Heather Brilliant - Why Moats Matter: The Morningstar Approach to Stock Investing

Jacket Design/Illustration: Christopher Cantore

Copyright 2014 by Morningstar, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Brilliant, Heather.

Why moats matter : the Morningstar approach to stock investing / Heather Brilliant, Elizabeth Collins.

1 online resource.

Includes index.

Description based on print version record and CIP data provided by publisher; resource not viewed.

ISBN 978-1-118-76102-1 (pdf) ISBN 978-1-118-76027-7 (epub)

ISBN 978-1-118-76023-9 (hardback)

1. Stocks. 2. Investment analysis. I. Collins, Elizabeth, 1979- II. Morningstar, Inc.

III. Title.

HG4661

332.6322dc23

2014017196

This book is dedicated to Morningstars equity analysts, past, present, and future.

Finding great businesses at great prices is the holy grail of investing. Yet surprisingly few investors focus on uncovering businesses with the potential to compound in value over time. Why is this? For one thing, uncovering the next Coca-Cola or Johnson & Johnson is hardthese great businesses are much more identifiable after they have been pumping out fantastic returns for years. Further, many assume that the greatness of these businesses must already be well-understood by the market, and therefore trade at prices that already reflect all the benefits of owning them. But thats not always the casenot by a long shot. In this book, we lay out a framework for finding great businesses, and show you how to know when theyre trading at a discount to intrinsic value. These concepts form the cornerstone of Morningstars approach to stock investing.

At Morningstar, weve always viewed investing in the most fundamental sense: We want to hold shares in great businesses for long periods of time. How can you tell a great business from a poor one? A great business is one that can fend off competition and earn high returns on capital for many years to come. Clearly, anyone can look at the historical returns a business has earned to see whether it has benefited from a competitive advantage in the pastbut our goal is to find businesses with the potential to keep generating excess returns in the future. To do that, we need to understand how the business generates cash flow. We do this by examining the competitive landscape of the industry and focusing on how a given company competes within that industry. Were looking for companies that have economic moatsstructural advantages that protect them from competitors, just as physical moats protected castles from enemies. Through our research, weve determined that economic moats generally stem from at least one of five sources of competitive advantagecost advantage, intangible assets, switching costs, efficient scale, and network effecteach of which we explore in great 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 underlying cash flows is the key to successful long-term investing. When you focus on a companys 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, you start to think like an owner, not a trader. And thinking like an owner will make you a better investor. We walk you through our approach to valuing businesses, which focuses on estimating the cash we expect a business to generate in the future, and discounting that to the present in order to arrive at a fair value estimate for the business.

As youve probably guessed, this book doesnt tell you how to get rich quick by juggling stocks. What it gives you is a fundamental framework for successful long-term investing. The book will help you answer two key questions: How can I identify a great business, and when should I buy that business to maximize my return? If you get these two things right more often than not, youre well on your way to investing success.

Ours is not the only valid method for investing in stocks, but its one that has worked well over the years. Using fundamental moat and valuation analysis has led to superior risk-adjusted returns and made Morningstar analysts some of the industrys top stock-pickers. In this book, we share all the ins and outs of our moat-driven investment philosophy, which you can use to identify great stock picks for your own portfolio.

Morningstars entire global equity research team contributed to this book, and were fortunate to have such a great group working together every day to analyze companies and competitive advantage. Mike Holt, Joel Bloomer, and Alex Morozov have each done a fantastic job leading the team from Chicago, Sydney, and Amsterdam, respectively, and were very appreciative of their help and support in putting this book together. We would also like to specifically thank those members of the team who contributed chapters to