Feb 9, 2016

Build your portfolio like a castle - Morningstar.com.au

According to the old saying in sport, "form is temporary, class is permanent". It means that when a class player or team loses their form, you stick with them as class will prevail and form will return.

The saying also transposes to investments. Morningstar's economic moat methodology is designed to identify exceptional companies that will stand the test of time.

Morningstar's equity analysts look for structural competitive advantages that allow a company to earn above-average returns on capital over a sustained period of time, which prevent these returns from quickly eroding. Simply put, they are looking for class rather than form.

Great management, size, dominant market share, easily replicable technology and hot products are "form" characteristics that do not create economic moats. These are all attractive aspects of a business, but not structural advantages that can sustain high returns over a long period, according to Morningstar.

There are five sources of sustainable competitive advantage: intangible assets, switching costs, network effect, cost advantage and efficient scale.

The best way to understand these moat characteristics is through examples. Coca-Cola's source of sustainable competitive advantage is intangible; its ubiquitous brand means consumers are willing to pay a high premium for what is essentially sugar water.

Oracle is a good example of a "switching cost" moat source, as moving away from its tightly integrated databases could cause massive disruptions for clients. UPS's moat is its low-cost courier network's high capital return.

Evaluating companies based on their moat characteristics is a qualitative process. Morningstar also calculates the fair value of the identified wide moat company because there is no point overpaying, no matter the quality of the company.

Morningstar's team of analysts use a three-stage discounted cash flow model to determine fair value estimates of each company in its coverage universe. Over time, a company's stock may trade above or below Morningstar's fair value estimate and this creates potential opportunities to invest in a company at a discount to fair value.

By combining its qualitative economic moat methodology and quantitative fair value process, Morningstar has developed a comprehensive analytical framework.

The results are ranked and the top 20 most attractively priced US wide moat companies are captured in the Morningstar Wide Moat Focus Index. The index components are equally weighted and the components are reviewed and rebalanced quarterly.

Current companies in the index include Warren Buffett's own Berkshire Hathaway. Buffett is a great proponent of economic moats, which are one of his key considerations when he invests in a company. It is not surprising then that the Wide Moat Focus Index has provided a Buffett-like 32.8 per cent annual return over the three years to 31 July 2015.

Other holdings in Morningstar's Wide Moat Focus Index are Google, Twenty-First Century Fox and Harley Davidson.

Australian investors can access this investment strategy through the Market Vectors Morningstar Wide Moat ETF (MOAT). MOAT tracks the Morningstar Wide Moat Focus Index.

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