Investing in Growth Stocks the Morningstar Way

06/27/2012 10:25 am EST

Focus: STOCKS

Michael Tian

Senior Equity Analyst and Equities Strategist, Morningstar Opportunistic Investor

What is growth investing?
To many investors, growth investing conjures up images of sexy start-ups, glitzy IPOs, and companies that promise not only a brave new world, but also command eye-watering valuations. The implication, of course, is that growth investing focuses on unproven and fast-evolving companies. The investor buys with the hope of a big payout (for example, Google), but accepts that many or even most investments will eventually fizzle out (for example, SunPower). This approach, being filled with soaring highs and abysmal lows, carries a whiff of the speculative and is generally regarded as having a high element of risk.

Needless to say, we do not believe growth investing has to be this way.

The central question for successful growth investing, as we see it, is this: How long can above-average growth continue? Answer this question correctly, and you can make a lot of money, even if you pay a big price tag for a company’s stock. Compounding growth is a powerful force.

Let’s consider a hypothetical: You buy a stock that is earning $1 per share today for a whopping 50 times earnings. Nominal GDP growth is 5% per year, but the company continues to grow at 15% a year—a respectable but not a blistering rate— and one that might be expected of a company trading for such a lofty valuation.

Ten years later, the company will be earning $4 per share; 20 years later, $16 per share; and 30 years later, $66 per share. At this point, the stock is generating profits equal to your cost basis every nine months! Let’s assume that at this point the stock’s valuation falls to 20 times earnings from 50 times (so the stock is worth $1,326 per share). Even with the P/E collapse, you’ve multiplied your initial investment about 26 times, even assuming zero dividends. This is a pretty solid—and likely market-beating—outcome.

Unfortunately, things don’t always work out this way. Growth is difficult to generate, and even more difficult to sustain. Usually, a hot young growth company has come up with a great product or a new way of doing business. As a result, it takes an early lead in a nascent industry that promises to become an economic powerhouse. But more often than not, determined rivals move in with better mousetraps (or just cheaper mousetraps), and eventually eclipse the pioneering upstart. In Morningstar’s language, the upstart was never able to create an economic moat—some type of competitive advantage that keeps rivals at bay, and protects its business franchise.

Without a moat, the company’s growth is not sustainable in the long run. That’s why so many of today’s hot growth companies end up becoming the declining companies of tomorrow, a fate that has befallen many a former darling. Remember, growth investors were once swooning over the likes of Gap, Motorola, and Energy Conversion Devices.

How can investors spot growth that’s unlikely to fizzle out?
Morningstar’s answer: Focus on the economic moat trend. This is our measure of a company’s ability to continually strengthen its economic moat, not just becoming a bigger company, but a stronger one. There’s a gulf of difference between the two. Oftentimes, a company with a growing economic moat is not only becoming more successful at protecting its current profits, but also its growth prospects. Rather than simply focusing on companies already benefiting from strong competitive advantages—or focusing on companies that already have wide economic moats—we look at companies that are still building and growing their economic moats. We believe this brand of growth investing leads to high-quality companies that can consistently compound their intrinsic values year after year.

At Morningstar Opportunistic Investor, the newsletter that I edit, we buy not just growing companies, but sustainably growing companies. Our brand of growth investing won’t get you into many stocks that you can tout at cocktail parties. In fact, more often than not, you’d be greeted with a blank stare upon mentioning their names. However, our companies boast consistently winning business models, and benefit from long-lasting tailwinds that enable them to grow in excess of GDP for many years. Moreover, by focusing on these systematic compounders of value, we lower the risks inherent in traditional growth investing.

Economic Moats: Backgrounder
To understand moat trends, it’s vital to first know what economic moats are. Anyone familiar with Warren Buffett would be at least cursorily familiar with these concepts, but Morningstar has done more than most to sort and catalogue moats across thousands of companies worldwide.

In short, an economic moat measures whether a business’ returns on capital will stand the test of time. The economy is fiercely competitive. When a company develops a new product or a new way of doing business, common sense tells you that rivals always will try to copy it, or even improve on it. In an efficient and competitive market, these rivals eventually will succeed, taking away the excess profit that the pioneering firm was making. In other words, it’s tough to generate extraordinarily high margins and returns for a long period of time.

Nevertheless, in any economy, a relatively small number of firms are able to keep one step ahead of the competition and protect their high profits for many years. Some brand-name firms, like Coca-Cola or General Electric, have been around for nearly a century. All else equal, it’s better to invest in a company whose profits will stick around for a while.

Evaluating economic moats is a qualitative process and tough to quantify. At Morningstar, we classify moats as either wide, narrow, or none. To determine which bucket a company fits into, we spend a lot of time getting to know the industries we cover, combing through financial statements, and talking to management.

