Any number of factors can expand or shrink each company's competitive advantage over time, and investors need to take that into account, says Michael Tian of Morningstar.
Moats and moat trends. We’re here with Mike Tian, who’s going to tell us exactly what a moat is and then how moat trends work.
Here at Morningstar, our big stick, so to speak, is about economic moats, or what we call sustainable competitive advantages.
Basically, when a company has a sustainable competitor advantage, you can earn returns on capital in excess of cost of capital, and when it’s doing that it’s creating value for shareholders. We’ve shown throughout the years that a company with these advantages are able to, and are much more likely to create lasting shareholder value.
Then how do the trends work within the context of the moats?
A couple of years ago—we’ve been rating moats for about a decade now—but a few years ago, we slowly began to realize that the concept of moat by itself is a little bit static.
For example, if you just say X company has a certain competitive advantage, you don’t really know how that advantage is evolving through time. Five years from now, is that advantage going to be stronger or is it going to be weaker? We thought that could make a very big difference in your investment returns.
So we began assigning categories so to speak to our coverage universe. We cover about 1,200 stocks in the US, and we kind of broke it down to three different buckets: positive moat trends, stable moat trends, and negative moat trends.
Positive moat trends, of course, are companies that are still growing their competitive advantages. So five years from now, three years from now, those advantages are going to be stronger than they are today. The negative ones being the exact opposite, where the advantages are being eroded by competition, regulatory forces, consumer preferences, demographics, or anything else along those lines.
So when you’re looking at these, are you looking at them in real time? For example, when you say you’re projecting out five years, are you looking at where that company’s possibly going to be within that trend in five years, or are you looking at them right now and saying right now relative to the trend they’re ahead of the game?
This is sort of a forward-looking moat trend, so to speak. We’re always trying to project a few years into the future and see how things are.
It’s a little bit of a funny concept, but I think if you kind of picture a company’s competitive advantages today and you imagine yourself going to sleep for a couple of years and suddenly waking up. Have the things that you kind of mostly expect to happen have happened, or are the moats stronger or weaker than they were before? That’s kind of how we think about it.