Morningstar Advisor - April/May 2013 - (Page 49)

What Moats Tell Us About Risk Stocks with strong competitive advantages offer a path to returns with less risk. By Warren Miller Competition is great for consumers; it drives prices lower and spurs innovation. It is also the enemy of profits. Virtually every business faces competition of one kind or another, but only some businesses can successfully defend their profits from competitive threats. These identifiable, structural, and durable defenses form what we refer to as an economic moat. Based on the moat attributes a company possesses, we award it a wide, narrow, or no moat Morningstar Economic Moat Rating. a reliable dividend from a risky one, and an attractive total return from a poor one. It probably comes as no surprise that moats also tell us about the riskiness of a company. None of the measures in the graphs below is explicitly incorporated in our moat methodology, yet we find that they all have correlation to our moat ratings. Wide-moat companies have lower market beta than do no-moat companies. Of course, the market recognizes all of this and compensates investors accordingly. Wide-moat companies generate less excess returns than do narrow- and no-moat firms. However, if investors add a valuation rating, such as the Morningstar Rating for stocks, to a wide moat rating, they increase their chances of earning better returns with less risk. For investors, moats get to the heart of what separates a good business from a bad business, These statistics are a mix of fundamental and price-based indicators of risk. A couple of them jump out. No-moat companies are 53 times more likely to go bankrupt as are wide-moat companies. Wide-moat companies are more than three times as profitable as no-moat companies. Leverage Liquidity CAPM Beta 1.14% Wide Wide 0.89 Narrow 1.31% Narrow $3.06M Narrow 1.09 None 1.48% None None 1.29 Wide $5.37M $3.20M Warren Miller, CFA, is director of quantitative research with Morningstar. Josh Peters, editor of Morningstar DividendInvestor, contributed to this article. Enterprise Value/Market Cap. Average Daily Volume (09/2002–12/2012). Return on Assets Volatility Wide 9% Wide 19% Wide Narrow 6% Narrow 25% Narrow 1.8 None 2% None 32% None 2.5 Likelihood of Dividend Cut 1 Annualized Total Return Volatility (09/2002–12/2012). Based on Number of Dividend Cuts between 2002 and 2012. Market Cap Drawdown Likelihood of Bankruptcy Wide $51B Wide 23% Wide Narrow $15B Narrow 25% Narrow 17 None 32% None 53 None $6B Maximum Peak-to-Trough Drawdown (09/2002–12/2012). 1 Based on Number of Bankruptcy Filings between 2002 and 2012. MorningstarAdvisor.com 49 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013