Morningstar Magazine - February/March 2014 - (Page 53)

Number of Moat Upgrades and Downgrades 2002-12 Upgrades Downgrades 60 40 20 0 -20 -40 -60 -80 Three companies best exemplify this approach: Monsanto MON, Intuitive Surgical ISRG, and Alexion Pharmaceuticals ALXN. Management teams often see R&D budgets as bloated and easy sources of cost-cuts to meet shortterm earnings goals, but as the recent struggles at Hewlett-Packard HP and Procter & Gamble PG show, failing to reinvest in research can hurt a firm's competitiveness. Management teams that hold the course, consider R&D the lifeblood of the firm, and continuously reinvest in research, deserve credit for being longer-term oriented than most executive offices. Management Matters -100 2002 2003 2004 2005 2006 3. Paradigm Shift Another major source of moat upgrades was a paradigm shift within an industry. We describe a paradigm shift as a significant change in an industry's business model where certain firms were either the primary instigator or one of the major beneficiaries. In terms of moat sources, paradigm shifts can fall under efficient scale (for example, the barriers to entry for a new railroad are enormous), switching costs (commonly associated with market shifts that force certain technologies such as antivirus software to become mission-critical functions), and intangibles (in the case of the intellectual property position of Qualcomm QCOM regarding code division multiple access). For investors seeking to profit from paradigm shifts, the task can be difficult because the phrase tends to be associated with many instances of failed and hyped-up stories. We'd suggest looking for instances where a company has already staked out a strong position as an industry standard or intellectual property supplier to the industry. The strong value chains already surrounding the firms are the best signals they will continue to capture excess returns. By thinking about a firm's competitive position 10 and 20 years down the road, our moat framework forces us 2007 2008 2009 2010 2011 2012 to differentiate between a company positioned in a fast-growing market without any competitive advantages versus one with a substantial ecosystem of suppliers and customers. While these types of shifts are hard to predict we expect firms will continue to create competitive advantages by encouraging or benefiting from paradigm shifts within their industries. Three examples of firms and industries benefiting from paradigm shifts are Qualcomm, Symantec SYMC, and the six major railroad companies. In each case, the respective management teams have clearly contributed to the moat upgrades. 4. Innovation Many of our upgrades, particularly within the health-care industry, were linked to innovation. Innovation is primarily captured within our intangibles moat source, and we typically upgrade moats as regulators approve a new drug or product we think has sizable commercial potential, which usually means that patents surrounding that drug or product are now a considerable barrier to entry for other firms. The combination of long-lived patents, the validation of the firm's research prowess, and the increased confidence the firm has the capabilities to fund R&D budgets in the future is a potent combination for moat upgrades. One common thread that ties together these moat-upgrade reasons is management action. Morningstar has long contended that good (or bad) management can have a substantial impact on economic value creation. In a September 2012 Morningstar report, titled "In the Taxonomy of Moat Destruction, Patterns Emerge," analysts found management actions accounted for 22% of moat downgrades. It was the second largest source of moat destruction. (Competition was first, with 29% of downgraded firms being affected.) Our study shows the value good management can add. For restructuring, shedding underperforming assets, initiating cost-saving efforts, and acquiring attractive businesses are all decisions that can create value. For industry consolidation, as an industry moves from hundreds of competitors to just a few over years or decades, the well-managed companies remaining will likely capture economic rents. For paradigm shifts, the best approach is to focus on firms whose management actions have already put it in a strong competitive position in its industry. Finally, management teams that consider research and development the lifeblood of the firm tend to be longer-term oriented than most executives and are well positioned to capture economic rents. K Stephen Ellis is the director of the financial services team at Morningstar. James Sinegal is a senior equity analyst with Morningstar. global.morningstar.com/Morningstarmagazine 53 http://global.morningstar.com/Morningstarmagazine

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