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The Secret to Profitable Investing: Why Moats Matter

Morningstar analysts David Wang and Elizabeth Collins explain why it matters to find stocks with a strong competitive advantage over their peers

Morningstar Analysts 26 August, 2014 | 9:38AM

Many people attribute Diageo’s (DGE) competitive advantage solely to its portfolio of premium alcoholic beverage brands such as Baileys, Smirnoff, and Johnnie Walker. At Morningstar, we delve deeper into the U.K.’s largest alcoholic beverage maker and find that much of Diageo’s success actually comes from operating a highly efficient distribution network that is unmatched by its peers.

This type of insight is characteristic of Morningstar’s thorough understanding of sustainable competitive advantages, which we call economic moats. Combined with our focus on intrinsic value, margin of safety, and a long-term time horizon, our economic moat framework has been instrumental in helping us achieve outperformance over market benchmarks for the past decade through our index and real-money portfolios. We illustrate our economic moat framework in our new book, Why Moats Matter: The Morningstar Approach to Stock Investing.

At Morningstar, we take a fundamental view of stock investing by looking to hold shares of great businesses for long periods of time. As physical moats protect castles from enemies, economic moats are structural advantages that protect companies from competitors. Through our proprietary research of over a thousand companies, we have identified five major moat sources: intangible assets, cost advantage, switching costs, network effect, and efficient scale.

Unilever (ULVR) is a great example of a packaged-food business with intangible assets due to its portfolio of top brands. In fact, Unilever’s top 15 brands, including Dove and Lipton, each generate over €1 billion in annual revenue. We believe that a testament to the strength of Unilever’s brands is the company’s ability to raise prices across its products while simultaneously growing volumes over many years.

Cost advantage is the primary source of moats in the basic materials sector, since companies typically cannot set the prices of the undifferentiated commodities that they produce. We believe Rio Tinto derives its moat from being able to produce metals, including iron ore, at far lower costs than many of its competitors.

As one of the top producers of catalytic converters, which are used to transform vehicle exhaust to innocuous gases, Johnson Matthey derives an economic moat through switching costs. Automakers hate changing emissions control systems in the middle of decade-long vehicle life cycles, since doing so could lead to disruptions and require substantial time to develop new components. We believe the network effect contributes to the economic moat of the London Stock Exchange Group (LSE). Trading liquidity on the London Stock Exchange encourages other market participants to join, which adds to more liquidity.

This creates a positive feedback loop to enhance the LSE’s network effect. Carnival (CCL) is a business that has an economic moat based on efficient scale, a dynamic in which a market of limited size is served effectively by just a few companies. Potential competitors are discouraged from entering because doing so would result in insufficient returns for all players. Carnival operates about half of the total capacity of the global cruise market, so the entrance of a new rival would dilute the returns on invested capital for the entire cruise industry.

In our new book, we offer checklists for analysing moats in each of these five categories. We also provide details on how to investigate moat trends, which are a measure of whether a company’s competitive advantages are strengthening or weakening. Lastly, our book describes how to assess competitive advantages in each sector, so investors have the tools they need to apply our moat framework in their own research.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Carnival PLC4,754.83 GBX0.08
Diageo PLC2,427.12 GBX0.27
London Stock Exchange Group PLC3,782.88 GBX0.05
Unilever PLC4,266.78 GBX0.12
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