Morningstar Magazine - February/March 2014 - (Page 52)

Strategies: Investment Research How a Company Increases Its Moat By Stephen Ellis and James Sinegal We studied the reasons behind all our moat upgrades. Good management was the common thread. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors. Understanding the size of a company's competitive position is critical information for an investor. Morningstar's equity analysts try to capture the strength and sustainability of a firm's competitive advantage with their economic moat rating. Analysts award a company a moat rating of none, narrow, or wide. Sources of a sustainable moat include cost advantages, the network effect, high switching costs, and intangible assets. Morningstar assigned its first moat rating in 2002, and since then, analysts have rated about 2,000 companies. Today, analysts cover about 1,500 firms, and they are constantly reviewing the ratings for changes in the competitive characteristics of companies. From 2002 to 2013, analysts made 270 upgrades, where a firm improved to narrow moat from no moat or to a wide moat from narrow (see exhibit). We wondered what caused these upgrades. Is there a common thread among these firms from many different industries that caused their moats to widen? If there is, what can we as investors learn from it? To find the answers to these questions, we looked over more than 10 years of data and internal resources (old reports, proposals, 52 Morningstar February/March 2014 and analysts' input). We then classified the reasons analysts gave for their moat upgrades. We found that about 50% of the moat upgrades could be assigned to four rationales: restructuring, paradigm shift, innovation, and industry consolidation. These factors aren't always sufficient for a moat upgrade, but they appear necessary for success. (The remaining half of the upgrade data set was a mix of rationales where the sample size ended up too small to be meaningful enough to draw larger conclusions.) Let's dive a little deeper into each upgrade reason in order of importance. 1. Restructuring Restructuring is one the easiest ways for a firm to improve its moat, especially if it can shed businesses that are not creating profits in order to focus on ones that are. Restructuring can also change a company's cost structure for the better. If a firm can make changes that lower its position on the industry cost curve, it can improve its competitive advantage. Indeed, the private equity model is predicated on restructuring and cost-cutting at portfolio firms. Unfortunately for passive investors, the difficulty comes in predicting which restructurings (especially those related to cost-cutting initiatives) will be successful, because many are not. As Warren Buffett once said, "The really good manager does not wake up in the morning and say, 'This is the day I'm going to cut costs,' any more than he wakes up and decides to practice breathing." For the most part, a company attempting to alter its mix of businesses has an easier time than one attempting to lower its position on a cost curve. We think several good examples of companies creating economic moats through restructuring are Lockheed Martin LMT and DuPont DD. 2. Consolidation Consolidation occasionally occurs in an industry suffering from overcapacity and intense competition. As an industry moves from a perfectly competitive market to one better characterized as an oligopoly, remaining firms often experience increased economies of scale, improvements in pricing power, and more concentrated bargaining power. Unlike the other reasons for moat upgrades that we've mentioned, we think industry consolidation is easily observable by investors through closely studying mergers and acquisition actiivity. In general, once a good portion of the industry's value chain is controlled by anywhere from two to 10 firms, there is likely to be some significant economic value creation occurring by the companies with the most skilled managers. Two of the best examples of this trend occurring are within the online brokerages and oil services industries.

Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2014

Morningstar Magazine - February/March 2014
Contents
Contributors
Letter From the Editor
Preparing for the Next 50 Years
Morningstar Managers of the Year
Fixing the Trust Deficit
Rethinking the Path to Retirement
Trends
Same Old, Same Old
Global Briefs
The Economic Implications of an Older World
Banking on Performance
Is the Affordable Care Act Healing Health Care’s Woes?70
Baxter Has a Positive Prognosis
Leading Fidelity’s Charge for RIAs
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Moving the Goal Post

Morningstar Magazine - February/March 2014