Morningstar Magazine - August/September 2017 - 9

all, legendary value investor Warren Buffett wrote
in a 1999 Fortune article, "The key to investing is ...
determining the competitive advantage of
any given company and, above all, the durability
of that advantage. The products or services
that have wide, sustainable moats around them
are the ones that deliver rewards to investors."
But perhaps Morningstar's equity research
department is rare in the breadth, rigor,
and consistency of its application of this methodology. To ensure we apply our methodology
consistently across our broad coverage universe,
and given the central importance of the
economic moat rating to the Morningstar equity
research methodology, a committee of
16 senior members of the Morningstar research
team oversees all of the individual company
ratings. Because the committee members
represent each of the major sectors, this approach
provides context for an individual company's
rating, and we can avoid common pitfalls such
as thinking that only the finest company in
an industry deserves a wide moat rating, or that
"best-in-industry" status automatically equates
to a sustainable competitive advantage.

competitive advantages are among the more
critical determinants of terminal valuation.
My experience with discounted cash flow models
confirms this. Changing assumptions about
how profitable a company will be five to 20 years
into the future is much more impactful on the fair
value estimate than fine-tuning assumptions
for the next several years. Therefore, it makes
sense that we focus on determining a company's
ability to fend off competitors for a sustained
period of time, as it helps us identify high-quality
companies and value them accurately.
Given the importance of getting the moat
assessment right in order to better value the
company, I find the role of the economic
moat committee especially important. As Edward
Chancellor writes in Capital Returns: Investing
Through the Capital Cycle, "Industry specialists are
prone to taking the 'inside view.' Having
got lost in a thicket of detail, industry specialists
end up not seeing the wood for the trees. They
may, for instance, spend too much time comparing
the performance and prospects of companies
within their sector and fail to recognize, as a result,
the risks that the industry as a whole is running."

Valuing the Moats

It's important to note that we focus on competitive advantages not only to identify high-quality
companies, but also, and perhaps more
importantly, to attempt to value them more
accurately than our competition. Identifying
companies with sustainable competitive
advantages is only step one. A passive portfolio
of all stocks that have received Morningstar's
wide moat rating has actually underperformed the
markets since its 2002 inception. Meanwhile,
the Wide Moat Focus Index, which is a portfolio
of our cheapest wide-moat stocks relative
to fair value, has generated excess returns versus
the overall market.
In Investment Valuation: Tools and Techniques
for Determining the Value of Any Asset, Aswath
Damodaran points out that "a large portion
of the value of any stock or equity in a business
comes from the terminal value [the period beyond
an analyst's explicit forecast for near-term
earnings and cash flows]." Damodaran argues
that the magnitude and sustainability of

Chancellor argues that there are systematic
flaws in the specialist analyst model, which largely
derive from the relationship between research
analysts and the companies they follow,
and include 1) analysts becoming too close to
management, 2) analysts having access
to too much information, which doesn't improve
decision-making, 3) analysts operating in
a cocoon with underexposure to what is going
on in the rest of the world outside of the
specific industry, and 4) analysts hesitating to
assess management's incentives when there are
corporate finance relationships in play.
At Morningstar, while we need analysts to focus
on industry and company specifics to responsibly
value stocks and communicate their findings,
the economic moat committee is there to make
sure that the analyst is taking advantage
of our department's extensive knowledge base
on general competitive themes. In short, the moat
committee can help a specialist analyst not
miss the forest for the trees.

Our Edge

This brings me back to a reflection on Silver's
warnings. As Morningstar equity analysts compete
in the game of forecasting, what edge do
they have over other analysts or investors? I'll
admit that the competition is fierce and wellresourced, but I believe that there are three areas
where Morningstar analysts have an edge
that I hope will contribute to a continuation of the
strong long-term track record for the Wide Moat
Focus Index.
First, by dedicating ourselves to rigorous
analysis of long-term competitive advantages,
we are focusing our efforts on the assumptions
that matter the most for determining the valuation
of companies.
Second, we have a long-term time horizon
for our stock calls, so our analysts are able to feel
comfortable making long-term bets when
the market in aggregate is assuming that current
non-normal conditions will continue in perpetuity.
Finally, the goals of the Morningstar equity
research department reflect our company's values
of putting investors first. We know that the
internal and external clients of our equity research
expect our stock calls to work out over time,
and that is why our clients place value on our
equity research. Therefore, we prioritize valuation
accuracy and face fewer possible conflicts
of interest from the other ways that equity
research can get monetized at other companies,
such as through investment banking relationships
or corporate access services.
As you'll read in the Spotlight section (Page 27),
the Wide Moat Focus performed well in a
variety of measures relative to the overall market
over the past 10 years. While it's no secret that
stock-picking is a competitive field, Morningstar
equity research's prioritization of rigorous
economic moat analysis, long-term time horizon,
and avoidance of the conflicts of interest that
can lead to analyst bias should continue to allow
the team to deliver great results for investors. K
Elizabeth Collins, CFA, is director of equity research, North
America, with Morningstar Research Services. She is
a member of the editorial board of Morningstar magazine.

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Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017
