investor
× 12 months for $199 | $189 for Premium Members× Online opp.morningstar.com× Phone 1-866-910-1145
Buying Core Holdings at a Discount× Download a free issue of StockInvestor.
× www.morningstar.com/goto/WebMSI× Subscribe to StockInvestor. × 12 PDF issues for $119 | $109 for Premium Members
× Online msi.morningstar.com× Phone 1-866-910-1145