Economic moats, referring to the advantages a company has over its competitors, are competitive structures that help great companies continue to be great investments. Stock in a company with a wide economic moat is usually a much safer investment.This book will:

• Introduce Morningstar's approach to investing
• Establish the difference between business quality and undervalued stocks
• Explain economic moat and its network effect, cost benefits, and efficient scales
• Discuss industry standards for determining moats
• Help determine what moat means for stock returns and their impact on stock valuation

Heather E. Brilliant, CFA, Co-Chief Executive Officer, Morningstar Australasia
Prior to assuming her current role, Brilliant led Morningstar's global equity and corporate credit research teams, consisting of more than 120 analysts, strategists, and directors. Brilliant is a member of the CFA Institute Board of Governors and is a past chairman of the CFA Society of Chicago.

Elizabeth Collins, CFA, Director of Equity Research, North America, Morningstar
Collins is responsible for leading Morningstar's team of North American-based equity research analysts. She has served as chair of Morningstar's Economic Moat committee, a group of senior members of the equity research team responsible for reviewing all Economic Moat and Moat Trend ratings issued by Morningstar.

Morningstar is a leading provider of independent investment research in North America, Europe, Australia, and Asia. We offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.
To find out more about Morningstar's approach to stock investing and receive a free trial of our research, visit: www.global.morningstar.com/whymoatsmatter

Preface ix

Acknowledgments xi

Chapter 1 Guiding Principles of Morningstar’s Equity Research 1

Question 1: How Can We Identify Which Businesses Are Great? 2

Question 2: When Is the Best Time to Invest in Great Businesses? 6

Chapter 2 What Makes a Moat? 11

Moat Sources 13

Notes 33

Chapter 3 Why Moat Trends Matter 35

Contributed by Stephen Ellis, a member of Morningstar’s Economic Moat Committee and head of Financial Services equity research at Morningstar

Moat Trends and Fundamental Performance 37

Five Key Considerations for Moat Trends 38

Intangibles 41

Cost Advantage 44

Switching Costs 47

Network Effect 51

Efficient Scale 54

Best Practices for Moat Trend Analysis 57

Chapter 4 How Stewardship Affects Economic Moats 61

Contributed by Todd Wenning, who oversees Morningstar’s equity stewardship methodology

Meet Our Stewardship Methodology 62

Drilling Down 63

Chapter 5 Applying Moats to Dividend Investing 81

Contributed by Josh Peters, director of equity-income strategy for Morningstar and editor of the Morningstar® DividendInvestorSM newsletter

Why Dividends Matter 83

Which Dividends? 87

Chapter 6 The Importance of Valuation 93

Contributed by Joel Bloomer, Matt Coffina, and Gareth James, members of Morningstar’s Moat Committee and contributors to Morningstar’s valuation methodology

Valuation Concepts 95

Cost of Capital and Returns on Capital 96

Morningstar’s Valuation Approach 97

Example: Calculating ROIC 99

Forecasting Future Free Cash Flows 102

The Morningstar RatingTM for Stocks 106

Fair Value Uncertainty and Cost of Equity 107

Notes 111

Chapter 7 Do Moat Ratings Predict Stock Returns? 113

Contributed by Warren Miller, head of quantitative research at Morningstar

Chapter 8 Putting Moat and Valuation to Work: Portfolio Strategies 121

Wide Moat Focus Index 121

The Tortoise and Hare Portfolios 124

Chapter 9 Basic Materials 129

Commodity Manufacturers 130

Commodity Processors 133

Metals and Mining 135

Chapter 10 Consumer 139

Beverages 140

Consumer Products 141

Tobacco 143

Restaurants 144

Retail Defensive 146

Specialty Retail 148

Lodging 149

Notes 151

Chapter 11 Energy 153

Oil and Gas Drilling 154

Oil and Gas Exploration and Production 156

Oil and Gas Midstream 158

Refining 159

Oil and Gas Integrateds 161

Engineering Services 163

Chapter 12 Financial Services 167

Banks 168

Capital Markets 170

Credit Services 172

Financial Exchanges 173

Insurance 174

Chapter 13 Healthcare 177

Pharmaceuticals 178

Biotechnology 180

viii Contents

Medical Devices 182

Medical Instruments and Supplies 184

Diagnostics and Research 185

Chapter 14 Industrials 187

Railroads 188

Airport Operators 190

Aerospace and Defense 191

Trucking and Marine Shipping 192

Waste Management 193

Heavy Equipment 195

Diversified Industrials 197

Chapter 15 Technology 199

Consumer Technology 200

Enterprise Hardware Systems 202

IT Services 203

Semiconductors 205

Software 207

Telecom Services 209

Chapter 16 Utilities 211

Regulated and Diversified Utilities 212

Independent Power Producers 214

About the Authors 217

Index 221