What Morningstar gets wrong about MOATs

Abstract

In this paper, I will demonstrate a flaw in Morningstar's method for determining a company's MOAT. Specifically, I argue that ROIC is not an accurate measure of value creation, as new investments can erode previously created value while still indicating a ROIC above the company's cost of capital for many years.

Introduction

Morningstar is one of the most successful independent investment research companies, widely known for its MOAT ratings. These ratings classify companies as having None, Narrow, or Wide moats. The MOAT concept, inspired by Warren Buffett, focuses on a company's competitive advantage. In a 1999 article for Fortune magazine, Buffett explained his view on moats: “The key to investing is… 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.”

In the book Why Moats Matter by Brilliant and Collins[1], the authors further describe the qualities of companies with strong competitive advantages. On the first page of the book, they explain that a great business is one that “can fend off competition and earn high returns on capital for many years into the future—increasing earnings, returning cash to shareholders, and compounding intrinsic value.” Through this definition, the authors share their perspective on what constitutes value.

The authors also explain Morningstar’s criteria for establishing a MOAT in a company:

1.???? Return on Invested Capital (ROIC): The first condition a company must satisfy is that it is likely to achieve consistently a ROIC higher than its cost of capital.

2.???? Sources of MOAT: The company must have both qualitative and quantitative evidence of possessing at least one of the following sources of MOAT:

·???????? Intangible Assets: Brands, patents, or government licenses that fend off competitors.

·???????? Cost Advantage: Economies of scale, enabling the company to sell goods at a lower cost or higher margins than competitors.

·???????? Switching Costs: When customers face significant risks or inconveniences by changing providers.

·???????? Network Effect: A positive cycle where the value of a good or service increases for all users as more people adopt it.

·???????? Efficient Scale: A market that is efficiently served by one or a few companies, deterring new entrants due to the likelihood of insufficient returns.

3.???? MOAT Durability: The analyst must assess the durability of the MOAT. If the MOAT is expected to last more than 10 years, a Narrow MOAT rating is assigned. If it is expected to last over 20 years, a Wide MOAT rating is given. Companies not expected to sustain their MOAT for at least 10 years receive a None MOAT rating.

A common misconception is that only industry leaders have a MOAT. However, the authors point out that some industries lack a MOAT altogether. Instead, they focus on a company's ability to sustain returns.

When a Morningstar analyst identifies a compelling case for a company with a MOAT, they must present it to an internal committee for approval. This process ensures consistency and prevents reliance on the judgment of a single analyst.

In summary, when Morningstar assigns a MOAT rating, it evaluates whether the company is creating value, is likely to continue doing so, and has a structural competitive advantage that protects its returns over the long term. The term structural is key here, as none of the MOAT sources depend on a single individual or changes in management.

The Problem with ROIC

Morningstar uses ROIC as a measure to determine if a company's returns exceed its cost of capital. ROIC provides insight into how effectively the firm utilizes both new and existing investments. However, a problem arises in Morningstar's approach when ROIC is higher than the Return on New Invested Capital (RONIC), while RONIC is lower than the cost of capital.

There is a common misconception that ROIC is the primary metric for measuring value creation. However, RONIC is the more appropriate metric for calculating the earnings growth rate and, consequently, for assessing value creation.

Let’s start with the definition of both metrics.

NOPLAT (Net Operating Profit Less Adjusted Taxes) is generally considered to be operating income multiplied by one minus the effective tax rate. Invested capital encompasses all the investments a company makes to sustain its core operations, including fixed assets, goodwill, and working capital. For some companies, it may also be relevant to capitalize marketing and R&D expenses, as these are crucial for conducting business.

The formula above tells us that RONIC is a metric that measures the return on new investments, as it calculates the incremental returns divided by the incremental increase in invested capital.

Below we can see the formula to valuate the assets of any company, also called Free Cash-flow to the Firm.

WACC, or Weighted Average Cost of Capital, represents the average rate that a company is expected to pay to finance its assets. Free Cash Flow to the Firm refers to the earnings available to both shareholders and debtholders, and it is equivalent to NOPLAT after subtracting the reinvestments made into the firm. The reinvestment rate is calculated as the investments made to sustain core operations divided by NOPLAT. In other words, it measures the increase or decrease in invested capital relative to NOPLAT.

It is important to understand what ??, or the growth rate of NOPLAT, is equivalent to. One educated guess for the value of NOPLAT at time ??+1 could be NOPLAT at time ?? plus a variance.

As we have seen before,

We can define ?Invested Capital as the reinvestment rate times NOPLAT.

