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What Makes a Moat?

Paul Larson, Chief Equities Strategist and Chairman, Morningstar Economic Moat Committee

Economic moats represent sustainable competitive advantages that allow

companies to protect their value and lead to the excess returns captured in the
Morningstar Wide Moat Focus Index.
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Active equity returns drive a significant portion of active
management returns. By representing the sources of
these active returns in a rules-based process, we can offer
the benefits of active management in a passive index
structure. Our family of Active Equity Indexes does just this.
It captures the systematic active return sources identified
in Morningstar’s equity research in transparent, rules-based
Indexes. This isn’t traditional indexing, but it’s not
traditional active management either. A number of our Active
Equity indexes rely on an important proprietary metric—
the Morningstar® Economic Moat™ Rating—to identify the
sustainable competitive advantages of companies that
may be undervalued by the market.
To make money in today’s dynamic market environment, one
needs to invest in companies that will perform in the face
of sustained competitive pressure. But how can you accurately
identify companies that are great today and likely to remain
great for many years to come? The answer to this question lies
in competitive advantages, or economic moats. Just as moats
were dug around medieval castles to keep the opposition at bay,
economic moats protect the high returns on capital enjoyed
by the world’s best companies.
Moats 101
In a famous 1999 Fortune article, legendary investor Warren
Buffett wrote, “The key to investing is…determining the
competitive advantage of any given company and, above all,
the durability of that advantage. The products or services that
have wide, sustainable moats around them are the ones
that deliver rewards to investors.” This idea, coined “economic
moat,” refers to the sustainable advantages that protect

Figure 1. Fundamental Performance by Morningstar® Economic Moat™ Rating

Wide moat firms are more profitable than narrow moat firms.
Return on Return on Return on Operating
Invested Capital Assets Equity Margin Net Margin
(%) (%) (%) (%) (%)

Wide Moat 16.3 9.3 18.6 24.1 17.0

Narrow Moat 11.6 5.1 13.0 15.5 10.8
No Moat 9.2 3.6 8.4 8.2 6.0
Median, 3-Year Historical Results
Source: Morningstar Equity Analyst Discounted Cash-Flow Models. Data as of November 12, 2012.
What Makes a Moat?
a company against competitors—the way a moat protects a
castle. While Warren Buffett may have developed the
moat concept, Morningstar has taken the idea a step further.
Whenever a company develops a profitable product or service,
it isn’t long before other firms try to capitalize on that
opportunity by producing a similar—if not better—version.
Basic economic theory says that in a perfectly competitive
market, rivals will eventually eat up any excess profits earned
by a successful business. In other words, profits attract
competition, and competition makes it difficult for firms to
generate strong growth and margins for long periods.
But looking at the history of firms, many companies earn high
returns on capital for an extended period of time, in
conflict with economic theory. Such companies are able to
withstand the relentless onslaught of competition for
long periods, and these are the wealth compounding machines.
The explanation lies in structural characteristics known
as economic moats.
Figure 2. Moats Add Intrinsic Value
Companies with the widest moats have the potential to create
value for longer periods of time.
Return on Invested Capital
Time Horizon (Years) 10 15
No Moat Narrow Moat Wide Moat
Moats Determine the Size of Value Creation
The amount of value a company will create for itself and its
shareholders is largely determined by two things: the amount of
value currently being created and the sustainability of the
excess returns on capital. The first factor is readily apparent to
the market because it is in the financial statements.
However, the second factor—which is not in the historical
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financial statements and cannot readily be screened for—
is just as important and is a function of the duration of the
competitive advantage.
Here is another way to illustrate this idea: Take three companies,
each with a similar value-creating return on invested capital
(ROIC) today. The company that is able to sustain the ROIC the
longest is going to be able to add the most value for itself over
the coming years. In Figure 2, the company with the widest
moat and the longest advantage period has the greatest value
creation (area under the curve). In a nutshell, companies that
have moats can create value for longer periods of time and are
worth more, all else being equal.
Moat Sources
Over the years of looking at companies, Morningstar has
identified five major sources of competitive advantage:
1. Switching Costs—Switching costs are those one-time inconve-
niences or expenses a customer incurs to change from one
product to another. Customers facing high switching costs often
won’t switch unless they are offered a large improvement in
either price or performance. Companies whose customers have
switching costs can charge higher prices (and reap more profits)
without the threat of losing business. Consider a firm like
Oracle—the massive software giant that sells database
programs to companies that store and retrieve vast amounts
of data. Oracle’s databases are generally connected to
other software programs, so if a company wants to change
from an Oracle database, it would not only need to move all its
data, but also reattach all the different programs that pull
from Oracle. Therefore, companies tend not to switch, which is
why businesses like Oracle have extraordinarily high
renewal rates.
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2. Network Effect—The network effect occurs when the value of
a particular good or service increases for both new and
existing users as more people use that good or service, often
creating a virtuous circle that allows the strong to get
stronger. Take eBay as an example—it has the most buyers on
its platform, so it attracts the most sellers. Meanwhile,
because it has the most sellers, it is the most compelling source
for buyers looking for non-standard goods.
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Figure 3. Characteristics by Source of Moat

