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Holly Cook: Morningstar equity analysts cover 1,800 stocks globally, over 250 of which are based in Europe. I’m joined today by Heather Brilliant. She is Head of Credit and Equity Research at Morningstar, and she is going to tell us a little bit more about how we cover these stocks.
Heather, thanks very much for joining me.
Heather Brilliant: Thanks for having me Holly.
Cook: So, I know we have a rather complex methodology in analysing companies, but can you try and give us a bit of a brief overview of what the key factors are that our analysts to look at?
Brilliant: Sure. I think there is couple of key elements. The first is what we call the economic moat of a company and the second is the valuation. So, the economic moat is really our attempt to analyse the sustainable competitive advantage of each of the businesses that we cover, and this is a really core tenant of our philosophy because it’s basically a quality indicator. We are trying to evaluate whether the business can earn excess returns for the long run. And on the valuation front we try to look beyond just the next quarter and really evaluate what we think the business is worth; and then we look for opportunities when the stock is trading materially below that valuation and that’s when we really recommend the stocks.
Cook: So, the competitive advantage, the economic moat aspect, what features are you looking at then when you are analysing a company?
Brilliant: The most important feature from a quantitative perspective is whether the company is earning excess returns on capital, above and beyond the cost of capital that it needs to spend in order to grow its business or to function. But when it comes down to the way we find that, we are really looking for a few different elements.
We think that it's somewhat similar to a competitive analysis that you might hear about around the business sphere, but we put our own take on it because we think there is really some elements that are missing in a general typical analysis. We first look for what we call network effect and companies with a network effect have the ability to benefit from more users. So, the more users there are, the greater the network effect. eBay is a great example of this, even in its PayPal subsidiary where it’s really got a lot of buyers and sellers or people using its payment services on both sides.
And the second would be a cost advantage. That’s pretty straight forward. A business that can produce something cheaper than its competitors will have an advantage and will be able to exploit that over the long run. The third in intangible assets; an intangible assets includes things like brands that compel consumers to pay more, patents, licences from government agencies, and things like that. They are really help it on excess returns.
And the fourth is what we call efficient scale and that’s really a business that is benefiting from being in a smaller market such that the market is so small that if another entrant were to come in it would no longer be economical for either player. So, the fact that the market is small kind of keeps other competitors from entering the market.
And the fifth is switching costs and these would be any businesses where it's very costly for a consumer business to switch to a competing provider or where the benefits of switching are highly unknown. So, an example of this might be in the software industry with Oracle, for example. People might not love Oracle software, but once it’s embedded in the company’s functionality, it’s extremely difficult for a business to switch. And so they don’t, simply because it’s difficult to switch and they don’t know if the competing software will be any better.
Cook: So, that’s how our analysts workout whether a company has got that competitive advantage. How about actually valuing the stock, what do you look at there?
Brilliant: When it comes to valuing stocks we use a discounted cash flow model to really look at the valuation. And what that means is that we are forecasting the cash flows that we expect the business to generate over the next 5 to 10 years. And really a discounted cash flow model even goes beyond that because we start looking at the period over which we expect excess returns to fade to the cost of capital, and of course the perpetuity value is part of a discounted cash flow model as well.
So we use all of this to come up with a fair value estimate, which is likened to an intrinsic value. So, when you hear the term intrinsic value in the market, we are really talking about is: what do we think the underlying business is worth, what are the cash flows that the business can generate going to produce for the company?
Cook: And so whereas the Morningstar Star Ratings for funds indentify performance of that fund, looking historically, the Star Ratings for the stocks are actually an idea of whether there is a potential opportunity to get into a stock or whether it's perhaps overvalued, right?
Brilliant: Exactly. So what we do is we take that fair value estimate and then we look at where the market price is trading. And our goal is to buy stocks when they are trading below what we think they are worth, and to sell them when they are trading above what we think they are worth. And so we use the Star Rating to demonstrate when we think that valuation is out of whack. So a stock that has a 5-Star rating is trading well below what we think it’s worth. And the quantity of that discount actually depends on how uncertain we think the cash flows of the business are.
So, for example, a business that is very easy to forecast, that is a relatively straightforward business, we would need less of a discount or less of a margin of safety before we’d feel comfortable buying it. But something that is highly volatile and has very disparate cash flows from one quarter to the next or one year to the next, we would wait for a bigger discount because it’s a lot harder to get that intrinsic value right and so you need to leave a buffer for a margin of error really.
Cook: So, how have our ratings performed then over time?
Brilliant: Generally speaking our ratings on wide moat companies that are trading at a discounted fair value have tremendously outperformed the market. Now, of course, it depends on what market you are looking at, but generally speaking we compare to the S&P 500 and we have seen excess returns for wide moat, undervalued stocks in the neighbourhood of 600 basis points a year, at least, on average of course.
And if you look at shorter time frames the returns don’t always look so great, but we purposely take a long term view and I think that’s a really important tenant of our philosophy. We are purposely trying to ignore short term movements in the market and focus on the long term value of the business, the long term competitive advantage and be able help investors identify when those things are out of whack with what the market is saying in the short term.
Cook: Well, thanks Heather. You’ve really explained what our analysts are actually doing and how our research can help individuals identify that long term opportunities. Thanks very much.
Brilliant: Thanks for having me Holly.
Cook: For Morningstar, I’m Holly Cook. Thanks for watching.
