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JASON STIPP: I'm Jason Stipp for Morningstar. Anyone who's read a Morningstar equity research report knows that we are quite keen on the concept of economic moat.


Morningstar's Paul Larson, an equity strategist and the editor of Morningstar StockInvestor, is here to give us some detail behind the moat rating and also of Morningstar's Wide Moat Indexes.


STIPP: The moat concept, before we start to talk about the rating, has been around for a little while. Where did Morningstar first learn about the moat concept, and how do we build it out into our rating?


LARSON: This is a concept that Warren Buffett really came up with in his famous article in Fortune Magazine about a dozen years ago, where he said that companies that have a competitive advantage, or a wide economic moat, are the companies that provide rewards to investors.


And we read that article, agreed with the concept, and took that concept to the next level. Then in 2002, we started explicitly rating companies by their economic moat--putting them into one of three buckets: either no economic moat (meaning they have no competitive advantage); narrow economic moat (meaning they may have something, but it's not going to last quite as long as the wide moat firms), and the third bucket and the best bucket are the [wide-moat] firms where we think the competitive advantage is going to last 20 years or greater.


STIPP: You mentioned the wide moats are the best bucket. These were the kind of companies that we at Morningstar like to find, because they have those enduring competitive advantages. We have actually identified five sources of wide moats. These are fundamental qualities that companies have, and I'd like to learn a little bit more about those. The first one, I've heard you say, is one of the most powerful sources of economic moat, and that's the network effect. What is that?


LARSON: The network effect is an effect where the value of a given network grows exponentially with each node of the network that's added. This is perhaps best illustrated by examples. When you look at the payment networks--like Visa, MasterCard, and maybe even Discover--those credit card payments are accepted [by merchants], because those are the cards that we [consumers] have in our wallets. And why do we carry around those particular cards in our wallets? Well, that's what's accepted as payment [by vendors], and so it's a virtuous network. Every person that takes out another Visa credit card is adding to that network and making it more likely that the merchants are going to sign up for Visa. A more recent phenomenon is--look at the company that's about to IPO--Facebook. Why is everyone on Facebook? Well, because that's where everyone else is. And the value of Facebook grows as more people join. You might think of the network effect [like this]: As more customers join the network, it makes that network more valuable for other customers.


You mentioned that this is a relatively rare source of competitive advantage. It is indeed relatively rare, but it is also the most powerful, the companies that have this advantage tend to have relatively high levels of profitability.


STIPP: It certainly sounds like the epitome of a virtuous cycle, when those network effects get going. Second source of economic moat has to do with switching costs--the cost to move to a competitor. And when that's high, that means economic moats could be wide. Can you give me some more detail on that?


LARSON: I like to explain this by saying that time is money and money is time, and they are sort of interchangeable. It may not cost a customer money to switch from one provider to another. In fact, they may actually save money by switching. But if it's going to cost them time to switch, that may increase inertia and keep them with an existing provider, and allow that provider some pricing power.


The typical example is ... bank deposit accounts. Those deposits tend not to turn over a whole lot, and that's because it costs customers time to actually switch banks. They would have to go to the new bank, fill out the forms, switch over all their information, so on and so forth. They tend not to do that, because that takes time, and again time is money, and money is time.


Also when you look at some service firms, like bank processing firms, you have companies like Fiserv or Jack Henry that have renewal rates in the high 90% range. And why is that? If you're a bank, you're not necessarily going to risk interrupting your core operations just to save $1 or $2 on maybe a slightly cheaper software platform. So you're going to stay with the existing platform.


STIPP: Certainly the hassle factor comes into play there--you just don't want to switch unless you absolutely have to. Another source of economic moat is a cost advantage, and I think a low-cost provider often comes to mind here. Can you tell me about how a cost advantage helps a company attain a wide moat?


LARSON: When you have a cost advantage, this means that you can either charge the same price as the other competitors that are out there, and reap a higher profit margin, or you can charge slightly lower prices and maybe try and gain some share from competitors.


[There are] a couple of different ways you can get a cost advantage. One way would be economies of scale; if you're just a bigger company, you can typically source things cheaper and have lower overhead costs. But also if you are looking at, say, a basic materials company, and they have inherently low costs--say they are mining a certain geology that has much lower cost than geologies elsewhere around the world--that's an inherent cost advantage, something structural to the business, and could be a source of economic moat.


STIPP: The fourth source of economic moat is the intangible assets. This must be that certain something that gives a company a step up above its competitors. What kinds of intangible assets would you consider to be the kind that really gives a company a wide moat?


LARSON: You have one that's very explicit, and this is a patent, which gives a company basically a legalized monopoly. In certain situations, especially say in the pharmaceutical industry, if you have a best-in-class drug, and you have legalized monopoly, that gives you enormous pricing power.


Another sort of intangible asset would be a brand that allows the company some pricing power. Now, not just any brand can be a source of an economic moat. If you have a brand for a random consumer-electronics, say a DVD player or something, that's not going to confer a company pricing power. But if you have a brand, like a Coke or a Tiffany, that allows you to charge just that little bit of premium, that could certainly be a source of economic moat.


A final intangible would be certain government approvals. If you have a permit for a landfill or a casino license in an area where there are a limited number of casinos, those sorts of assets are intangible but certainly provide a competitive advantage.


STIPP: A fifth source of economic moat is one that we've identified more recently. It's known as efficient scale. What are the details behind that?


LARSON: This is a phenomenon I like to explain by saying that it's like a game of musical chairs, where all the chairs are already taken. When you have a company that's providing a service to a limited market, and there's a relatively small number of competitors supplying to that market, it may not make sense for a new competitor to enter the market, because that new competitor would destroy the returns for all the players involved.


