Morningstar Magazine - August/September 2017 - 60

Investors

reason, because they're investing in some sort of
sustainable competitive advantage that will benefit
the firm over a long period of time. It could be
some company that's developed a new
technology and is trying to build switching costs
around that technology. Think of a software
company that's investing heavily in sales and
marketing to get a product into as many
customers' hands as possible because they know
that once they've done that, they have enough
switching costs around that product to
make it very sticky, enabling the firm to earn
very strong lifetime values out of those
customer relationships.
Companies where you're taking that short-term
pain to build a long-term competitive advantage
can be attractive investment opportunities
if the market has chosen to be myopic in those
situations and not give the firm credit for
what it's trying to do.
Collins: Andrew, any companies come to mind that

fit the profile here?

Lane: Amazon.com AMZN, which has a wide
moat rating. On a strictly backward-looking basis,
Amazon hasn't necessarily harvested all
the enormous investments that it's made, but
looking forward, we expect profitability
to grow substantially.
Hodel: Amazon's a great example, maybe
the ultimate example of a firm that's been willing
to invest very aggressively at the expense of
near-term profitability. Their shareholders expect
that. It'd almost be a negative if Amazon
slowed its investment and started to become
too profitable. "Has Jeff Bezos lost his long-term
vision?" It's a really interesting case study.
Collins: Guidewire GWRE is another example. They

do software for property and casualty insurers. It takes
them up to 18 months to deploy at an insurance
company, but they offer claims management, billing,
and underwriting software for their customers. But
once they're there, it's highly likely that their customers
wouldn't defect because the switching costs are
so high. But because of accounting rules, they have
to expense all of the marketing and deployment
over the life of the initial contract, when in actuality it's
highly likely that those costs are, in economic terms,

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Morningstar August/September 2017

amortized over the life to the customer. So, as
they're growing, they're posting operating margins
of low single digits, but ultimately, we think as
they go into harvest mode, if they ever decided to, this
is more of a high-20s-operating-margin-type business.

Lane: I'd also mention Salesforce.com CRM.
Salesforce has the relatively rare designation
of wide moat and positive moat trend. The
company has a sustainable competitive advantage
based on switching costs and network effect
that we expect to last perhaps 20 years
or more, and we think switching costs are actually
intensifying. So, the company already has
a very compelling competitive position, yet that
competitive position will strengthen further
in the future.

Salesforce offers a wide variety of software
solutions for their customers. Just to elaborate on
the power of switching costs, in the second
quarter of 2013, only about 13% of the company's
top 40 customers used four or more of Salesforce's
software solutions. As of the second quarter
of 2017, about 75% of its top 200 customers used
four or more of the company's software solutions,
and 99% of those 200 customers used at
least two of the company's software solutions.
So, phrased differently, when Salesforce
lands a customer, it tends to entrench itself in that
customer's business, which increases the
customer's cost of switching to a different vendor.
McDevitt: Some of these companies, such
as Alphabet GOOG and Facebook FB, have high fair
value uncertainty ratings right now. There's
a heavy percentage of the assumed present value
of those businesses that's based far in the
future, right?
Lane: Yes. We only have five wide-moat-rated
companies globally with a very high uncertainty
rating, and that reflects the margin of safety
we require to feel comfortable with assigning
a wide moat when we're really analyzing
competitive dynamics 20 years into the future.

Uncertainty and Trends
Collins: Can we talk more about the uncertainty rating
and the moat trend rating? Why are these significant?

Lane: The moat trend rating aims to indicate
whether the moat sources underpinning an
economic moat will be strengthening, weakening,
or stable over time. So, to assign a positive
or negative moat trend to a company, the analyst
must propose a compelling argument as to
specifically which source of competitive advantage
is strengthening or weakening.

The moat trend rating should be independent
of the economic moat rating. Accordingly,
some companies have a no-moat rating and
negative trend rating. Here, any traces of
competitive advantage they might have remaining
are diminishing. We also, therefore, have some
wide-moat companies that have a positive
moat trend. I mentioned Salesforce earlier. There's
a clear, durable competitive advantage, yet
competitive position is strengthening further in the
coming years.
With regard to uncertainty, this is effectively
a measure of the degree of conviction
we have in forecasting future cash flows for
a company. We look at factors such as margins,
financial leverage, revenue cyclicality, and
operating leverage. We also look at companyspecific risks that face a given company,
such as unique liabilities that might lie down the
road. Anything that would require investors
to demand a wider margin of safety for their entry
point relative to our fair value estimate may
lead to a higher uncertainty rating.
These are not static ratings. Whether it's our moat
rating, fair value rating, uncertainty rating, the
stewardship rating-these are all being assessed
constantly by our analysts and are always subject
to change.
Collins: Andrew, what do you think are the most

important activities that an equity analyst who is trying
to figure out what the future holds over the long term
should do?

Lane: Particularly for an analyst who is new
to an industry, cutting through the noise presented
by those companies' management teams is
an important skill. Doing this is more difficult than
it might sound. When you have a limited amount
of information from which to draw conclusions,
and much of that information is coming directly
http://www.Salesforce.com http://www.Amazon.com
Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017