Different moat sources trade at different multiples of earnings and have varying growth rates.
10-Yr Forward
P/E Current Revenue Days to Market Dividend
Number 5-Yr Avg P/E Growth Cover Cap Yield
of Firms (%) (%) (%) (%) (USD Mil) (%)

Switching Costs 286 18.3 17.8 8.3 3.1 10,002 2.7

Network Effect 101 17.0 19.3 11.0 3.2 6,654 1.8
Intangible Assets 382 18.7 18.7 8.2 3.0 11,309 2.3
Cost Advantage 388 16.1 16.1 9.0 2.8 13,065 2.3
Efficient Scale 224 15.5 15.5 7.6 3.0 11,111 4.1
Source: Morningstar Direct.
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3. Intangible Assets—Intangible assets are things such as patents
or government licenses that explicitly keep competitors
at bay. Pharmaceutical firms such as Abbott or Pfizer certainly
benefit from this. Another sort of intangible asset that
can provide an advantage is a strong brand. Intangible assets
can have a powerful connection with performance and
market characteristics, as seen in Figure 3.
4. Cost Advantage—Firms that can figure out ways to provide
goods or services at lower cost have an advantage because
they can undercut their rivals on price. Alternatively, they
may sell their products or services at the same prices as rivals,
but achieve a fatter profit margin. Wal-Mart is a textbook
example of a low-cost producer because it can use its size
to acquire and distribute merchandise on the cheap, passing
part of the savings to its customers.
5. Efficient Scale—This is primarily a dynamic where there is a
limited market size that is being effectively served by one or a
small handful of companies. The companies that benefit from
this phenomenon are efficiently scaled to fit a market that only
supports one or a few competitors, limiting rivalry. International
Speedway is a great example; there is simply not enough
demand for more than a single NASCAR racetrack in any given
city. Lockheed Martin is another good example as the country
does not need more than one supplier of F-35 jets.

Figure 4. The Moat Assignment Process

The Morningstar Moat assignment process is overseen by a committee of senior researchers. Steps include ensuring a company’s return on invested capital
is in excess of its cost of capital and that it has a sustainable competitive advantage.

1. Returns 2. Advantages 3. Longevity

Has the firm historically generated Does the firm have one or more of the How strong is the firm’s competitive
solid returns on capital? following competitive advantages? advantage? Is it likely to last a Narrow
Yes Yes Moat
– Switching Costs long time or a relatively short time?
– Network Effect
– Intangible Assets How many years will the firm’s
No
– Cost Advantage competitive advantage last?
Is the firm’s future likely to be – Efficient Scale
different than its past? Wide
Moat

No No

No Moat No Moat No Moat

 What Makes a Moat? 4

Figure 5. The Morningstar® Wide Moat Focus Index Construction Process

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Morningstar® Morningstar
Security Selection Morningstar® Wide Moat Focus Index
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US Market Index Moat Assignment Process

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3 A broad market index, representing
97% of U.S. equity market cap.
3 Morningstar equity analyst assigns:
– Wide moat rating
– Fair value estimate
3 Company cannot be under review at
time of stock assignment.
3 The 20 securities with the lowest
current market price/fair value
estimate are selected for inclusion
in the index.

