Morningstar Magazine - December 2017/January 2018 - 7

Letter From the Editor

Moaty Profits

Jerry Kerns

Follow Jerry on Twitter
@jerrykerns

The focus of our August/September issue was
economic moats-the characteristics that
enable companies to maintain sustainable
advantages over their competition. We looked at
the types of moats and found that some
are more beneficial than others, both from a
fundamental perspective and when it comes to the
performance of companies' stocks. Moats take
center stage again this issue, as we take our
first crack at explaining an economic conundrum:
Why are companies earning abnormally high
profits relative to historical norms?
Academics have also taken on the issue of
abnormal profitability, from a different angle: They
are looking at the increasing concentration of
ownership of large companies by big institutional
investors. The likes of Vanguard and BlackRock BLK
own increasingly large chunks of publicly
traded companies. The concern is that the
incentive for these owners is to act in ways that
stifle competition, because it benefits them
more if the companies they own cooperate with
each other instead of competing. One proponent
of the theory is law professor Eric Posner.
Morningstar's Haywood Kelly and Aron Szapiro
interview Posner, who has some interesting
solutions, including limiting large indexing firms
to owning one company per competitive
industry ("Do Vanguard and BlackRock Own Too
Much of Corporate America?" Page 34).
The financial press also has taken notice. (The
Economist, for example, wrote about its
concerns earlier this year in an article titled
"The University of Chicago Worries About a Lack
of Competition.") Policymakers may be next,
as Szapiro points out in his Policy column ("Would
Policymakers Target Index Funds?" Page 18).
Posner's solution is extreme and one that we find

hard to endorse, given the advantages ordinary
Americans gain from low-cost passive investing.
Still, the question of ownership concentration and
outsize company profits is an issue that is
gaining traction, and researchers are only in the
early stages of understanding what is occurring.
To us, the explanation for today's historically
abnormal profitability comes back to moats.
Equity analysts Damien Conover and Michael Holt
compared today's largest companies with
those 30 years ago. They found that today's top
companies not only possess more moats,
but they also own wider ones ("More Moats, More
Profits," Page 29). The sources of these moats
are evolving, too. Significantly more top companies
get their competitive advantages from network
effects, intangible assets, and switching
costs than they did three decades ago. These types
of moats, especially the network effect, tend to
be very profitable and have given rise to the
powerful technology and healthcare companies
we see today that are able to exploit technological
advancements and the web's interconnectivity to
dominate their sectors. The analysts conclude
that although they expect profit margins overall
to eventually revert to their mean, firms that
possess these strong moats are in good position
to protect their high profits.
The classic language of moats speaks to the
way tech and the web have transformed
competition and created, perhaps, new kinds
of companies-with sustainable competitive
advantages that they may be able to defend
for decades.

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7


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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
Morningstar Magazine - December 2017/January 2018 - 5
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Morningstar Magazine - December 2017/January 2018 - 7
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