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  • Home>Research & Insights>Spotlight>Not All Moats Are Created Equal

    Not All Moats Are Created Equal

    Some sources of moats are more potent than others.

    Morningstar and Daniel Needham, CFA, 08/09/2017

    By Andrew Lane and Danny Goode

    When assigning economic moat ratings, Morningstar analysts and the Morningstar economic moat committee take both quantitative and qualitative considerations into account. On the quantitative side, we look to the spread between forecast returns on invested capital and our assumed weighted average cost of capital, which represents economic profit generation. Per our methodology, the durability of economic profits is far more important than magnitude. Additionally, clear evidence must exist that the company benefits from at least one of five moat sources: intangible assets, cost advantage, switching costs, network effect, and efficient scale.

    In this article, we analyze various financial metrics across different moat ratings and moat sources to better substantiate the fundamental performance that investors should expect when investing across the cohorts we define. Our findings indicate that not all moats are created equal; certain moat characteristics consistently lead to more attractive financial performance than others.

    Our Method
    In conducting our analysis, we included our entire coverage universe after eliminating duplicate share classes. We counted companies with ADRs only once. This ensures that each company receives an equal weighting in our calculations.

    After we categorized our entire coverage universe of wide-, narrow-, and no-moat stocks, we then divided companies into different cohorts, sorted by their sources of competitive advantage. We compared various financial metrics across these cohorts to better understand the fundamental characteristics investors should expect to see across the classifications that we use.

    We were forced to make one major assumption in performing this analysis. When assigning companies to cohorts based on moat rating and moat source, we employ a static approach. In other words, for time-series data, we treat each company as though it has always existed in the cohort to which it is currently assigned. For the vast majority of companies, this assumption is not problematic. However, some companies have moved between different moat rating and moat source buckets over time. Historical data for these companies is considered only in the context of their current classifications.

    All data used in this analysis was derived from Morningstar Direct and pulled on May 16. To minimize the effect of outliers, we used medians whenever possible. Here are our findings:

    Wide-Moat Firms Are Far More Profitable Than Narrow- and No-Moat Firms
    This conclusion comes as no surprise, given that a company’s return on invested capital is the primary form of quantitative evidence we consider when assigning an economic moat rating in the first place. However, in observing the metrics associated with each moat rating cohort, the data in EXHIBIT 1 is useful in quantifying the potency of each moat rating.