Assigning Moat Ratings
Given the importance that the Economic Moat Rating has in
Morningstar’s process and with a number of products,
a committee of more than 15 senior Morningstar researchers
oversees all of the individual ratings. When assigning
Moat Ratings, Morningstar’s analysts and the committee
first look for the attributes explained previously. But the
proof should be in the pudding, namely, a company’s returns
on invested capital; Morningstar looks for a company to
achieve an ROIC in excess of its cost of capital. The size of
ROIC-cost of capital spread is far less important than the
expected duration of the excess profits. A company needs to
have an expected competitive advantage period of at least
10 years to attain a narrow moat rating, and at least 20 years
to attain a wide moat rating (see Figure 4).
Important to the Process
Beyond its importance in valuation, analyzing moats can im-
prove returns in two other ways. First, the market often does not
perceive the additional value companies with high and sustain-
able returns will generate. Simple math dictates that firms
with economic moats should trade at significant premiums (e.g.,
higher multiples of earnings, cash flow, and book value) over
those with no moats. But it takes time for a company’s moat to
be confirmed, and the market—with all of its short-term
incentives—is all too myopic in this day and age. In other words,
the market is often much more homogenous than it should
be. This is an inefficiency that can be exploited.
The second way that moats add value is when the market under-
estimates the durability of advantaged companies (and also
underestimates the fragility of firms with no moats), something
that happens with surprising frequency. Investing in firms that
hold the high ground is a sound strategy when periodic floods
(recessions, crisis of confidence, and so on) are bound to hit.
Morningstar® Wide Moat Focus IndexSM
In 2007, we introduced the Wide Moat Focus Index to capture
the systemic sources of active returns resulting from the
Economic Moat Rating outlined here. When constructing the
Wide Moat Focus Index, we start with all U.S.-based
and U.S.-traded corporations rated with a wide moat rating
(excluding MLPs), yielding approximately 150 companies
that are eligible for the index. Then the companies are sorted
by market price relative to Morningstar fair value estimates
and include the 20 securities trading at the largest discount to
fair value. The holdings are equal-weighted, and the index
is rebalanced and reconstituted quarterly.
Based on actual moat ratings assigned over the previous decade,
the Morningstar Wide Moat Focus Index has back-tested results
starting in mid-2002. As illustrated in Figure 6, the index has
posted exceptionally strong performance, beating approximately
95% of large-cap active funds since inception.
5 Morningstar Indexes 2012 13

Figure 6. Growth of a $10,000 Investment and Risk/Return: Sep. 20, 2002–Oct. 31, 2012

®
Morningstar
40,000 Wide Moat Focus
Index
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39,730

30,000

Morningstar®
US Market Index
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22,380
20,000
US Open End Large
Blend Active Managers
19,090
USD

10,000
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Total Returns
Standard Max
3-Years 5-Years 10-Years Deviation Sharpe Beta Drawdown
(%) (%) (%) (%) Ratio (%) (%)

Morningstar Wide Moat Focus Index 15.17 8.00 13.12 20.00 0.69 1.17 -42.43
Morningstar US Market Index 13.71 0.79 7.70 15.55 0.49 1.02 -50.76
US Open End Large Blend Active Managers 11.19 -0.71 6.42 15.22 0.39 1.00 -50.79

Figure 7. Morningstar® Wide Moat Focus Index Style Trail

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Using Morningstar’s differentiated economic moat framework
The index is plotted with each quarterly portfolio on the Morningstar in combination with the stock valuations that are based on
Style Box.™ The September 2012 portfolio is circled in black. Given long-term projected cash flow, our process has produced excess
that wide moat stocks tend to be larger caps, the index has generally
landed in the large cap row over the past decade.
returns that have persisted through different market
environments. The strategies focused on economic moats have
Deep Value Core Value Core Core Growth High Growth performed well over the last decade, which has seen two
back-to-back commodity booms, a major financial crisis, a Great
Morningstar Wide Moat Focus Recession, a boom-bust cycle in the housing markets, and
Oct. 2002–Sep. 2012
Giant

a surprisingly strong rebound in corporate earnings. If a pre-

requisite to properly evaluating an investment strategy is
looking at it across a variety of market environments, the past
Large

decade certainly fits the bill.

Conclusion
The Wide Moat Focus Index validates Morningstar’s strategy to
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pay close attention to companies’ competitive advantages—

the importance of which the market persistently underestimates.
Morningstar’s equity research team has demonstrated a strong
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ability to identify the implications of economic moats when

forecasting the long-run cash flows of businesses, increasing
the probability of finding mispriced stocks and leading to
Micro

a better investor experience. K