Jason Stipp: I'm Jason Stipp for Morningstar. As regular readers know, Morningstar analysts spend a lot of time thinking about a company's economic moat, or its competitive advantage. And we recently had some changes in moat ratings. Some moved up to wide moat; some wide moats moved down to narrow.
Here with me to offer the details is Morningstar's Paul Larson. He is an equity strategist and the editor of Morningstar StockInvestor.
Paul, thanks for joining me.
Paul Larson: Thanks for having me.
Stipp: Let's get the downgrades out of the way first. We had recently a set of a kind of company that we downgraded from wide to narrow. What were those companies, and what's the behind the downgrade?
Larson: Well, the group that we recently downgraded were the remaining banks that we still had at wide moat. The situation was that we had banks rated wide moat from certain geographies that had relatively attractive regulation and also where markets were relatively concentrated, where we basically had oligopolies, namely the Canadian banks, one Australian bank that we recently picked up, and then a handful of other banks around the world.
So, the banks that we downgraded, the five major Canadian banks, Bank of Nova Scotia, Bank of Montreal, CIBC, RBC, and TD. And then the other banks were Svenska Handelsbanken, HSBC, and the Australian Westpac.
Stipp: So, you had actually downgraded some other banks earlier for certain reasons, and so when you took another look at these particular banks, you went ahead and downgraded those as well.
Can you explain why initially you started to downgrade some of the bigger, more well-known banks, perhaps in U.S.? What was behind that? And then why these particular banks, why ... what you thought may have been an advantage really isn't turning out to be as big of an advantage?
Larson: When you look at a bank in general, these are inherently levered institutions, which is sort of a strike number one.
Strike number two is, these are companies that are dependent on management, and when you have an inherently levered institution that's dependent on management, that's really not a good combination. When we are looking for a wide-moat firm, we want to find companies that, you know, the old Peter Lynch joke, that any monkey can run, because eventually one will be running it. And banks are not businesses that can run on their own. They have to be efficiently run. Otherwise they can very quickly run into trouble.
Then also you have this dependence on regulation, and as the last couple of years have shown, regulators are not always perfect at mitigating the risk that these institutions face.
Stipp: Aside from the risk issue, I think there are also concerns that regulations will restrain the earnings power of certain banks. Does that factor into your decision at all?
Larson: Actually from a moat standpoint, that may actually be a good thing if the regulators require larger capital cushions, require that these firms operate with lower leverage. So even if the return on assets remains the same, if you're operating with lower leverage, that means that your return on equity is going to be lower, all else equal. So these companies, back in the old days, they may have earned high-teens ROE, and now maybe only mid-teens or even low-teens ROE. But if that's more stable from a moat standpoint, maybe these are actually slightly moatier. But still I think that at the end of the day, we just weren't comfortable saying, "OK, can we be confident in a 20-year timeframe that these companies are going to sustain that competitive advantage, absent good managers."
Stipp: So these few banks still have certain advantages. As you mentioned, some of them have regional geographic advantages, just not quite enough to tip them into that wide moat, then?
Larson: Exactly.
Stipp: So, let's start and talk about some of the upgrades. A couple of international companies got upgrades to wide moat status. The first one is out of the Netherlands. Can you talk about that company and why it has the competitive advantage it has?
Larson: The company is Wolters Kluwer, and this is an information company, and information businesses tend to be pretty good businesses. This is one that provides information to legal firms, to finance firms, and also health-care firms. This is a company that has inherent switching costs, meaning that whenever a company starts using the databases that Wolters Kluwer provides, it's very difficult to rip Wolters Kluwer out and insert another data provider. So these inherent switching costs mean that you have a relatively high level of recurring revenue, which is certainly a good thing.
Also, Wolters Kluwer is getting rid of some of their lower-margin businesses, some of their underperforming businesses, and really focusing on the businesses where they're doing the best, and where they have the widest moat, and it's that business mix shift that is largely behind the upgrade that we recently had.
Stipp: So this company from the Netherlands, is there any way that a U.S. investor would be able to get access to those shares?
Larson: Actually on this one, yes. They do trade on the OTC, so investors here in the U.S. can buy the shares.
Stipp: So it sounds like certainly an interesting one worthy of some further investigation.
The second one is a New Zealand company. This one would be harder for U.S. investors to access, but it really is an interesting story about how the moat works. Can you talk a little bit about the New Zealand one?
Larson: The company is called Trade Me, and the easiest way to envision what this company does is it's basically the eBay of New Zealand, where they have a consumer-to-consumer trading site.
The competitive advantage here is the network effect, meaning they have the most New Zealand buyers on their platforms, so they attract the most sellers in that market, and because they have the most sellers, they're going to attract the most buyers. It's a very virtuous cycle.
I think it's very telling that you have this relatively small-fry company in New Zealand that really dominates that market. EBay has not been able to get a toehold whatsoever in New Zealand because of the network effect. The network effect is something that eBay benefits from around the world in a lot of other geographies, but in this one particular market, Trade Me really dominates.
Stipp: Do you think this is a market that eBay would really even want to go into? Is it big enough for eBay to put into the hopper?
Larson: Thanks for the question, because I think that really shows the benefit of what we've been calling at Morningstar recently the efficient scale concept where you have a relatively small market being efficiently served by one or a small number of companies, and New Zealand certainly qualifies for efficient scale in a large number of industries, because it is such a small market. EBay can go on living just fine without dominating New Zealand, and that certainly benefits Trade Me.
Stipp: All right, Paul. Some very interesting stories. Hope it's okay if I call you the "moat master" because you come with the upgrades and downgrades. Thanks for all the information today.
Larson: Thanks for having me again.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
Disclosure: Paul Larson owns shares of eBay.
