Incorporate economic moat analysis for profitable investing Why Moats Matter is a comprehensive guide to finding great companies with economic moats, or competitive advantages. This book explains the investment approach used by Morningstar, Inc., and includes a free trial to Morningstar's Research. Economic moats-or sustainable competitive advantages-protect companies from competitors. Legendary investor Warren Buffett devised the economic moat concept. Morningstar has made it the foundation of a successful stock-investing philosophy. Morningstar views investing in the most fundamental sense: For Morningstar, investing is about holding shares in great businesses for long periods of time. How can investors tell a great business from a poor one? A great business can fend off competition and earn high returns on capital for many years to come. The key to finding these great companies is identifying economic moats that stem from at least one of five sources of competitive advantage-cost advantage, intangible assets, switching costs, efficient scale, and network effect. Each source is explored in depth throughout this book. Even better than finding a great business is finding one at a great price. The stock market affords virtually unlimited opportunities to track prices and buy or sell securities at any hour of the day or night. But looking past that noise and understanding the value of a business's underlying cash flows is the key to successful long-term investing. When investors focus on a company's fundamental value relative to its stock price, and not where the stock price sits today versus a month ago, a day ago, or five minutes ago, investors start to think like owners, not traders. And thinking like an owner will makes readers better investors. The book provides a fundamental framework for successful long-term investing. The book helps investors answer two key questions: How can investors identify a great business, and when should investors buy that business to maximize return? Using fundamental moat and valuation analysis has led to superior risk-adjusted returns and made Morningstar analysts some of the industry's top stock-pickers. In this book, Morningstar shares the ins and outs of its moat-driven investment philosophy, which readers can use to identify great stock picks for their own portfolios.
Preface ix Acknowledgments xi Chapter 1 Guiding Principles of Morningstar's Equity Research 1 Question 1: How Can We Identify Which Businesses Are Great? 2 Question 2: When Is the Best Time to Invest in Great Businesses? 6 Chapter 2 What Makes a Moat? 11 Moat Sources 13 Notes 33 Chapter 3 Why Moat Trends Matter 35 Contributed by Stephen Ellis, a member of Morningstar's Economic Moat Committee and head of Financial Services equity research at Morningstar Moat Trends and Fundamental Performance 37 Five Key Considerations for Moat Trends 38 Intangibles 41 Cost Advantage 44 Switching Costs 47 Network Effect 51 Efficient Scale 54 Best Practices for Moat Trend Analysis 57 Chapter 4 How Stewardship Affects Economic Moats 61 Contributed by Todd Wenning, who oversees Morningstar's equity stewardship methodology Meet Our Stewardship Methodology 62 Drilling Down 63 Chapter 5 Applying Moats to Dividend Investing 81 Contributed by Josh Peters, director of equity-income strategy for Morningstar and editor of the Morningstar(R) DividendInvestorSM newsletter Why Dividends Matter 83 Which Dividends? 87 Chapter 6 The Importance of Valuation 93 Contributed by Joel Bloomer, Matt Coffina, and Gareth James, members of Morningstar's Moat Committee and contributors to Morningstar's valuation methodology Valuation Concepts 95 Cost of Capital and Returns on Capital 96 Morningstar's Valuation Approach 97 Example: Calculating ROIC 99 Forecasting Future Free Cash Flows 102 The Morningstar RatingTM for Stocks 106 Fair Value Uncertainty and Cost of Equity 107 Notes 111 Chapter 7 Do Moat Ratings Predict Stock Returns? 113 Contributed by Warren Miller, head of quantitative research at Morningstar Chapter 8 Putting Moat and Valuation to Work: Portfolio Strategies 121 Wide Moat Focus Index 121 The Tortoise and Hare Portfolios 124 Chapter 9 Basic Materials 129 Commodity Manufacturers 130 Commodity Processors 133 Metals and Mining 135 Chapter 10 Consumer 139 Beverages 140 Consumer Products 141 Tobacco 143 Restaurants 144 Retail Defensive 146 Specialty Retail 148 Lodging 149 Notes 151 Chapter 11 Energy 153 Oil and Gas Drilling 154 Oil and Gas Exploration and Production 156 Oil and Gas Midstream 158 Refining 159 Oil and Gas Integrateds 161 Engineering Services 163 Chapter 12 Financial Services 167 Banks 168 Capital Markets 170 Credit Services 172 Financial Exchanges 173 Insurance 174 Chapter 13 Healthcare 177 Pharmaceuticals 178 Biotechnology 180 viii Contents Medical Devices 182 Medical Instruments and Supplies 184 Diagnostics and Research 185 Chapter 14 Industrials 187 Railroads 188 Airport Operators 190 Aerospace and Defense 191 Trucking and Marine Shipping 192 Waste Management 193 Heavy Equipment 195 Diversified Industrials 197 Chapter 15 Technology 199 Consumer Technology 200 Enterprise Hardware Systems 202 IT Services 203 Semiconductors 205 Software 207 Telecom Services 209 Chapter 16 Utilities 211 Regulated and Diversified Utilities 212 Independent Power Producers 214 About the Authors 217 Index 221
