Morningstar Magazine - December 2017/January 2018 - 30

Spotlight: Abnormal Profitability

EXHIBIT 1

Moats Protect High Profit Levels

As natural skeptics, we explore the glass-halfempty side of things in a bull market. As we
examine profit margins that are running at peak
levels relative to the past few decades, we believe
there are some longer-term structural shifts in
globalization that should continue to hold costs
down. Other dynamics, however, appear more
cyclical, including low interest rates, low inflation,
and lagging wage growth coming out of the
recession, all of which have helped prime margins
for the majority of firms. Eventually, costs
are likely to rise in the form of wage and material
inflation, along with more expensive financing.
Further, the capital cycle suggests that we
are at a point where firms will expand deeper into
areas of high profitability, opening up more
price competition.
Within this context, we find it important to
examine the staying power of these profit levels
within our moat analysis. Firms with moats
hold structural advantages that should increase
their ability to defend against increasing
costs and competition. To do this, we looked
at the largest 100 companies by market capitalization since the 1980s. As profit margins have
expanded over this time frame ( E X H I BI T 2 ), an
increasing representation of moats among these
large firms helps support their elevated
margins. The high levels of profitability suggest
a moderation in the intensity and success
of competition. It's not that firms are colluding to
impair competitive forces to capture monopoly
profits. Rather, we see an increase in the
durability and defensibility of the largest firms'
competitive positions.

Rising Valuations High profits and optimism have led to current multiples that have
only been exceeded by the dot-com bubble and 1920s bull market.
Cyclically Adjusted PE Ratio

50
40

Cyclically Adjusted PE Ratio

50
31.12 30
40
20

01/1900-10/2017

1900

1920

1940

1960

1980

31.12 30
10

0
20

2000

Source: Robert Shiller, Yale School of Management.

10

01/1900-10/2017

1900

1920

1940

1960

1980

0

2000

EXHIBIT 2 Profit Margins of the Largest 100 Firms by Market Capitalization Traded on U.S. Exchanges
Average

Bigger Profits Margins of the largest 100 firms have expanded over the past
30 years.

25%
20

Operating Margin

Average Profit Margins of the Largest 100 Firms by Market Capitalization Traded on U.S. Exchanges

Operating Margin
Net Margin

1982

1986

1990

1994

1998

1982-2016 13.24

2002

2006

2010

2014

Net Margin
1982-2016

1982

1986

1990

1994

1998

17.85
25%
15
13.24
20
10
17.85

2002

2006

2010

15
5
0
10
5
0

2014

Source: Morningstar Direct.

Harvesting Greater Profits

Over the past three decades, the moat
composition of the largest 100 firms has shifted
toward wider moats. We base our historical
analysis of moats on our current moat methodology and retroactively apply our framework
to determine the moats of the leading companies
in 1987. While moats relate more to the
spread between returns and the cost of capital,
and less to absolute profit margins, the
increased representation of wider-moat
firms likely contributed to the elevated levels of
overall profitability.

30

Morningstar December/January 2018

Given highly competitive markets, we expect that
the increasing profits seen over the past few
decades should be competed away as rivals are
enticed to participate in each market. Some
businesses, however, have structural advantages
that enable a stronger defense against competition, enabling high profits over an extended period.
As competitive advantages have improved for
the leading firms, we believe the ability to shield
profits from normal competition has increased,
enabling higher overall profits. The high concentra-

tion of wide and narrow moats among the
largest 100 firms suggests that their elevated profit
margins partly reflect the successful defense
of competitive positions. In analysis looking at
the past 10 years, wide-moat firms have generated
more than triple the operating margins of
no-moat firms, while narrow-moat firms have
posted more than double the returns of no-moat
companies. As the moat rating improves,
the margins expand, supporting the importance
of moats in protecting profits ( EXHIBIT 3 ).



Table of Contents for the Digital Edition of Morningstar Magazine - December 2017/January 2018

Contents
Morningstar Magazine - December 2017/January 2018 - Cover1
Morningstar Magazine - December 2017/January 2018 - Cover2
Morningstar Magazine - December 2017/January 2018 - 1
Morningstar Magazine - December 2017/January 2018 - 2
Morningstar Magazine - December 2017/January 2018 - Contents
Morningstar Magazine - December 2017/January 2018 - 4
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