For some of us, corporate moats are static. But for the moat team at Morningstar (MORN, Financial), they are dynamic.
In the book “Why Moats Matter: The Morningstar Approach to Stock Investing,” contributor Stephen Ellis, the head of financial services equity research at Morningstar, wrote, “Moat ratings can tell you the width of a company’s current moat, but trend ratings tell you if that moat is holding up well, is getting even stronger, or is in danger of being filled in by a rampaging horde of invaders.”
Ellis, along with lead authors Heather Brilliant and Elizabeth Collins, argue that as corporations evolve, their moats either grow, mature or die—all part of a life cycle. The trend ratings come in three strengths:
- Positive: means the corporation’s competitive advantages are getting stronger; that took in just 8% of companies with a moat rating in 2013.
- Negative: those advantages are shrinking, not getting stronger; 16% in 2013.
- Stable: there is little change in either direction.
The following chart from the book shows the state of positive (orange) and negative (blue) trends across sectors:
In practice, this means assessing the competitive landscape over the next 10 to 20 years. (A “narrow” moat means a company’s advantage is expected to persist for at least 10 years and “wide” moat means the advantage should last at least 20 years.)
It also means sorting temporary competitive threats from the more permanent and dangerous long-term threats. The trend assessment process uses the same five sources of moats used to set moat ratings; for example, if a company’s moat is based on low-cost manufacturing, will a capacity expansion increase its cost-gap with competitors? If yes, that would widen its moat (a positive trend), as would the inclusion of a network effect to a company that already has a cost advantage.
Positive and negative trending also shows up in the fundamentals:
“We find that positive-trend firms tend to grow more quickly, produce more profits, and generate higher returns on invested capital than firms included in the S&P 500. On the other hand, negative-trend firms generally show weaker metrics than both positive-trend firms and the S&P 500 firms. This makes sense, given our focus on competitive advantages.”
The authors go on to observe that companies with negative trends are often losing market share, can’t raise their prices or are being undercut by the competition. Companies with positive trends have improving fundamentals because they are becoming more competitive. The authors also discussed five “key considerations” for moat trends:
- Various combinations occur; for example, a company can have a wide moat rating and a positive trend, or a no-moat rating along with a negative trend.
- The ratings for the existence of a moat and its trend are not connected; the two ratings are derived independently.
- A change in a company’s return on invested capital may not affect a moat-trend rating because ROICs can increase for non-moat reasons such as cycles.
- There is no direct connection between moat trends and a company’s growth.
- Trend ratings are not affected by shifts in the business mix.
Ellis and his co-authors went back to the five sources of economic moats to illustrate how each might contribute to a trend rating:
Intangibles
In 2014, when this book was published, pharmaceutical company AstraZeneca (AZN, Financial) had been suffering declining productivity for more than a decade, while, at the same time, the Food and Drug Administration had become more cautious in licensing new drugs. AstraZeneca’s trend, then, was negative.
On the other hand, Seattle Genetics (SGEN, Financial) was a young biotech company with a proprietary research and development platform. As a result, Morningstar expected its positive trend to continue.
Cost advantage
In this source category, the authors compared United Parcel Service (UPS, Financial) with FedEx (FDX, Financial). The former traditionally dominated ground delivery while the latter controlled airborne deliveries. However, in the late 1990s, UPS decided to go after some of the FedEx market, prompting FedEx to buy UPS’s biggest competitor and set up its own ground delivery system.
Morningstar assessed FedEx as deserving a positive trend rating for two key reasons, lower labor costs and technology that automates most its package handling requirements. These advantages led to improved margins and continuing growth of market share.
Switching costs
For an example of a positive trend rating due to switching costs, the authors turned to Cerner (CERN, Financial), which operates electronic medical systems for health care facilities. Medical professionals using its services can update patients’ health care records at any facility and retrieve them at any other facility that uses Cerner’s services. Once locked into Cerner’s services, it becomes extremely difficult for facilities to switch to any other company.
Still, such barriers can be eroded by time and new technology. For example, SAP (SAP, Financial), an enterprise software company, had a very strong moat in the recent past. It is now being challenged, however, by cloud systems and software-as-a-service. One such newcomer, Salesforce.com (CRM, Financial), offers software-as-a-service and has been disrupting SAP’s business.
Network effect
The network effect is called “one of the most powerful moat sources a company can have.” To illustrate their case, the authors referenced MercadoLibre (MELI, Financial), the Amazon (AMZN, Financial) and eBay (EBAY, Financial) of Latin America. It earned a positive moat trend for three reasons: its main market, South America, had a much lower level of internet penetration than North America, it already had a very high market share, so new entrants are discouraged, and it learned from eBay’s successes and failures (eBay had invested in the company).
As examples of negative trends, the authors cited the New York Stock Exchange (NYSE) and Nasdaq (NDAQ), both of which are being challenged by electronic trading specialists.
Efficient scale
Typical of examples of companies with efficient scale moats are pipelines and railroads, which dominate the locations they serve. To provide examples of companies with a positively-trending moat, the authors named Alexion (ALXN) and BioMarin (BMRN), two pharmaceutical firms that specialize in orphan drugs (fewer than 200,000 patients in the U.S.). Alexion has developed a drug that treats paroxysmal nocturnal hemogrobinuria and sells for more than $400,000 per year; yet it is unlikely to face competition since the disease affects fewer than 10,000 patients.
For examples of negatively trending moats, the authors list the telecom sector, specifically the way the market has evolved in New Zealand since 2000. Once served by a near monopoly, customers now have choices and new entrants quickly gained market share.
For each of these moat sources, the authors have provided some of the questions they ask to determine the direction, if any, of a moat trend.
The lesson from chapter three? Moats are dynamic and evolve as macro or micro conditions change. Because of these changing conditions, moat trends can be positive or negative. If there is no significant change, there may be no trend. Investors, obviously, want to find companies with moats, and one that are positively trending.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
