What makes one business higher or lower quality than another?

At Morningstar we think the most important factor is whether a company can be relied on to earn healthy returns on investments made in its business. Not just for one year but for many, many years.

This kind of money machine, which takes invested capital and repeatedly spits out further profits at high levels of returns, is not common. In fact, it defies capitalism. It is usually only possible in the presence of a moat – a durable structural advantage that stops other firms from competing away the firm’s profits.

Moats make up a big part of our team’s investment research process here at Morningstar. In fact, any moat awarded or taken away from a firm must first make it past our Moat Committee – a real group that meets to pass or deny motions. Or should that be moations?

Three levels of moat

Morningstar Moat ratings come in three varieties:

  • A Wide Moat rating is the gold standard. This means our analyst thinks the company enjoys structural advantages that are more likely than not to support excess profits and returns on investment for at least 20 years.

  • A Narrow Moat means the company appears to have durable advantages likely to underpin excess returns for at least ten years. However, our analysts have some doubts about the advantage lasting for 20 years or more. 

  • A No Moat rating means our analysts think the company lacks a durable competitive advantage. Therefore they are unlikely to earn excess returns on capital for a decade or more.

We spend a lot of time talking about companies with moats. Today, we’re going to talk about some high-profile companies given a No Moat rating by our analysts.

Hopefully by learning some reasons a company might not deserve this distinction, you’ll be better placed to spot those that do. Let’s start with a big one.

Coles

Supermarket giant Coles (ASX: COL) has cost advantages over smaller competitors due to its significant scale, which brings buying power. The convenient store locations of its Coles supermarket and liquor stores, which account for over 90% of operating income, would also be hard for a new entrant to replicate.

Despite these positives, Aldi’s entry into the Australian market increased competition in the industry. Our analysts think these pressures are unlikely to abate, and that the rise of Aldi – and potentially Amazon Fresh a few years out – could push supermarket margins structurally lower in the long-term.

This dampens the confidence our analysts need to predict at least 10 years of economic profits. By economic profits, we mean returns on invested capital (in the form of profits) that are consistently above the costs of making those investments.

The bigger question, then, might be why Woolworths clings on to its Narrow Moat rating. With 25% more food sales than Coles, Woolies enjoys even more buying power than Coles while also benefitting from high quality store locations.

Morningstar’s Johannes Faul does note, however, that Woolworths' ability to earn excess returns could eventually come under threat from increased competition as well.

News Corp

Rupert Murdoch’s News Corp (ASX: NWS) is a good example of how a business can own moaty assets but not be awarded a moat overall.

The jewel in News Corp’s crown is its 61% shareholding in REA Group (ASX: REA). REA operates Australia’s largest property listings website, which Morningstar’s Roy Van Keulen thinks has a Wide Moat due to network effects.

Network effects are when each additional user of a product adds value to other users. In the case of REA Group, having the highest number of property listings attracts the most website visitors and vice versa. Eventually, this virtuous cycle leads to a product that would be extremely hard for new entrants to replicate. REA’s “must buy” listing space has also allowed it to rise prices regardless of market conditions.

REA Group, however, only comprises around a quarter of News Corp earnings. The other three quarters come from segments that our News Corp analyst Brian Han thinks lack an economic moat.

News Corp’s news and pay TV assets face severe competition from streaming services and other forms of online media. Meanwhile, Dow Jones is home to brands like the Wall Street Journal and Barrons yet falling average subscription revenues suggest it lacks pricing power.

Dow’s professional data products may have moaty aspects but returns on capital have been fairly poor. Meanwhile, News Corp’s book publishing business faces extra competition from the rise of self-published e-books.

Treasury Wine Estates

Treasury Wine Estates (ASX: TWE) is home to the iconic Penfolds, as well as several other well-known wine brands.

The latest vintage of Penfolds Grange, the company’s flagship wine, fetched $1000 a bottle – up more than 5% from the previous year. Despite Treasury’s portfolio of strong brands and growing focus on higher-end wines, our analyst Angus Hewitt does not think it has an economic moat.

The wine business is beset with high inventory requirements, high costs of land ownership, high levels of competition (especially at lower and mid-tier price points) and a lack of scale-based advantages. Moats in alcohol are typically underpinned by intangible brand assets or cost advantages, and he doesn’t think Treasury has a maintainable advantage in either.

The luxury-focused Penfolds segment enjoys these intangible assets in isolation, particularly through the Penfolds brand, but this is offset by the rest of the Treasury’s portfolio and leads to a no-moat rating in aggregate. Hewitt sees wine brands are stand-alone assets: the strength of a brand like Penfolds do not translate to improved pricing or awareness for another group brand like 19 Crimes.

This has been reflected by Treasury Wine Estates consistently earning returns on invested capital below the costs to make those investments. While Hewitt thinks this could improve in the future, he is not confident that Treasury can earn excess returns consistently enough to warrant a moat.

Closing thoughts

More than anything, a moat rating comes down to our analysts’ level of confidence that a company earning attractive returns on investment can keep doing so for a long time. This is not possible unless something is in place to keep competition out.

This ‘something’ is a moat – and while they are rare, they are certainly worth looking for. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.