Periodically, it’s important to review the basics of our investment philosophy, both for investors who are new to Morningstar and for long-time followers who could use a refresher. We use a particular vocabulary at Morningstar, and in this article we’ll explain what we mean by economic moats, moat trends, stewardship, and so on.
Economic Moats
A company with a very profitable business is like a castle that is constantly under attack by competitors. Without a strong defence, competitors will soon imitate the company’s products, charge lower prices, steal market share, and erode profit margins to the point where the business is merely average, at best.
Economic moats — a term Morningstar borrowed from Warren Buffett — are what keep competitors at bay. An economic moat is a sustainable competitive advantage that allows a company to earn excess returns on capital (that is, returns on invested capital greater than the cost of capital) for a very long time. We define a wide moat as a competitive advantage that is almost certain to last at least 10 years, and probably 20 years or more. The standard for a narrow moat is lower—it only needs to be more likely than not that the competitive advantage will last for 10 years.
Morningstar has identified five potential sources of an economic moat. Every company with a moat rating of wide or narrow exhibits at least one of these advantages, and in some cases more than one.
Network Effect: The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service.
Intangible Assets: Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products. For example, patents protect the excess returns of pharmaceutical and consumer products firms like Unilever (ULVR) can charge higher prices because of their well-known brands.
Cost Advantage: Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins.
Switching Costs: When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power.
Efficient Scale: When a niche market is effectively served by one or a small handful of companies, efficient scale may be present.
Moat Trends
Economic moats aren’t stagnant over time. Rather, competitive dynamics are constantly shifting as technology develops, regulations change, competitors exit or enter a market, companies gain scale, and so on. This is where our moat trend ratings come in.
If the underlying sources (or potential sources) of a company’s competitive advantage are improving over time, the company has a positive moat trend. If the underlying sources (or potential sources) of an economic moat are weakening or a company faces a substantial competitive threat that is growing, then it has a negative moat trend.
Stewardship
Morningstar’s stewardship ratings—which can be exemplary, standard, or poor—reflect our view of the quality of management. In particular, we emphasize strategic execution (whether management has a sound strategy and is carrying it out effectively) and capital allocation (whether management uses shareholder capital appropriately, between internal reinvestment, acquisitions, share repurchases, and dividends).
Fair Value Estimates
If stock prices always reflected the true intrinsic value of the underlying businesses, there would be no point to stock-picking. However, the reality is that stock prices often deviate from fair value, sometimes by a wide margin. Value-investing pioneer Ben Graham provided our favourite analogy: In the short run, the market is a voting machine—a stock’s price reflects its current popularity and the market’s whims. However, in the long run the market is a weighing machine—stock prices eventually converge toward the intrinsic value of the businesses they represent.
Morningstar’s analysts assign fair value estimates to every company we cover using a discounted cash flow model. This valuation technique is based on the premise that a company is worth the sum of its future free cash flows, discounted back to the present at a rate that provides an adequate return on investors’ capital.
Our analysts make specific forecasts about a company’s future revenue, operating costs, working capital investments, capital expenditures, and other financial statement line items. Analysts must also estimate a discount rate—a weighted average of the cost of debt (which can be observed, though it changes over time) and the cost of equity (which is unobservable and requires us to make an educated guess about the returns required by stock investors).
Uncertainty
That leads us to Morningstar’s uncertainty ratings, which reflect how confident we are in our fair value estimates. Uncertainty can be low, medium, high, very high, or extreme. For example, it’s relatively easy to estimate the intrinsic value of a regulated utility or mature consumer staples firm—since they have fairly predictable cash flows—and these companies tend to receive low uncertainty ratings. It’s much harder to pin down the intrinsic value of a single-product biotech (which could be a hit or a flop) or an oil refiner (which is highly sensitive to commodity prices), so these companies usually have high or very high uncertainty.
Price/Fair Value Ratios and Star Ratings
Lastly, there is a connection between price/fair value ratios, uncertainty, and star ratings. For stocks with high uncertainty, we require a large discount to our fair value estimate before assigning a 4- or 5-star rating, and a large premium to fair value before assigning a 2- or 1-star rating. This accounts for the greater likelihood that our fair value estimates are wrong, usually because we overestimated or underestimated future cash flows. Star ratings adjust automatically based on where a stock is trading relative to our estimate of its intrinsic value.
