President of Equity Research Brian Nelson debunks the myth that the economic moat is not included in stock prices. Length: ~8 minutes.
Tickerized for firms in the Morningstar Wide Moat ETF (MOAT), as of October 14, 2015.
Brian Nelson, CFA:
This is Brian Nelson from Valuentum Securities. I wanted to talk about an important concept and answer an important question. Is Warren Buffet’s economic moat priced into stock prices?
Before I answer that question, I think we need to define a couple things. Return on invested capital is a measure of a business’ performance. It’s calculated as earnings before interest divided by net new investment, which is a measure of return on new invested capital. So what is the return the companies get in terms of earnings relative to the capital that is investing to drive that earnings stream.
On the other hand, for an investor, an investor’s return is made up of dividends, capital appreciation, and the reinvestment of those dividends. So, in our sixteen page reports when you look at return on invested capital, we’re focused on the business’ return, or how strong that business is in terms of reinvesting its capital to drive further earnings. That’s an important distinction.
The concept of Warren Buffett’s economic moat is very straightforward to understand. It represents competitive advantages. One of the more important competitive advantages that Warren Buffett talks about is something called the network effect, and there’s a variety of other competitive advantages out there as well. For example, a pharmaceutical company may have a patent on a drug that lasts for twenty years, where it has market exclusivity of that drug. That would be a competitive advantage, and then of course when you look at some of the airlines like Southwest (LUV) or Spirit Airlines (SAVE), for example, being a low cost carrier. These are sources of what Warren Buffett would call an economic moat.
But to get back to our question: is the economic moat priced into stocks? In order to do that, we need to think about what actually drives the prices of stocks, and that is in part buying and selling by investors. But the concept of valuation is going to be a strong consideration behind whether or not there is buying and selling. So, the valuation equation breaks down to a forecast of future free cash flows and discounting those back to today. No matter what company, whether it has significant competitive advantages or the widest moat out there or a no moat company with very poor competitive advantages, they’re both going to have free cash flow streams that need to be forecasted–and when they’re discounted back to today, we’re going to arrive at a fair value for each one of those.
The very important concept of the time value of money, the passing of time, is going to create value for these particular companies over time. As time passes, the value of these companies is based on the free cash flows, and the value of the company is going to increase by the discount rate less whatever a company pays out as a dividends–so that’s the capital appreciation return. For companies with strong competitive advantages, they’re going to have a very strong free cash flow stream, but that’s already captured into the forecasts. It’s still going to advance by the discount rate, and sometimes these companies with strong competitive advantages pay high yields, high dividends.
So one would expect wide moat companies, companies with significant competitive advantages, to actually advance slower. To not have as high of total return than companies without significant competitive advantages because companies without significant competitive advantages are riskier. They require higher discount rates to that future free cash flow stream and they don’t pay out dividends. So one would expect riskier companies to have a higher total return than wider moat companies, and recent research has suggested that over a ten-year period that considered the dot-com bubble, the real estate boom and subsequent bust, as well as the Great Recession, and the ongoing recovery that companies without competitive advantages outperformed over that ten-year period.
The investor has to ask themselves whether or not they’re investing in the market longer than a ten-year period. Typically speaking, no moat or companies with lower competitive advantages because of their risk profile and the fact they’re not paying out capital to the investor in the form of dividends are going to have a higher total return and empirical evidence has shown this, and the academic framework expects this to happen.
So the answer to the question, are Warren Buffet’s economic moats priced into stocks? The answer is yes. We see that we expected it in academic research, and we also see it empirically over a time horizon that covers a variety of different cycles, and this is something that investors should work to understand. Now an investor may counter and say well Warren Buffet’s economic moat rating, and the companies that kind of fit into that bucket, well they have better risk adjusted returns, but the risk adjusted measure depends on the time horizon that you’re measuring it.
For example, if the time horizon is a ten year period, well we have one measure of risk and we have one measure of return. Over that particular time period, over a ten-year period, companies with poor competitive advantages have better return profiles than companies with better competitive advantages. Am I saying that investors should run out and buy a whole bunch of no moat companies because they’re going to outperform over a ten year period? Not at all. So should I say they go out and buy wide moat companies? No, what I am trying to say is that the primary determinant between what is a good investment and what is a bad investment or a poor investment is based on the difference between the price versus value equation. Is the investor getting a bargain for that future free cash flow stream.
Valuation is going to be paramount over the long haul to finding and uncovering outperforming stocks. Discounted cash flow methodology is the first pillar within the Valuentum Buying Index, and that is why it’s first and foremost. Thank you so much for joining.