MATT COFINA: For Morningstar, I’m
Matt Coffina. I’m joined today by Elizabeth Collins, who is the director of
our basic materials team and also chairs our economic moat committee.
We’re going to talk about how the moat committee works and how Morningstar
assigns economic moat ratings to companies.
Thanks for joining me, Elizabeth.
ELIZABETH COLLINS: Thanks for having me.
COFINA: First, could you tell us how does the moat committee work,
and why is it important to our equity-research process?
COLLINS: On the moat committee, we have a
little bit over 15 senior members of the equity research department. And
this moat committee meets about two to three times a week, and we vote on
analyst proposals for their company’s moat ratings. And basically, the
analysts make a case for why they think a company should have a particular
moat rating. We ask critical-thinking questions about the company’s
competitive advantages. Then the voters cast their votes, and the majority
I think it’s
important for our equity research methodology because it ensures
consistency and rigor, and so that if you’re reading about a moat
rating on any particular company, you know that it’s consistently
applied across our coverage universe. It's comparable on an
apples-to-apples basis no matter what the sector or industry
COFFINA: Morningstar has identified
five sources of an economic moat. Can you tell me what those are?
COLLINS: Sure. We’ve intangible
assets, customer switching costs, cost advantages, network effect, and the
efficient scale phenomenon.
COFFINA: Start with cost advantages. What is that and what’s an
example of a company with a cost advantage?
COLLINS: Sure. So, a cost advantage, it might be that
you’re selling a commodity product or something where there is not an
opportunity to differentiate on prices. But if you’re a company [with a
cost advantage] you have an advantage because of your ability to
sustainably produce the good or service at a cost lower than everybody
else. So, you capture that spread between prices that everybody is
charging and your costs, which are lower than everybody
And a good example on this
category would be Ultra Petroleum, which is a natural gas producer. Mother
Nature gave them very advantaged geological assets that they had for many
years, and they produce natural gas at a cost lower than the rest of
COFFINA: How about
So, intangible assets is a category that covers a lot of ground. We have
brands, patents, and then government regulations, things of that nature.
So, let me talk about brands. Here we’re looking for brands that allow
companies to charge a premium price. So a brand, if it just means name
recognition, that doesn’t really qualify for an economic moat, but if it
allows the company to charge a higher price, then that’s something that
might be moat-worthy.
good example here is Coca-Cola. Unlike some grocery-store items, where
people are willing to save money and buy the store brand or generic brand,
soda is something where brand really matters and people are less willing
to trade down to store brands.
I think one of the strongest sources of an economic moat is the network
effect. Can you give me an example of a network effect?
COLLINS: I think you are right. The
network effect is a very potent form of competitive advantage. I think the
best example here is eBay, and with the network affect the value of a good or
service increases for both buyers and sellers, as more buyers and sellers
are added to the network.
So, if you think about it, you want to sell your old Beanie
Babies, you are going to go to the platform that has the most potential
buyers--bidders [in eBay's case]. And if you're in the market for Beanie
Babies, you want to go to the platform that has the most potential
sellers of Beanie Babies. And so, the platform becomes stronger as more
people get added to the platform.
COFFINA: Great. [Can you talk about] switching costs?
COLLINS: Switching costs is where
several competitors might be offering a similar good or service. But you
don't see as much price competition because customers won't switch for small
differences in price because the value they gain from getting that lower
price would be more than offset by the costs they would have to incur in
either time or money in order to undergo the
So, in this case, we see
examples like Oracle. It has massive database offerings. Companies don't
want to undergo the cost of switching providers because it would be huge
headaches for them. They lose business, [and it causes] disruption of their
business. So, basically there is high cost of failure and low cost of
ongoing service. It makes sense to stick with your existing
COFFINA: And lastly,
I think probably the least intuitive of the sources of moat is efficient
scale is where a limited market is effectively served by one or a small
number of existing players. And potential entrants are disincentivized
from entering the market because doing so would result in a market share
battle, and in order to recoup their costs of investment for entering the
industry they’d have to compete a lot on price. Doing so would depress prices
for all players, depressing returns for everybody in the industry, and it
defeats the purpose of entering in the first place.
A good example of an efficient scale phenomenon is
pipeline. So, a good example would be Kinder Morgan. It only makes sense to
transport a certain amount of oil from point A to point B. Once a pipeline
is built that meets that need, it doesn't make any sense to undergo the
capital costs in order to build another pipeline.
COFFINA: How do we weigh in the moat committee
quantitative versus qualitative evidence when assigning a moat rating?
COLLINS: I think that they are
both equally important. So, we're looking for the qualitative factors, the
underlying sources of competitive advantage, the five sources that you
and I just talked about. But we also have some quantitative hurdles that we
want companies to jump over before we award them a narrow or wide economic
moat rating. Our ratings are forward-looking.
For a narrow-moat company we're looking for them to
have economic profits. In most cases, that means returns on invested
capital that are higher than the weighted average cost of capital, that
are sustainable for at least 10 years. With a wide-moat company, we want
those positive economic profits to be sustainable for at least 20 years.
There is also a degree of certainty that we look at. We have a higher degree
of certainty with a wide-moat company, and with a narrow moat company even
we need to be more likely than not certain that the economic profits will
be positive 10 years from now.
COFFINA: Well, this has been great. Thanks for joining me,
COLLINS: Thanks for
Morningstar, I'm Matt Coffina
- - - - - - - -
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