Morningstar Magazine - August/September 2017 - 8

Dispatches

The Moat Edge
How our rigorous
analysis leads to better
fair value estimates.

Phillips Curve
10

Indexing in America

12

Keep It Simple, and Keep It Cheap

15

Advice to the Graduate

16

Will Tax Reform Hit
Retirement Contributions?

19

A Heavy Emotional Price

21

Americas
Greater Europe
Asia

LETTER FROM THE BOARD

Elizabeth Collins

Ivory Towers

The Old Squirrel

Policy

Behavior Gap

Global Briefs
24
25

In The Signal and the Noise: Why So Many
Predictions Fail-but Some Don't, author Nate
Silver tells some stories of successful
predictive endeavors, plus plenty of cautionary
tales. This book has been top of mind for
me as I reflect on the track record of the
Morningstar Wide Moat Focus Index. The idea
behind the index is completely simple: Invest
in companies with sustainable competitive
advantages but only when they are trading
at a discount to their intrinsic value. But because
intrinsic value is determined by future cash
flows discounted back to today using an
appropriate rate of return, the deployment of
this methodology involves forecasting
and is, therefore, no easy feat. Undervalued
stock opportunities only occur when the
aggregate market prediction differs from the
individual analyst's.
Economic forecasting, political punditry, credit
ratings on mortgage-backed securities,
baseball player valuation, meteorology, epidemic
threat assessments, sports betting, poker,
chess, stock investing, and climatology all fall
under Silver's microscope, and he tears
apart human biases as well as artificial intelligence
shortcomings. The Signal and the Noise covers
a lot of territory, but one part sticks out to me:
"If you have strong analytical skills that might
be applicable in a number of disciplines, it is very
much worth considering the strength of the
competition. It is very often possible to make profit
by being pretty good at prediction in fields
where the competition succumbs to poor incentives,

8

Morningstar August/September 2017

bad habits, or blind adherence to tradition, or
because you have better data or technology than
they do. It is much harder to be very good
in fields where everyone else is getting the basics
right-and you may be fooling yourself
if you think you have much of an edge....
If you're approaching prediction as more of a
business proposition, you're usually better off
finding someplace where you can be the big fish in
a small pond."
For example, as Michael Lewis documented
in Moneyball: The Art of Winning an Unfair Game,
the 2002 Oakland Athletics were able to
exploit an opportunity where certain player
statistics were underappreciated for their
predictive signals and, therefore, undervalued by
the "market." The team assembled a roster
of valuable players despite a small budget thanks
to a lack of statistical savvy among other
teams' general managers and scouts. A decade
and a half later, though, those opportunities to find
"mispriced" players are rarer, given increased
usage of statistical analysis among many teams.
Similarly, "upper-middle-class" poker players-
those who fall short of being world-class
players-can reliably win only when they compete
against inexperienced players who have yet to
master even the basics, such as folding bad hands,
betting on good ones, and considering what
an opponent holds. Between 2003 and 2006, the
number of entrants for the World Series
of Poker Main Event soared to 8,773 from 839 after
dark-horse player Chris Moneymaker (his real
name!) won the 2003 World Series (his first live
tournament) after qualifying in an online
tournament. ESPN's miniseries on Moneymaker
played repeatedly and subtly convinced
viewers that poker was easy to learn and easy
to profit from. Internet poker companies also
started marketing more aggressively. The influx of
inexperienced poker players to live games
and Internet sites created an opportunity for
skilled professional players to exploit the mistakes
that amateur players are prone to making.
Moat Committee: Ensures Consistency

The Wide Moat Focus Index is not alone in using
a strategy of investing in high-quality companies
trading at a discount to intrinsic value. After
Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017