Some markets are just natural monopolies. Perhaps the example that I like best is International Speedway, which owns NASCAR race tracks. Here in the Chicago market, we have a NASCAR racetrack, and in the Chicago market, we can support exactly one NASCAR racetrack. So if I had a billion dollars, why would I build another racetrack in the market when there's already one here, it just wouldn't make sense.


STIPP: When you are looking at these companies, you can qualitatively identify some of these factors that might give a company a wide economic moat. But for someone who wants more proof that the moat is actually carrying through to the bottom line for these companies, how can you confirm that the economic moat that you think exists in a company is really coming through in the financials?


LARSON: These are all qualitative factors that I've spoken about thus far. But these qualitative factors are indeed going to show up in the quantitative financial statements. When we are looking to assign economic moats at Morningstar, where the rubber really hits the road is the return on invested capital relative to the company's cost of capital. If a company does have a competitive advantage, it should translate to higher ROICs relative to that cost of capital, and having that positive spread is really what we are looking for.


But it's not necessarily the absolute size of the spread that we are concerned about, or the magnitude of the spread, we are more concerned about the sustainability of the spread. A company that has a high return on invested capital, say, a random fashion retailer that happens to get lucky and hit a fashion trend and has a 40% return in a given year, we are not going to say that company has an economic moat; it just got lucky. Whereas, if you take a random railroad or a pipeline company, they may not have very high returns on capital, maybe 11% or 12%, something like that, but that spread to the cost of capital of just a few percentage points is going to last for a very long period of time, and we are going say those firms have wide or narrow moats.


STIPP: Beyond just looking at the financials of the company and considering the qualitative aspects of the company that could give it a wide moat, there's a formal process here at Morningstar that we'll go through before we actually put that final rating on a firm. Layers of folks will take a look at it. Can you describe that process to me?


LARSON: We have a formal economic moat committee under our equity research business, and this is a committee that I happen to chair along with one of our vice presidents, Heather Brilliant. This is a committee comprised of about 20 senior analysts from the equity research business unit, and when we initiate coverage on a new company, the company has to go through the economic moat committee, and the committee actually assigns the rating.


Also, whenever we change an economic moat rating, these changes also have to get the approval of the committee. ... The committee has a democratic process, simple majority rules, not every committee member is present at every meeting, but we do have at least five voting members for any given decision.


STIPP: You mentioned that you will meet and talk about potential changes to rating. It's not always the case that a wide moat company is born on the day that company is formed. There can be some changes: A wide-moat company may become a narrow-moat company over time or vice versa. What factors are you looking at that might determine a rating upgrade or downgrade?


LARSON: We're looking at the qualitative business aspects that we talked about. We're also looking at the returns on invested capital. If we thought, initially, say four or five years ago, that a company was going to have falling returns on capital, but things have stayed pretty steady or maybe even ticked up a little bit, that might prompt a reconsideration.


STIPP: Paul, one of the ways that Morningstar has used its moat rating, specifically its wide moat ratings, is in putting together a Wide Moat Focus Index. Can you talk to me a bit about how that index is constructed?


LARSON: The first thing that we do is take all the companies that we cover at Morningstar and look at only the U.S.-based corporations that have a wide economic moat. When you look at all the wide moats in general, there are about 150 to 160 wide-moat firms, but then when you cut out the ADRs and you cut out the master limited partnerships, you are down to about 120 firms that are U.S.-based corporations with a wide moat.


And then ... we take those 120 firms and rank-order them based on the price-to-fair value estimate metric. And ... every quarter we are going to take the 20 cheapest [wide-moat companies] on that price-to-fair value metric and create an index. And because we have 20 names, and we equal-weight those 20 names, that means every security is going to get a 5% weight, and then we're going to reconstitute the index and rebalance it quarterly.


At reconstitution, we're going to do that exercise again, where we are going to look for the 20 cheapest wide-moat firms and then [we'll] rebalance ... put every position at a 5% weight again.


STIPP: ... Morningstar analysts place fair value estimates on all the companies under coverage and on all the companies that have moat ratings. If you are going to look at that price-to-fair value [when constituting the index], if the market sells off in a certain area, you could end up buying quite a bit of companies in that area because they have sold off, but maybe we do not think their prospects have fundamentally changed. Do you have any limits on how much of a sector you will allow the index to have exposure to?


LARSON: As the index name implies, it is quite a focused index, and it can focus on individual sectors, out-of-favor sectors, at any given time. For instance, two years ago, we had a 30% weight in the consumer discretionary sector. Now that sector has done quite well in recent periods, and when you look at the index today, we have 0% weight in that consumer discretionary sector. So, the index weights can go from quite large to zero and anything in between.


We're basically sector agnostic when we are creating this index, which is quite a divergence from how a lot of active mutual fund managers think about things. They look at the S&P 500 and they don't want to stray too much from those sector weights. But again we're sector agnostic.


STIPP: I would guess that you are also agnostic as to the market cap of the company, but does the index tend to have a certain bias as far as the companies that end up in it after you do these screens?


LARSON: You are absolutely right that we don't look at company size when constructing the index, but because wide-moat firms tend to be large-cap firms, the Wide Moat Focus Index also tends to skew toward large cap.


It ... skews actually a little bit smaller than the S&P 500. It has a little bit of a small- and mid-cap tilt relative to the S&P 500, but still very safe in that large-cap bucket. Now, when you look at value versus growth, it also fits squarely in the core category.


STIPP: Maybe the value metrics that you are considering could be a little bit different than traditional value metrics of a company that's called a "value company"?


LARSON: When we say that we like values here at Morningstar, we think that any security can be a value. It's not just stocks that have low growth rates that trade at very, very cheap multiples. If you have a high growth stock that's trading at a discount to its estimated growth in the future, that can also be a value in our eyes.


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