Wide moats, as you might imagine, are quite rare. To qualify, we need to be reasonably confident that the company will earn returns above its cost of capital for 20 years. Only about 10% of the 1,700 companies in our worldwide coverage universe have wide moats. Narrow moats are a bit more common, but we still need to be reasonably confident that these companies will earn returns above their cost of capital for at least 15 years. Narrow moats make up around 50% of our coverage universe, which actually greatly overstates their prevalence in the business world. It’s such a large percentage because we actively skew our coverage universe toward companies having at least a narrow economic moat.

Our moat trend rating indicates the change in the width of a company’s moat through time. We know this is a pretty abstract definition. Therefore, instead of struggling over the technicalities, we ask a simple question:

Place yourself three years into the future, and evaluate the company’s economic moat. Is the moat as a whole wider or narrower than it is today?

Since moats have life cycles, all growing moats will eventually turn into declining moats. For this reason, it is not useful to ask, “What is the moat trend over the next 30 years?” Rather, we chose three years as our time dimension for the following reasons:

1. It’s short enough for us to have reasonable visibility.
2. It’s long enough to put us in the right frame of mind to ask the right questions. We are not looking for cyclical (economic or product cycle) changes to a company’s fortunes. Instead, we are looking for structural factors that have an impact on sustainable competitive advantages.

All economic moats come from some combination of the following sources: low costs, intangible assets, switching costs, network effects, or efficient scale. If we are looking for the change in a company’s moat, then logically the trend must tie into at least one of these categories.

For example, if a moat is based on having very efficient manufacturing (low costs via economies of scale), and the company will spend $500 million to completely automate its factory, widening the gap between its average cost and that of its competitors, it may have a positive moat trend. On the other hand, if the manufacturer is established in a high-cost Western Hemisphere country, and emerging-economy competitors are rapidly gaining scale and expertise, thereby narrowing its unit cost differential, there may be ample ground for a negative moat trend designation.

In most instances, it’s important to think about a company’s or industry’s long-term strategic position holistically. The long-term prospects facing the industry often have a big impact on the firm’s moat trend. It’s generally easier to build moats in an industry that’s healthy and has long-term growth drivers. For example, if the moat is based on scale, growing volume will tend to push per unit costs lower, potentially expanding the moat. If the moat is based on network effects, a growing industry will tend to add nodes to the network, making the network more valuable and more difficult to replicate. If a moat is based on superior intellectual property, a growing customer base and higher profits will fund more research and development. All these are virtuous cycles that can be exploited by well-run and well-positioned firms.

On the other hand, if the industry faces stagnation, these virtuous cycles can reverse and turn into vicious cycles. For example, if the moat is based on scale, shrinking volume will push up per unit costs, naturally eroding the moat. If the moat is based on networks, losing nodes automatically erodes the value of the network.

At Morningstar, we are passionate about understanding competitive advantage. In fact, our company has a saying: The moat is the moat. In other words, our own business’ success is driven by helping investors understand competitive advantages and to approach investing by examining how these advantages evolve in the long run.

Results
We formally codified the evolution of a company’s economic moat in 2009. We have three ratings: negative, stable, and positive. Negative, of course, is for companies whose moats are actively being eroded, whereas positive is for companies still building and strengthening theirs.

Since we began assigning moat trend ratings in September 2009, those firms with a positive rating outperformed the S&P 500 by about 11.6 percentage points and the Russell 2000 by about 7.7 percentage points cumulatively through Dec. 31, 2011. The volatility of these returns was not markedly different from the two indexes (they were higher than the S&P, but lower than the Russell). This margin may not sound huge, but they represent nearly 5 percentage points of outperformance per year. As any adherent of the efficient market hypothesis might tell you, this is a fairly interesting result.

Another sign that we were on the right track: Companies with a negative moat trend underperformed the S&P 500 by 13 percentage points, and the Russell 2000 by about 16.9 percentage points through December 2011. Again, the volatility of these returns was not markedly different from those of the benchmark indexes.

The record we present here is not that of some tiny list of cherry-picked companies. Although positive and negative moat trends are relatively rare, they number more than 150 companies each, representing 13% and 14% of Morningstar’s U.S.-rated coverage universe, respectively. Included in each category are companies of all sizes and from all different industries.

Naturally, we were quite pleased with this outcome. Identifying ex-ante two large and diversified cohorts that respectively outperformed and underperformed the indexes by significant margins is an impressive accomplishment.

More importantly, by closely looking at the evolution of companies’ economic moats, we also have created a way for investors to make money. Making money in this way does not require insider information, “expert networks,” banks of powerful computers crunching data, or expensive reports. For the most part, it just requires a sound mental framework and a willingness to be patient. Companies with positive moat trends are usually compounding their intrinsic values relatively quickly. In these circumstances, the investor’s best friend is time itself.

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