John Kessell of Morningstar explains how the firm creates high-performing portfolios through its research process, and looks at the value of economic moats.
Date: Jun 2011
Tags: Research, Differentiation
This theme, which permeates all of the research done at Morningstar, describes the protection that a company has around its business which allows it to generate high profitability, or high returns on its capital, for an extended period of time. In other words, he said, some unique businesses have structural characteristics which allow them to essentially generate high profitability relative to their cost of capital over many years.
So instead of a company having its profits eroded over five years or so, Kessell said companies with economic moats have higher profitability over a period of 15 to 20 years.
Economic moats explained
The first moat, explained Kessell, is around intangible assets. An example of this is brands, for which consumers are willing to pay more for the same product because of that brand. Coca-cola, in some markets, is an example of a moat based on a brand.
Other types of intangible assets which can give moats include patents, and licences / approvals which are required to conduct a certain business. These make it difficult for competitors to enter those markets, he said.
A second category of moat is high switching costs, added Kessell, where it is very difficult or costly to switch a product to another supplier. Enterprise software is an example of this, where it is hard to switch because of the risk and cost.
A third area is called the network effect, he said, which also increases exponentially as companies add more nodes to the network. A good example of this are credit card companies, which have established a base of merchants who accept the credit card and also consumers who carry the card, making it difficult for another company to replicate the existing network.
Another category of moat is the cost advantage, although Kessell said this isn’t purely linked to the size of the company and its ability to be a low-cost provider as a result.
According to Kessell, aspects of a company which aren't considered to be economic moats include good management. At the same time, companies with high profitability could just be related to a hot trend.
The importance of economic moats
To highlight the significance of moats, Kessell pointed to two portfolios which Morningstar runs based on the best types of moat it can assign. So from the firm’s universe of about 18,000 stocks it covers globally, there are only roughly 165 companies with such moats, and these portfolios are based on the 20 cheapest of these companies.
One of the portfolios rebalances quarterly; the other rebalances as often as daily to take advantage of market dislocations. The quarterly-rebalanced portfolio has a return over the last nine years of around double that of the S&P 500, he said, meaning a 15% per-year return compared with the 8% return of the S&P 500 index. The second portfolio has a performance over the same timeframe of nearly triple the S&P 500.
