Why Moat Trends Matter

Longtime followers of Morningstar's equity research are likely familiar with our economic moat ratings. Companies with wide economic moats have the strongest possible competitive advantages. Companies with narrow economic moats also have strong competitive positions, but we don't expect their advantages to last as long as those of wide-moat companies.

You are probably less familiar with our moat trend ratings. We don't generally publish our moat trend ratings on Morningstar.com, though we occasionally mention them in notes and reports. The moat trend rating describes how a company's competitive position is changing over time, and can be either "positive," indicating the competitive position is strengthening; negative, indicating the competitive position is weakening; or stable. Moat trends are an important part of my investment process for Morningstar StockInvestor's Tortoise and Hare model portfolios, and subscribers can find moat trend data on a variety of companies on StockInvestor's website, msi.morningstar.com.

The Sources of an Economic Moat To determine whether an economic moat is expanding or shrinking over time, we need to start with a solid understanding of the underlying sources of competitive advantage. Morningstar has identified five possible sources of an economic moat. Every company with an economic moat rating of wide or narrow exhibits at least one of these sources of advantage, and in some cases more than one.

Network Effect:

The network effect occurs when the value of a company's service increases for both new and existing users as more people use the service. For example, merchants have to accept

's MA payment cards because so many consumers use them, and consumers want MasterCard-branded cards because they are so widely accepted by merchants.

Intangible Assets:

Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company's products, or allow the company to charge a significant price premium. The best consumer goods companies like

PEP can sell more products at higher prices because of their brands.

Cost Advantage:

Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example,

ESRX controls such a large percentage of U.S. pharmaceutical spending that it can negotiate favorable terms with suppliers like drug manufacturers and retail pharmacies.

Switching Costs:

When it would be too expensive or troublesome to stop using a company's products, the company often has pricing power. For example, in many cases

's ORCL customers would risk too much disruption to their critical business functions if they tried an alternative software provider.

Efficient Scale:

When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. For example, if another company tried to construct competing natural gas pipelines and other midstream energy assets along the same routes served by

EPD, it could cause returns for both companies to fall well below the cost of capital.

A Wide Moat Is Great, but Is It Expanding or Eroding? Once we've identified the underlying sources (or potential sources) of a company's competitive advantage, we can ask whether those sources are strengthening or weakening over time.

Not only does

EBAY have a wide moat based on the network effect, but its competitive position is also strengthening over time. The more consumers use eBay's PayPal payments system, the more likely merchants are to accept it, which encourages even more consumers to use it, and so on.

' CMP wide moat is based in part on its low-cost rock salt mine in Goderich, Ontario. As the company expands capacity at this mine, its low-cost advantage gets even stronger. Health-care IT provider

CERN has a wide moat based on very high switching costs. It is only getting more costly for hospitals to switch software providers as they adopt more comprehensive platforms used by numerous departments.

On the negative side,

CAT faces increasing competition from firms such as China's Sany. While we still think Caterpillar has a wide moat based on its broad dealer network and ability to minimize equipment downtime, this advantage is being slowly eroded by competitors, especially in emerging markets.

's LLY wide moat also appears to be shrinking as it loses patent protection on a number of key pharmaceuticals, hurting its intangibles advantage. The pipeline of new drugs isn't yet strong enough to offset these patent expirations. Also, it appears the switching costs that have sustained

MSFT for decades are finally being eroded by the transition toward tablets and smartphones in place of PCs, and the migration of various applications to the "cloud."

Performance of Our Moat Trend Ratings We first introduced our moat trend rating in mid-2009, and since that time the rating has already established a strong track record for predicting stock price performance. From September 2009 through March 2013, companies with positive moat trends outperformed the S&P 500 by 22.3 percentage points (87.7% cumulative return, versus 65.4% for the S&P 500). Companies with negative moat trends underperformed the index by 14.9 percentage points (50.5% cumulative return).

This strong result was achieved even without giving any consideration to valuation. The most likely explanation, in my opinion, is that average investors often have a hard time discerning changes in a company's competitive position. Everyone knows that

GOOG,

XOM, and

JNJ are great businesses likely to earn high returns on capital for a very long time. It's less obvious if the underlying sources of advantage are strengthening or weakening, which means moat trends are less likely to be incorporated in stock prices, at least initially.

The Most Undervalued Firms With Positive Moat Trends Every month, StockInvestor publishes the "Expanding-Moat Watchlist," a list of the most-undervalued stocks with wide or narrow economic moats and positive moat trends. Here were the three most-undervalued names as of the last issue:

UPL

Price: $20.89 | Fair Value Estimate: $40 | Price/Fair Value: 0.52

Ultra Petroleum is a low-cost natural gas exploration and production company. Ultra is cementing its low-cost advantage with improved takeaway capacity and year-round drilling permits in Wyoming, and by expanding into more low-cost acreage in Pennsylvania. While finding and development costs of around $1.50/mcf are among the lowest in North America, Ultra has been hit hard by depressed natural gas prices. While gas prices have more than doubled from the lows reached in mid-2012, at around $4.15/mcf, natural gas is still almost 25% cheaper than our energy team's long-run forecast of $5.40/mcf, accounting for much of the disconnect between our fair value estimate and the stock price. I normally try to avoid betting on commodity prices, but given the deep discount to fair value, Ultra is a possible addition to

StockInvestor's

Hare portfolio (which contains our more aggressive picks).

BIDU

Price: $88.57 | Fair Value Estimate: $137 | Price/Fair Value: 0.65

Baidu is already in

StockInvestor's

Hare portfolio. Baidu is basically the Google of China. The company benefits from mild switching costs; once people get accustomed to a search engine, they tend to start their Internet surfing there by default, without considering alternatives. More important, the company benefits from a growing network effect. The more people use the service, the more data Baidu collects, which helps it surface more relevant content and ads that make the website more useful for both consumers and advertisers. The stock has been down because of competitive pressures and growing pains from the shift toward mobile advertising. Still, revenue and operating income were up 41.6% and 24%, respectively, in the fourth quarter, and I think the company has a very long runway for growth. Trading for barely 16 times 2013 earnings estimates, investors aren't paying much for this growth.

CLD

Price: $18.21 | Fair Value Estimate: $28 | Price/Fair Value: 0.65

Cloud Peak is also in

StockInvestor's

Hare portfolio. The company mines coal more cheaply than almost anyone in the world. Better still, the cost advantage from Cloud Peak's favorable positioning in the Powder River Basin is only getting stronger with cost inflation in older Appalachian mines. Cloud Peak faces some cyclical headwinds: low natural-gas prices that have encouraged utilities to shift generation to natural-gas plants and an overhang of coal inventories. There are also secular threats from legislation aimed at reducing greenhouse gas emissions, which could permanently erode the demand for coal in the U.S. Regardless, our forecast for an eventual rebound in coal prices results in a fair value estimate for Cloud Peak that is significantly above the current stock price.

Data as of market close on April 15, 2013.