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Personal Wealth: Morningstar Helps Identify Economic 'Moats'
Independent investment research firm Morningstar Inc.'s "fat-pitch" investment philosophy - find great companies that boast competitive advantages and buy them at a discount to fair value - is simple to understand, but difficult to employ. Outstanding businesses rarely come cheap.
Highly profitable firms attract competitors, and only firms that are able to keep competition at bay will earn above-normal profits for a long time. An economic moat - or competitive advantage - allows a company to fend off competitors and earn sustainable profits.
Morningstar publishes fair value estimates and star ratings on more than 1,800 companies. The firm evaluates companies by looking at whether a company's return on invested capital has exceeded the firm's cost of capital in the past, and then asks whether it's likely to do so in the future. If the answer is "no" on both counts, then the firm has no moat, no matter how attractive it might sound on the surface.
According to Morningstar, free cash flow - not reported earnings - is what counts. If a company can't earn its cost of capital, growth destroys value instead of creating it.
Another step is identifying a competitive advantage, since even companies that have posted strong returns on capital in the past might not have a moat if there's no identifiable reason why those high returns will continue. A well-established brand or other defensible advantage provides companies with an economic moat. For a stock to have a wide moat, the firm's competitive advantage should persist for quite some time.
Legendary investor Warren Buffett introduced investors to the concept of economic moats. Over the years, many of his annual letters to Berkshire Hathaway shareholders contain references to him looking to invest in businesses with "economic castles protected by unbreachable moats."
Moats are important to investors because any time a company develops a useful product or service, it isn't long before other firms try to capitalize on that opportunity by producing a similar - if not better - product.
The search for investment bargains, however, is a numbers game. The more rocks investors overturn, the better the chances of finding something valuable the rest of the market is missing.
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