At Morningstar we believe that to be a successful long-term investor you simply need to buy great companies at compelling prices. Our equity research ratings are designed to uncover companies that will provide superior long-term returns.
A great company has a sustainable competitive advantage
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors." Warren Buffett
The Morningstar Economic Moat Rating represents a company's sustainable competitive advantage. A company with an economic moat can fend off competition and earn high returns on capital for many years to come.
Morningstar has identified five sources of moat.
- Switching costs are those obstacles that keep customers from changing from one product to another.
- The network effect occurs when the value of a good or service increases for both new and existing users as more people use that good or service.
- Intangible assets are things such as patents, government licences, and brand identity that keep competitors at bay.
- A company with a cost advantage can produce goods or services at a lower cost, allowing them to undercut their competitors or achieve higher profitability.
- Efficient scale benefits companies operating in a market that only supports one or a few competitors, limiting rivalry.
A company whose competitive advantages we expect to last more than 20 years has a wide moat; one that can fend off their rivals for 10 years has a narrow moat; while a firm with either no advantage or one that we think will quickly dissipate has no moat.
Morningstar also assigns a Moat Trend rating of positive, stable, or negative, depending on whether a company’s sources of moat are growing stronger or getting weaker.
Purchasing a company at a compelling price
The father of value investing, Ben Graham, famously said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” He meant that in the short-term market prices reflect the popularity and unpopularity of stocks. But in the long run, the market assesses the substance of a company. The message is clear: what matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.
Differences in the price at which a company is trading and its intrinsic value can indicate an attractive investment opportunity. The Morningstar Fair Value Estimate tells investors what the long-term intrinsic value of a stock is, helping them see beyond the present market price.
Morningstar calculates the fair value estimate of a company based on how much cash we think the company will generate in the future. When determining the fair value estimate, Morningstar also takes into account the predictability of a company's future cash flows– the uncertainty rating. A stock with a higher uncertainty rating requires a larger margin of safety before earning a 4- or 5-star rating.
The rating is determined by three factors: a stock's current price, Morningstar's estimate of the stock's fair value, and the uncertainty rating of the fair value. The bigger the discount, the higher the star rating. Four- and 5-star ratings mean the stock is undervalued, while a 3-star rating means it's fairly valued, and 1- and 2-star stocks are overvalued. When looking for investments, a 5-star stock is generally a better opportunity than a 1-star stock.
