Ruth Saldanha: At Morningstar, we often preach about finding stocks with durable competitive advantages or economic moats, alongside exceptional management teams. However, finding both is easier said than done. Oftentimes, investors must choose between companies with great management and narrow or no economic moats or companies with a wide economic moat but average management. Which is the better pick? Adam Fleck, who is the Director of Research, Ratings and ESG for Morningstar Research Services, recently studied this and is here today to discuss it.
Adam, thanks so much for being here today.
Adam Fleck: Of course. Thanks so much for having me.
Why Economic Moats and Capital Allocation Matter
Saldanha: Let's start by talking about economic moats and capital allocation. How important are both to the stock picking process?
Fleck: Both the moat and the capital allocation rating are very important as inputs into the stock picking process. First, the moat, is a measure of quality of the business. It measures how durable the competitive advantages are of that company that can allow it to reap high returns on its invested capital for a long period of time. And the capital allocation rating, the second rating there, is a measure of management. Do the leaders of the company make smart decisions when considering the company's capital? Those factors are useful in predicting the future cash flows of the business and ultimately estimating its fair value. And that's really our North Star here is trying to find stocks trading at attractive prices compared to that intrinsic fair value estimate.
How Important Is a Good CEO in Building a Good Competitive Advantage? Not at All, Actually.
Saldanha: Let's talk about management a little bit more. How important is management in actually building that economic moat and once it's built, maintaining it? And another thing to ask is, how should investors know how to identify both wide moats and good management?
Fleck: Management can curate and tend to emote, but having a smart group of managers in charge of a business isn't a source of competitive advantage alone. It can be really hard when you think about it for even the best corporate leaders to outmaneuver competitors in a tough industry. On the other hand, management can absolutely destroy a moat. Acquisitions are commonly cited as the most frequent way that management can destroy that moat using company funds to buy a business outside of the core competency of a company, for instance, in the name of driving growth. We found that not all acquisitions do destroy moats, but it's still something really important to consider. Ultimately, when thinking about measuring both the moat and the management, it comes down to the same basic question. Is the company creating value for shareholders? Again, we use the return on invested capital metric as our gold standard to try to determine that. If a company can generate returns on its capital higher than the cost to raise that capital, it's ultimately doing a good thing.
Price is Paramount in Stock Picking
Saldanha: Where does price fit into all this?
Fleck: Price is paramount. It's true, not only for investors, of course, you think about you don't want to overpay for a stock, even if it's got a terrific underlying moat and fantastic management, but it's important for management of the company themselves too. Even the best strategic acquisition that supports a company's moat can destroy value if management overpays for that business. I'd be especially wary of companies that go out and justify lofty prices for their M&A using a justification of synergies, particularly revenue synergies. So, definitely something to watch out for.
Moats Vs Management – Which is the Better Buy?
Saldanha: So, assuming you have a stock that's cheap but also has just one good rating, either a wide economic moat or a good management, how should an investor decide which of the two to buy and why?
Fleck: Yeah, it's a choice that investors frequently have to make. Recent performance data shows that moats, particularly wide moats win out over even the best management teams. I looked at a sample of nearly 1,000 companies that Morningstar equity analysts have covered from 2017 until today and only 13 were assigned both an exemplary capital allocation rating and a no moat rating. But despite being a rarefied list of companies, those firms saw their median performance underperform wide moat stocks with standard or even poor rated capital allocators at the helm. Now, of course, past performance does not guarantee future results and valuation is another important overlay. We talked about price being paramount previously. But as a general comment, I would rather invest in a business run by mediocre managers but operating in a super high-quality end market than the best C-suite managing a lower-quality firm.
Cheap Stocks with Wide Moats, and Great Management
Saldanha: Are there any stocks right now that are cheap, have a wide economic moat and also an exemplary capital allocation rating? And more importantly, are these stocks automatic buys right now?
Fleck: There are only a handful of companies that Morningstar covers that have that enviable combination of a wide moat, exemplary capital allocation and a 5-Star rating, 8 to be exact. And to include large names, so we've probably heard of like Taiwan Semiconductor (TSM) and U.S. Bank (USB) and some smaller stocks like the healthcare firm, Zimmer Biomet (ZBH). The list changes overtime as stock prices oscillate, of course. The latest information and our analyst opinions are always available on our website. Are they automatic buys? It's hard to say, Ruth. There's always considerations. But being able to put together a high-quality management team, a high-quality end market and economic moat and a margin of safety as driven by the Star Rating, I think, is a great place to start.
Saldanha: Great. Thank you so much for being here today, Adam.
Fleck: Thanks for having me.
Saldanha: For Morningstar, I'm Ruth Saldanha.
