Morningstar’s moat investing methodology are based on its moat rating and valuations. Morningstar Head of Global Equity Research Elizabeth Collins shares how the Morningstar equity research team brings these core components together.
Fortifying Moat Ratings with Valuations
ED LOPEZ: Hi, I'm Ed Lopez, head of ETF product at VanEck, I'm here today with Elizabeth Collins, head of global equity research at Morningstar and we're talking the Morningstar process around their methodology. Elizabeth, thanks for joining us today.
COLLINS: Thanks so much for having me.
LOPEZ: Let's talk about the moat methodology. We'll break it down into a couple of components. One, the moat rating itself and the valuation, which I think is a very important part of that as well. In the marketplace today, quality is being talked about as a factor for one thing, but I think we also have talked about moat as this idea of buying quality companies, or good companies but buying them at the right price.
LOPEZ: Is the moat rating Morningstar’s view of quality? And how does that differ from what other people are using for factors?
COLLINS: Sure. And unfortunately I don't have a simple answer here, but I would say if there is one thing that I would care about most when it comes to quality it would be does a company have an economic moat or a sustainable competitive advantage? But let me say what that doesn’t entail. So a competitive advantage, a sustainable competitive advantage or moat is ...means that a company can fend off competitors for 10 or 20 years into the future so that their economic profits that they generate for shareholders are not whittled away – to the cost of capital, or worse.
What's left out of this definition of what you could call quality is uncertainty. So sometimes wide moat companies have low uncertainty, but sometimes they have high uncertainty. What's left out of this is a good management team. Sometimes it's the case that a good management team and a good board are at the helm of a wide moat company, but that's not always the case. Sometimes a wide moat company has such a strong business model that it can be run by mediocre management teams with little to no damage for shareholders.
And it also doesn't mean that the company has a history of generating economic profits for shareholders. This is a very forward looking measure that our analysts are conducting. And, finally, it doesn't mean that there will be a lack of cyclicality or swings in earnings power from year to year.
This is a long-term thing and it has to do with whether or not the company can generate economic profits for the long run.
LOPEZ: And you guys look at the moat rating in three different ways. A company could have either a wide moat, a narrow moat, or no moat. Is it always better to have just a wide moat?
COLLINS: I guess from a company’s perspective of whether or not it can generate value over the long term, shareholder value that is, it's better to be a wide moat company, all else equal. A wide moat company is one that can fend off competitors for 20 years or more. A narrow moat company is one that we think can fend off competitors for ten years or more. And then a no moat company is one that is either so uncertain that we can't confidently predict the future of economic profits. Or that we think that the profits will be whittled away within a ten year period.
LOPEZ: And if a company had that moat, that wide moat, that could protect them, they could defend for 20 years on, is it always a good buy? Or are we now venturing into the land of your valuation, the valuation part of your methodology?
COLLINS: Sure, that's a great question. The moat is simply a moniker that we use to describe the company's future, but it doesn’t comment on what the market is currently willing to pay for that company’s stock. So a wide moat company can be undervalued or overvalued, just as a no moat company can be undervalued or overvalued.
LOPEZ: So, then, let's talk about the valuation. How does Morningstar evaluate or value a company?
COLLINS: So, an analyst will do their industry and company research, they’ll forecast the company's profits and cash flows in a DCF (discounted cash flow) model, discount those future cash flows back today using a commensurate rate of return and all of that gets at an intrinsic value or a fair value estimate. Depending on where the stock price is trading relative to that fair value estimate and the size of the margin of safety will determine whether or not we think the company is attractively priced for investors.
LOPEZ: How is that different than the typical P/E ratio that a lot of people use to evaluate, to determine valuation of, a company?
COLLINS: Well, a P/E ratio will be based on price versus either this year’s earnings or maybe next year’s earnings. So it doesn’t capture all of the future earnings potential of the company. I think that matters. If it's a normalized point in time it can be okay to use a P/E ratio to figure out if a company is under or overvalued or fairly valued. But if it's a highly cyclical situation and you’re at the peak or the trough, you would get the wrong assessment. Or if the company was shrinking or growing rapidly a P/E ratio might not be the best way to capture whether or not a company is fairly valued.
LOPEZ: If an investor is following the moat methodology and the methodology followed within the index, Morningstar® Wide Moat Focus IndexSM, for instance, and selecting companies that are not only wide moat, but also cheap on a fair value standpoint. Are they value investors in that regard or are the companies at that point considered value companies in the context of value and growth?
COLLINS: I think the value label traditionally has been more constrained than how we operate at Morningstar. So I guess in a traditional value world you would be constrained to stocks with low P/E ratios or low P/B ratios. But our moat methodology and our DCF methodology means that we can capture undervalued scenarios where companies that have high growth potential are undervalued. So, for example, some of the technology stocks that might find their way into a wide moat undervalued universe might have very high P/E ratios. Simply because we think that their earnings and cash flows are growing at a very rapid clip in the future.
So, on a traditional metric, P/E, or P/B, it will look expensive, but if you put them in a DCF model and that growth materializes the way we think it will, then they’re undervalued.
LOPEZ: And could the same be true for, say, growth stocks – what could be considered traditionally growth stocks? Picking them up at a lower valuation. So you could essentially have a portfolio that's both value and growth from a traditional screen.
COLLINS: Right. We're just looking for stocks that are trading at discounts to their fair value estimate and ideally have a wide or maybe a narrow economic moat. That can be a mix of companies from a traditional growth versus value perspective.
LOPEZ: Elizabeth, thank you for joining me today.
COLLINS: It's been my pleasure.
LOPEZ: If you'd like to learn more about moat investing or additional insights from Van Eck then visit vaneck.com/ucits/subscribe.