Why Moats Matter
Why Moats Matter
Guiding Principles of Morningstar's Equity Research
What is a moat? For most people, images of water-filled trenches protecting castles from invaders immediately come to mind. We have taken that concept and applied it to investing, where an economic moat is a structural barrier protecting companies from competition.
Here at Morningstar, we've always viewed investing in the most fundamental sense of the word: We want to hold shares in great businesses for long periods of time. So what's a great business? Essentially, we believe it's one that can fend off competition and earn high returns on capital for many years into the future - increasing earnings, returning cash to shareholders, and compounding intrinsic value. Identifying companies like this is the goal of our economic moat analysis and our Morningstar Economic Moat Rating, which we explore in great detail in the coming chapters.
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 we think the key to successful long-term investing is concentrating not on the daily price movements of a stock but on the value of the cash flows generated by the underlying business. When you focus on a company's underlying fundamental value relative to its stock price, and not 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.
If you're looking for a book on how to get rich quick by trading in the stock market, you've come to the wrong place. Our goal is to give you a fundamental framework for successful long-term investing, which, we admit, is all we really know how to do. Our book aims to answer two primary questions: How can we identify which businesses are great? And when is the best time to buy these businesses, in order to maximize potential returns? If you can get just these two things right more often than not, you'll be well on your way to becoming a successful long-term investor.
When Morningstar first started analyzing stocks more than a decade ago, we began with some core principles that guide our research to this day. Then and now, our analytic work has centered on three main elements: sustainable competitive advantages, valuation, and margin of safety, which we believe are the keys to outperforming the stock market over time. How exactly do we define these terms and why do they matter? That's the purpose of this book. Throughout the coming chapters, we give you an overview of each of these principles, with the primary focus on how to identify companies with sustainable competitive advantages, or economic moats.
Question 1: How Can We Identify Which Businesses Are Great?
The answer to this question lies in finding companies with sustainable competitive advantages, or economic moats. Just as moats were dug around medieval castles to keep enemies at bay, economic moats protect the high returns on capital enjoyed by the world's best companies.
In a famous 1999 Fortune article, legendary investor Warren Buffett wrote, "The key to investing is . . . determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors." With gratitude to Mr. Buffett, Morningstar has taken the economic moat concept a step further and developed a comprehensive moat-based analytic framework that can be applied consistently across a broad, global list of companies.
Whenever a company develops a profitable product or service, it isn't long before other firms try to capitaliz