1. It is possible to have a wide economic moat rating and a positive trend, as well as a no-moat rating and a negative trend.
Companies with no-moat and negative trend ratings aren’t necessarily in imminent danger of bankruptcy, but we do believe these firms’ strategic and competitive positions are already weak and becoming worse over time. We also see wide-moat companies with positive trends that are still strengthening their moats. A wide-moat company already has great competitive advantages, and if these advantages are becoming even stronger or if the company is developing additional moat sources, we may award it a positive moat rating.
2. Moat and trend ratings are independent.
We evaluate moat and trend ratings independently. We view the trend rating as an indicator of how the firm’s competitive advantages are evolving within its given moat band. For example, a positive trend rating on a narrow-moat company indicates that the company’s competitive advantages are improving, but the qualitative and quantitative characteristics of the firm’s moat might not be strong enough to warrant a wide moat. Also, when a moat rating changes, we still evaluate the trend rating separately. For instance, if we have a narrowmoat company with a negative trend, we could decide to downgrade it to no moat but the trend could remain negative.
As you can see in Figure 3.2, while we view economic moat ratings on a three-part spectrum, there are gradients within each bucket. Some wide-moat companies have stronger, more durable competitive advantages than other wide-moat companies. You could say that these wide-moat companies are at the widest end of the wide category, and on the spectrum below, a stronger wide-moat company would sit to the right of a weaker wide-moat company.
However, we don’t use the trend rating to indicate a company’s position on the spectrum below. The stronger, wider-moat company may have a negative trend rating, while the weaker wide-moat company may have a positive trend rating. Each company is starting from a different position of strength, and the competitive advantages are heading in different directions.
3. Changes in ROIC do not necessarily affect our evaluation of moat trends.
Although rising ROICs are often associated with positive moat trends, this certainly doesn’t have to be the case. ROICs can go up for many non-moat related reasons. For example, product cycles and cyclicality will have a major effect on ROICs. Business mix changes may also alter ROICs without changing the moat dynamic. It’s even possible to have a negative moat trend and rising ROICs, for a while at least. For example, if a business without many growth prospects stops or slows down its investments (thereby “harvesting” its moat), it may very well experience rising returns for a number of years as its invested capital base declines in relation to profitability and asset turnover.
By the same token, falling ROICs aren’t automatically a sign that the trend is negative. ROICs can decline for a number of reasons—some of them actually good. When a firm makes a significant investment that will ultimately strengthen its economic moat, ROICs may decline. Perhaps it’s spending heavily on advertising or R&D to strengthen its intangible assets, or it might be building a major new factory that will eventually lower its costs. In both cases, the project is not generating earnings today, which depresses ROICs, but the firm is making the right long-term moves to sustain its competitive advantages. Thinking about moat trends extends beyond ROICs.
4. Moat trends are not necessarily related to growth.
High revenue growth or a sharp decline in revenue doesn’t indicate whether a firm has a positive or negative trend. Perhaps a company’s revenue is on the rise because it’s operating in a very high-growth market, but competition is intense and there are very few barriers to entry, threatening its ability to continue growing. Alternatively, revenue could temporarily decline if a business is undergoing a cyclical downturn, or if a customer delays an order of new components. It’s important to look at how the firm’s moat sources are changing over time rather than simple revenue growth to properly assess its competitive position.
5. Business-mix shift does not affect our trend ratings.
There are two schools of thought around how to take shifts in a company’s business mix into consideration when evaluating moat trends. The first maintains that a company with a business mix that is shifting toward moatier segments over time deserves a positive trend. The second holds that business mix doesn’t have an effect on the trend rating (though it is still important for determining economic moat ratings) because a shifting business mix merely indicates the presence of a higher-growth segment with a moat, rather than actual improvements or deteriorations in competitive positioning for the separate businesses on a stand-alone basis. We believe the second approach is more valid because it focuses attention on how the firm’s competitive advantages are changing rather than on simple growth rates. It’s consistent with our overall methodology, which emphasizes moats, to put a greater emphasis on improving or deteriorating competitive advantages rather than simple growth or decline. In addition, if we see a management team making poor capital-allocation decisions—perhaps acquiring a large company that doesn’t have a moat, thereby “diworsifying” its previously wide-moat business—we can downgrade the moat to narrow, given the new business mix, or a give the company a Poor stewardship rating. (See the next chapter for more on our stewardship ratings. We find that management’s capital-allocation decisions can have such a big impact on a company’s competitive positioning and economic profit potential that assessing the leadership team’s stewardship of shareholder capital is an important aspect of our research process.)
Probably the best way to learn how to evaluate moat trend is to look at some real-life scenarios and see how we’ve analyzed various situations and determined moat trends. Because the starting point for evaluating any moat trend should be determining which moat source is affected, we’ve grouped these case studies by moat source.
This excerpt was taken from:
Why Moats Matter: The Morningstar Approach to Stock Investing; ISBN: 978-1-118-76023-9 by Heather Brilliant and Elizabeth Collins. Reprinted with permission from Wiley.
Heather Brilliant, CFA, is co-chief executive officer of Morningstar Australasia. Before assuming this role in 2014, Brilliant was global director of equity and corporate credit research for seven years. In this role, she led Morningstar’s global equity and corporate credit research teams, consisting of more than 120 analysts, strategists, and directors. She also served on Morningstar’s Economic Moat committee, a group of senior members of the equity research team responsible for reviewing all of the firm’s Economic Moat and Moat Trend ratings.
Elizabeth Collins, CFA, is director of basic materials equity research for Morningstar. In this role, she oversees coverage of companies in the agriculture, building materials, chemicals, coal, forest products, metals and mining, packaging, and steel industries. Collins is chair of Morningstar’s Economic Moat committee, a group of senior members of the equity research team responsible for reviewing all Economic Moat and Moat Trend ratings issued by Morningstar.