Build a Moat in Your Portfolio - Morningstar

Build a Moat in Your Portfolio. × Matthew .... ROIC is compared against the weighted average cost of capital, ... Dad expects a 10% return (his cost of equity).
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Build a Moat in Your Portfolio ×

Matthew Coffina, CFA Editor, Morningstar StockInvestor

Disclosure × I own

many of the stocks that will be discussed today, both personally and in StockInvestor’s Tortoise and Hare portfolios. × None of this presentation is intended as investment advice. × Please consult a financial advisor for questions about the suitability of any investment strategy or product for your particular circumstances.

Morningstar’s Strategy

Invest in companies with strong and growing competitive advantages, trading at reasonable prices.

Five Morningstar Ratings Drive Stock Selection × Economic

Moats × Moat Trends × Stewardship × Price/Fair Value Ratios × Uncertainty/Star Ratings

Why Moats Matter × Wide-moat

firms’ ability to invest incremental capital at high rates of return = faster earnings growth and/or higher free cash flow. × Wide-moat firms are able to sustain excess returns longer than firms without moats. × Morningstar’s fair value estimates are more accurate for wide-moat firms because future cash flows are more predictable.

Star Ratings Performance* Wide Moat

Narrow Moat

No Moat

All

11.0%

11.6%

12.9%

QQQQQ

19.7%

15.8%

19.3%

QQQ

8.1%

10.6%

12.4%

Q

-2.3%

6.1%

15.3% *Annualized Returns, 6/26/2002-2/28/2014

The Tortoise and Hare Strategy × Real-money

portfolios focused on buying wide- and expanding-moat stocks at discounts to Morningstar’s fair value estimates. × Tortoise Portfolio invests in more conservative stocks. × Hare Portfolio takes on greater risk for higher total-return potential. × About 20 stocks in each portfolio. × Inception date of June 18, 2001.

Tortoise and Hare Performance Annualized Total Returns as of 2/28/14 Combined Tortoise & Hare

S&P 500

Trailing 1-Year

27.4%

25.4%

Trailing 5-Year

23.4%

23.0%

Trailing 10-Year

9.7%

7.2%

Since Inception

9.4%

5.5%

Other Benefits to a Wide-Moat Approach* × The

Tortoise and Hare have experienced low turnover (18% per year versus 89% for the average equity mutual fund). × Standard deviation of returns (14.1%) below the S&P 500 (15.2%). × Beta below one (0.87). × Greatest outperformance realized during down markets. *All figures represent averages since inception for the combined Tortoise and Hare.

Definition of a Moat × Sustainable

competitive advantage(s). × Enables a company to earn positive economic profits (ROIC>WACC). × At least one identifiable moat source.

Moat Ratings: Wide/Narrow/None × Width

of moat determined by duration of competitive advantage. × Narrow moats: Excess returns more likely than not in 10 years. × Wide moats: Excess returns nearly certain in 10 years, more likely than not in 20 years.

Wide Moats Are Rare × We

assign a wide moat rating to 14% of our global coverage universe. × However, we intentionally try to cover high-quality companies. × The share of wide moats in the overall economy/market would be much lower.

Prevalence of Moats by Sector

The Five Sources of a Moat × Network

Effect × Intangible Assets × Cost Advantage × Switching Costs × Efficient Scale

The Network Effect × The

value of a company’s service increases as more people use it.

Intangible Assets × Patents,

brands, or regulatory licenses that protect excess returns.

Cost Advantage × Economies

of scale, access to a unique asset, etc.

Switching Costs × It

is too