When deciding where to put money in the stock market, how can investors wade through the barrage of information and tell a great business from a poor one?
Look for moats.
That advice comes from Heather Brilliant and Elizabeth Collins of the investment research firm Morningstar Inc. Similar to the way medieval castles are protected by moats, investment-worthy companies have “economic moats,” or structural barriers that can fend off competitors and can earn high returns for many years, Brilliant and Collins write in their newly published book, “Why Moats Matter: The Morningstar Approach to Stock Investing.”
It’s a method that is based on a concept by billionaire investor Warren Buffett and one that Chicago-based Morningstar(Nasdaq: MORN) has used for many years as a basis for the firm’s successful stock-investing approach, the authors say. (Brilliant is co-chief executive of Morningstar Australasia and global head of equity and corporate credit research for Morningstar, and Collins is Morningstar’s director of equity research for North America.)
Now, with the book, Brilliant and Collins are looking to show investors how they themselves can find good stock picks and determine when to buy them.
"When you focus on a company's fundamental value relative to its stock price, and not on where the stock price is today relative to a month ago or a day ago or five minutes ago, you start to think like an owner rather than a trader,” Brilliant says. “It's this mindset that we believe is key to helping people become successful stock investors."
Collins says economic moats stem from five sources of competitive advantage:
- Cost advantage, when a company has high profit margins and sustainably lower costs than competitors;
- Intangible assets, such as brand recognition and patents that can keep competitors at bay;
- Switching costs, the expenses in terms of time, hassle, money or risk a customer would incur if it switches to a competitor;
- Efficient scale, when the company is in a limited market with few competitors;
- Network effect, when the value of the good or service increases as the company wins more customers.
A company needs to have at least one of these elements to be considered to have an economic moat, says Collins.
“Companies with a moat have benefits that are so structural that it's inherently part of the business itself,” says Brilliant.
One example is computer technology company Oracle Corp. (NYSE: ORCL), which benefits from switching costs. Even though other software companies provide similar products and services, Redwood City, Calif.-based Oracle is deemed to have a wide moat because once its enterprise software is embedded into its clients’ systems, it is extremely difficult for the client to switch to another software provider.
“Even if something came along that was twice as good and half the price, the customer would have to think twice about switching because of the major disruption it would cause,” says Brilliant.
In contrast, Morningstar gives Apple Inc. only a narrow moat, mainly based on the switching cost of its operating system rather than its devices. Apple’s iOS may keep its users loyal, but as popular as iPhones and iPads are, it would be relatively easy for other companies to launch rival devices, the analysts say.
“We give Apple a narrow moat because the product cycle for devices and computers are still so fast,” says Brilliant.
Another company with a wide moat is San Jose, Calif.-based Ebay Inc. (Nasdaq: EBAY), which has a powerful network effect. It has not only become a leader in online auctions but also has expanded its business to payments through its acquisition of Paypal.
“Having both sides of the transaction was part of Ebay’s success,” says Brilliant. “As they grew, they became the obvious choice that nobody else could catch up.”
An example of a company that didn’t have that same network effect was Chicago-based Groupon Inc. (Nasdaq: GRPN).
“I love to talk about Groupon because that’s one where our moat methodology made it very clear from the very first day it was in existence that it was not a ‘moaty’ business,” says Brilliant. Even when Groupon’s stock was soaring, Morningstar held off on recommending it.
“We said, 'It doesn’t have a moat so it’s not going to last, and it ended up being the case, which is how our moat ratings work,” notes Brilliant. “It was very easy [for customers] to switch to Living Social, or other offerings, like Amazon. Groupon would’ve liked a network effect there, but we didn’t see it.”
In addition to determining economic moats, Morningstar’s analysts also give moat ratings to companies, which forecast whether a company will generate sustainable profits for a decade or more. “Moaty” businesses will be able to survive short-term fluctuations in stock prices and unpredictable changes in the market or industry.
So when the stock price falls on a company that has a moat, look at it as a buying opportunity.
“Each time your reevaluate your portfolio, think about the valuation question: Are the companies that I hold today undervalued, fairly valued or overvalued? Don’t put a discrete timeline on things. It all depends on the valuation and if it’s performing to expectation," Collins says.
Collins adds that there are two reasons to sell a stock. “One is that it’s no longer a compelling buying opportunity or has appreciated to the fair value estimate; the second is you no longer think the future is going to play out as you once did,” she says.
Understanding the value of a stock also requires looking beyond just the price. A $200 stock may sound expensive, but it may be a better value than a $20 stock that won’t bring you good returns.
“You’ll wait for a $500 pair of shoes to go on sale for $350,” says Brilliant. “In your mind, it's worth $500. But if you paid $350 for a $30 pair of shoes, you'd be feeling hugely ripped off. So it’s not really about the price; it’s about the underlying value of the item your buying."
Brilliant says the important thing to do as an investor is to focus on the long term and not get sucked in by the "movings" of the market at any given moment.
“Apply a framework like this and stick to it — because we know you’ll have better performance than following those waves in the market,” she says.
originally posted by I-Chun Chen is a California-based free lance journalist.
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