Paul Larson, Morningstar – Economic Moats: Sources & Outcomes

 

We are providing extensive coverage of the Omaha Annual shareholder meeting. We have obtained exclusive excerpts of the first interview conducted by Warren Buffett. The interview with Fox Business News (FBN) can be found here.

Below are some notes from the Robert Miles Value Investing Conference which kicked off today.

Value Investor Conference: Omaha, Nebraska – May 3rd, 2012

 

Paul Larson, Morningstar, Inc. (NASDAQ:MORN) – Economic Moats: Sources & Outcomes

Mr. Larson is the Editor of Morningstar’s StockInvestor newsletter. He also manages StockInvestor’s Tortoise and Hare Portfolios.

• Return On Invested Capital (ROIC) is the primary test of a business’ moat.
• Moats general:
  • Capitalism works and competition reduces profitability… but some stay profitable
  • Moats are strategic business characteristics
    • Sustainable returns are more important than the ‘highest’ returns
    • Ex. Crocs (CROX) vs. Nokia (NOK) and Kinder Morgan (KMP) vs. Union Pacific (UPC)
    • 5 Sources of Moats (Morningstar)
      • Network Effects
        • The value of the service grows with additional users (circularity builds)
        • Ex. Mastercard (MC), Visa (V), E-Bay (EBAY), and Facebook (FB)
• Cost Advantages
  • Economy of scale in distribution/manufacturing;  Low cost resource base
  • Ex. Compass Minerals (CMP), Ultra Petroleum (UPL)
• Intangible Assets
  • Brands & Pricing Power – Sallie Mae (SLE) vs. Hershey (HSY), and Sony (SNU) vs. Tiffany (TIF)
  • Patents – Pharma
  • License & Government approvals – Casinos
  • Corporate Culture – Helpful, but not the strongest by itself
• Switching Costs
  • Time=Money, Money=Time – Consumer & Bank sectors especially
  • Ex. Oracle (ORCL), Autodesk (ADSK), Micros Systems (MCRS), Intuit (INTU)
  • My note: coming from the architecture & engineering field, I can attest to ADSK’s dominate position.
• Efficiencies of Scale
  • Limited market size; A new entrant would drive profits below cost of capital for all participants – Airports, Racetracks, Pipelines, Defense, Lubrizol
  • More modest profitability

• Morningstar Moat rating originated from Warren Buffett
  • 1999 Fortune article
  • Measure by ROIC vs. WACC
  • Wide (10%), Narrow (50%), None (40%)
  • More moats in Consumer, Defense, Healthcare, Financial Services
  • Morningstar is currently working on explicit listings of companies’ competitive advantages for use in reports:
    • Multiple, smaller competitive advantages is better than one larger one
    • Best competitive advantage is Intangible Assets
      • Ex. Healthcare patents, Consumer brands
• Least stable competitive advantage is Network Effects
• Efficiency of Scale resulted in best market return past few years – likely due to Utilities
• Switching Costs & Network Effects both seen on the most positive outliers – Apple (AAPL)
• Wide Moat Focus Index – Morningstar
  • Roughly 120 ‘Wide Moat’ out of S&P Index
  • 20 cheapest chosen
  • Equally weighted and re-balanced quarterly
  • Fun fact: Telecom has never been in it

• Q&A
  • Wide Moat Focus Index turnover?
    • Around 150%, average 5-6/20 each quarter
• Track record of actual management compared to back testing?
  • They back tested to 2002. They started actual managing in 2007.
• Narrow Moat/Wide Moat differentiation?
• Comes back to sustainability of competitive advantages; (+/- 10-15) years (narrow) and greater (wide)

Dustin Hunter, SunRift Capital Partners (www.sunriftcp.com)

 (These notes are to the best of my recollection and trusty ink pen. Discrepancies are due to my error in understanding & transcribing.)