Coming back to the previous equation,

This formula demonstrates that the growth of NOPLAT depends on the Reinvestment Rate and RONIC. Therefore, when Brilliant and Collins mention that the hallmark of a great business is its growing earnings, they should have focused on RONIC instead of ROIC. Additionally, this raises an issue, which is illustrated in the graph below.

The graph shows the progression of an initial ROIC of 80% over time, assuming a constant reinvestment rate of 50% and a fixed RONIC. We can observe that, unless RONIC equals ROIC, ROIC will inevitably decline over the years. However, this decline can still create value as long as RONIC remains greater than WACC.

The issue highlighted by the graph is that when RONIC is constant at 8% or -2%, it takes a substantial amount of time for ROIC to approach the RONIC figure. For example, even after 70 years, ROIC never converges to a RONIC of -2%, and it took 70 years for ROIC to approach a RONIC of 8% in the third scenario. In other words, because it takes many years for a high ROIC to approximate the RONIC figure, a company could receive a wide MOAT rating yet still destroy value over time, as seen in cases where RONIC is 8% or -2%. This outcome contradicts what Brilliant and Collins consider a hallmark of a great business, as earnings are not growing at the rate required to create value. This occurs because, the lower the RONIC, the more weight old investments have in the ROIC calculation.

Eventually, as most companies reach maturity—or in certain sectors—they may see high ROIC figures. However, as they continue to mature, their ROIC will likely decline. Therefore, mature companies are more prone to receiving a misclassified MOAT rating.

Misclassifications

In this section, we are going to see eight cases where companies received a MOAT classification by Morningstar but their RONIC have been lower than their cost of capital or their ROIC is lower than their cost of capital.

It’s notable that companies like AT&T, Boeing, and Disney have, for the past few years, consistently reported lower ROIC than their WACC. According to the traditional MOAT concept, such companies should not qualify as having a MOAT. However, they do. AT&T, for instance, is granted a Narrow MOAT; Boeing, despite recent headlines about potential bankruptcy, has a Wide MOAT; and Disney, though not facing Boeing’s challenges, also has a Wide MOAT despite its lower returns.

This raises the question: why would a company with low returns still be seen as having a competitive advantage? Perhaps the most controversial case is Boeing, which faces the possibility of bankruptcy in the coming years. This situation is reminiscent of the 2008 financial crisis when rating agencies gave triple-A ratings to junk mortgage-backed securities.

To prepare the table below, I used data from Bloomberg and applied the following formulas:

·???????? NOPLAT: Operating Income * (1 – Effective Tax Rate). For companies spending more than 10% of their revenue on R&D and/or marketing, I added back that period’s expense and subtracted the amortization of the capitalized asset.

·???????? Invested Capital: Net Fixed Assets + (Current Assets – Current Liabilities) + Goodwill. For companies spending over 10% of revenue on R&D and/or marketing, I added the value of the capitalized asset.

·???????? WACC: I used the WACC calculated by Morningstar to date.

I also calculated the RONIC over 1-, 5-, and 10-year periods. The rationale for this approach is that the 1-year changes can be too volatile, while the longer time periods provide a more reliable sense of new investment performance. My conclusions are based on these longer-term calculations.

P&G, WACC 7.2%, Wide MOAT

IBM, WACC 7.7%, Narrow MOAT

AT&T, WACC 7.4%, Narrow MOAT

Oracle, WACC 7.9%, Narrow MOAT

Boeing, WACC 8.5%, Wide MOAT

Siemens, WACC 7.9%, Wide MOAT

Disney, WACC 8.1%, Wide MOAT

Exxon Mobile, WACC 7.2%, Narrow MOAT

Conclusion

In this paper, I have demonstrated why ROIC is not a relevant measure for calculating earnings growth and, therefore, is not a reliable criterion for determining a MOAT. Instead, RONIC is a preferable measure. Using ROIC to establish a MOAT can be problematic, especially when RONIC is lower than both WACC and ROIC. The core issue is that ROIC reflects the performance of both new and old investments. When there’s a significant difference between the returns on these investments, ROIC takes longer to approximate RONIC.

This leads to an important question: why should a company that has destroyed value in recent years by failing to grow earnings adequately (RONIC < WACC) be granted a MOAT? I have provided examples where this situation occurs, along with another scenario: when ROIC has been consistently lower than WACC in recent years. This directly conflicts with Morningstar's primary criteria. Nonetheless, companies like Boeing—which has faced speculation about potential bankruptcy—are still granted a Wide MOAT. Morningstar’s application of its criteria appears inconsistent in such cases.

[1] “Why MOATS Matter, The Morningstar Approach of Stock Investing”, Heather Brilliant and Elizabeth Collins, Wiley 2014.