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How to judge a company? Look at its moat Add to ...

Warren Buffett loves moats.

Not the watery variety, mind you. The billionaire has long admired companies with competitive advantages that act as barriers to potential rivals. He likes to say that these fortunate companies have an “economic moat.”

Investors have an obvious incentive to find and treasure such firms, but unfortunately Mr. Buffett is not in the business of pointing out the companies that have strong moats and those that don’t. The Chicago-based research firm Morningstar is, however.

Morningstar, which makes moat judgments a core part of its investment advice, has gone so far as to trademark the phrases “economic moat” and “moat trend.” It assigns moat ratings to every one of the 1,600-plus companies it covers.

“We were trying to find companies with strong, sustainable competitive advantages,” says Morningstar’s Heather Brilliant. “We really felt like the term ‘economic moat’ fit, and it was something that could be popularized and used to a greater extent. So we started putting more research and rigour into determining whether a company has a moat or not.”

On first blush, the notion might seem gimmicky. But a closer look at Morningstar’s moat analysis can help investors better understand a key question they should consider when evaluating any stock: Just how strong is a company’s competitive position? And is it getting better or worse?

Broadly speaking, companies with wide economic moats have “the strongest possible competitive advantages,” Matthew Coffina of Morningstar says. Companies with narrow economic moats also have strong competitive positions, he says, “but we don't expect their advantages to last as long as those of wide-moat companies.”

Morningstar says an economic moat can be based on any one of several factors. Some firms – like Google or Facebook – benefit from a network effect that increases the value of their services as they attract more customers.

Other companies build their moats on intangible assets like patents and brands. (Pepsi-Cola, for instance.) Still others find their competitive edge in a cost advantage, or their efficient scale. And some (like IT giant Oracle) get an edge from pricing power because their customers face too many costs in switching to another company.

How do you tell if a company has a moat? If a firm consistently produces returns on invested capital that are greater than its peers for several years, that’s a good sign, Ms. Brilliant says.

The harder question, she adds, is determining how sustainable the moat will be – then figuring out if it’s available to investors at the right price. “Purely identifying companies with moats does not lead to excess returns,” she says. “What leads to excess returns is buying them at a discount.”

Calgary pipeline operator Enbridge is the only one out of 57 Canadian companies rated by Morningstar that has both a wide moat and a positive “moat trend.” A key part of its competitive edge is its scale: it has pipeline presences in the oil sands, the Bakken fields in the Midwest U.S., and in Cushing, Okla., as well as growth opportunities in natural gas and electricity.

Analyst David McColl says Enbridge is just one of a handful of pipeline companies “with the expertise, scale, access to capital, and geographic reach to successfully grow its pipeline transportation business.” He raised his fair-value estimate for Enbridge shares this week to $54 (U.S.), compared to recent prices around $45.

Canada’s big telecoms, Rogers Communications Inc., BCE Inc. and Telus Inc., all have narrow moats, according to Morningstar’s analysis. But they’re still considered attractive investments, despite competition from smaller wireless companies. Analyst Imari Love says Canada “is one of [Morningstar’s] favourite wireless markets, since it is dominated by three rational operators that value profit over market share.”

BCE and Rogers have stable moat trends, but Telus’s trend is negative, according to Morningstar. “Rogers (along with Telus and Bell), might have trouble winning the near-term margin battle – but its scale advantages, network superiority, and handset lineup put it in the pole position to win the long-term war,” Mr. Love says.

Mr. Love gives Telus a negative moat trend because of the deals BCE and Rogers have struck to acquire content for their wireless networks, “a move that would push Telus further behind its peers.”

Mr. Love’s fair value estimates are $60 for Rogers, $43 for BCE and $38 for Telus, giving Rogers “the best risk/reward dynamic in the sector.”

Canadian Tire Corp. and Magna International Inc. are among the Canadian companies Morningstar has deemed moatless.

Canadian Tire “possesses the competitive advantages of convenience and high store-brand recognition,” and has also implemented efficiency initiatives that will improve its position, the Morningstar retail analyst team says in a note.

Still, the analysts say, “We expect the increased competition from larger U.S.-based retailers, which have greater scale advantages, will pressure profit margins and returns on capital over the next decade.” Morningstar’s fair value estimate is $73 (Canadian), about current price levels.

While Morningstar finds Canadian Tire’s moat trend “stable” for now, Magna’s is negative, the firm believes. The auto-parts supplier has lower margins than other global companies in its sector, and its returns, says analyst Richard Hilgert, “have not been as impressive.” His fair value estimate is $50 (U.S.), below recent levels.


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