As you know, Ariel traces its philosophical lineage directly to the world’s greatest investor, Warren Buffett (Trades, Portfolio). Buffett’s beliefs and teachings have influenced many aspects of our core traditional value strategy, from the importance of staying within a well-defined circle of competence to the topic we will discuss this month: the economic moat1.
Buffett coined the term decades ago. And yet, we think his best description of the concept appears in his 2007 Berkshire Hathaway letter to shareholders, where he posits: “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns.” A company’s economic moat ultimately creates a durable competitive advantage relative to the competition. For instance, in the 1993 Berkshire letter he described some advantages held by both The Coca-Cola Co. (KO, Financial) and Gillette: “The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles.”
Morningstar, Inc. (MORN), another Chicago-based firm that admires Buffett, has instituted its own proprietary Morningstar Economic Moat Rating2. In so doing, the company’s equity analysts assign moat ratings to companies: no moat; narrow moat; or wide moat. Morningstar’s description says: “Whenever a company develops a profitable product or service, it doesn’t take long before competitive forces drive down its economic profits. Only companies with an economic moat—a structural competitive advantage that allows a firm to earn above-average returns on capital over a long period of time—are able to hold competitors at bay.”
Currently, Morningstar publishes moat ratings on 671securities. Of those, just 145 receive the coveted wide moat rating, 321 hold a narrow moat rating, and 205 receive the no moat rating. Because size and scale convey significant advantages, nearly 70% of the wide moat companies are large: more specifically, 98 wide moat firms are large companies, 41 are mid caps, and just 6 are small companies. In other words, it’s far more challenging for a small- or mid-cap manager to find wide moat firms.
More specifically, the moat ratings as of July 31, 2016 of the stocks in our longest-tenured portfolios are noteworthy. Both Ariel Fund and Ariel Appreciation Fund, as you recall, reside in Morningstar’s Mid-Cap Blend Category.
As you can see, Ariel Appreciation Fund has about 3.5 times as many wide moat firms as the typical peer fund, with Ariel Fund having double. Ariel Appreciation Fund has nearly double the median number of narrow moat companies, with Ariel Fund having about one-and-a-half times as many. And while the standard fund has more than 10% of holdings with a no moat rating, Ariel Fund has no such companies and Ariel Appreciation Fund has just one. To summarize, nearly 75% of Ariel Appreciation Fund’s companies have a moat, while more than half of Ariel Fund’s do—but the standard Mid-Cap Blend Fund is below half.
We too assign moat ratings to the stocks we analyze. And we agree with Morningstar that wide, narrow, and no moat ratings adequately describe what is obviously a complex concept. Our proprietary views on stocks are very closely aligned with Morningstar’s independent views. That is, for the holdings in Ariel Fund and Ariel Appreciation Fund, 16 out of 20 wide-moat holdings (according to our proprietary ratings) also have wide moats according to Morningstar. Similarly, 39 out of 43 stocks that we rate as narrow moat are also rated as such by Morningstar.
We think these results are noteworthy. Furthermore, we see them as proof that we execute our process consistently in keeping with our Buffett-inspired philosophy. Obviously, we believe that all our holdings have durable competitive advantages; we think Morningstar’s external view strongly supports that view. We will strive to continue to seek out and purchase such firms at a significant discount to their intrinsic values.
1An economic moat cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimations, declining fundamentals or external forces.
2Morningstar, Inc.’s Morningstar Economic MoatTM ranking measures the sustainability of a company’s profits and refers to how likely companies are to keep competitors at bay for an extended period. Morningstar reviews a company’s historical financial performance—companies that have generated returns on higher than their cost of capital for many years usually have a moat. Morningstar also carefully evaluates the source of a company’s excess economic profits. Source: Morningstar, Inc.
The opinions expressed are current as of the date of this commentary but are subject to change. The details offered in this commentary do not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
Past performance does not guarantee future results. Investing in small- and mid-cap stocks is more risky and more volatile than investing in large cap stocks. Investing in equity stocks is risky and subject to the volatility of the markets. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market. The Funds often invest a significant portion of its assets in companies within the financial services and consumer discretionary sectors and their performance may suffer if these sectors underperform the overall stock market.
