In Why moats help equity investors, we explained why we believe economic moats are one of the keys to investing success. Now we look at how investors should decide when it is the right time to buy. (You can watch the video here).
At Morningstar, the first step is figuring out how much a company is actually worth.
Heather Brilliant, CEO, Morningstar Australasia: I think there's many ways to value a business, but here at Morningstar we use discounted cash flow in order to estimate the underlying value of a business because if we're looking at the cash flows a business can generate over the future several years and decades, we can really get a sense of what kind of cash that business can bring to investors. And that's really what we're trying to estimate at the end of the day.
Narrator: Morningstar analysts use this discounted cash flow model to come up with a fair value estimate, or how much we think each share of a company is worth. Fortunately, for wide-moat investors there are some advantages to figuring out the fair value estimates of wide-moat stocks versus their no-moat counterparts.
Matt Coffina, Editor and Portfolio Manager, Morningstar StockInvestor: Most importantly, it's relatively easier to assign fair value estimates to wide-moat companies. They tend to be more predictable, and our fair value estimates tend to perform much better with wide-moat companies.
The other reason is that wide-moat companies tend to increase in intrinsic value over time. So they generate a lot of cash flow. They don't have high capital-reinvestment needs, and then they reinvest that capital in their businesses at relatively high rates of return, which leads to growth over the long run.
The key is to look for these very high-quality companies when they're available at reasonable prices or preferably at large discounts to what they're intrinsically worth.
Narrator: But how do you know when the discount is large enough to buy? Morningstar thinks that uncertainty around that fair value estimate offers a clue.
Coffina: If a company has a fair value estimate of $100 a share, that doesn't mean it's worth exactly $100 a share.
For Coca-Cola, with a low degree of uncertainty, that means the company is may be worth $90 to $110 because there's so many assumptions that go into these discounted cash flow valuation models.
On the other hand, a steel company that we say is worth $100 a share, that's probably going to have a much wider range around that. That company could be worth as little as $60 or as much as $150, and we just don't know because there's too much inherent uncertainty in the assumptions and the drivers of that valuation. In those circumstances, you might want a much larger discount to fair value before concluding that that company is undervalued, maybe a 30% or 40% discount to fair value would not be unwarranted.
Narrator: But sometimes these discounts just aren't available. Take the market environment of early 2014, where most shares were trading for more than their intrinsic worth. Should investors pay up to stay fully invested or stay in cash and wait for the prices to come down?
Brilliant: I personally think that in this type of environment where we're seeing a lot of wide-moat stocks trading at or above fair value that it makes sense to keep some dry powder, so that when the market does decide to correct, you can really step in and take advantage of that.
On the other hand, though, I do also think that for people who really would like to stay fully invested throughout market cycles, which I think also makes a lot of good sense, that focusing on wide-moat businesses anywhere below fair value is still better than buying no-moat fliers that could certainly end up going against you in a very painful way.
Coffina: As a general rule, I would prefer a fairly valued, very high-quality company over a lower-quality company that's cheaper. Those very high-quality companies tend to exceed your expectations. They tend to compound their intrinsic values relatively quickly over time. They find investment opportunities that you might not have thought existed, and over time they tend to be worth much more than they are today.
Narrator: Ariel Investments manages over $9 billion in mutual funds and separate account strategies. Their investment philosophy centers on finding high-quality companies and taking a long-term view.
John Rogers: We don't want to overpay even when we find a great business with a great moat, and we do believe that all things being equal, it's better to pay a little extra for a wonderful business--Warren Buffett often talks about that--than to go in and buy a sort of [bad] business at a bargain price.
You always have to make sure it has those characteristics, so even if the moat is a little bit smaller now than you would like to be, you can determine in the future that the moat is going to be greater and growing into the future.
Narrator: In many cases, it can make sense to pay up for the quality of wide-moat stocks. However, that doesn't mean you should pay any price or hold on to them forever, if the competitive landscape were to change.
Coffina: If we're worried about the company still having a competitive advantage five and 10 years from now, then I'm happy to sell it at fair value and look for better opportunity.
Selling based on valuation alone, I think, is something you have to be careful with. If you're dealing with a very, very high-quality company that has a very wide moat and is likely to increase in intrinsic value over time, often you are better off just waiting because over time the intrinsic value is going to catch up to the valuation. Even if the valuation gets a little bit ahead of itself in the short-run, it's really just a matter of time.
Rogers: Sometimes you are going to sell a company simply because it's gotten expensive, and you think that that great moat is already priced into the company. But our self-discipline has a lot to do with looking forward and looking to the future and determining whether the moat is going to get narrower and narrower and narrower and disappear over time.
A lot of our sales over the last several years have been when we and our team have determined that that solid moat won't be maintained into the future and that new competitors will come in and wreak havoc to the industry, and wreak havoc to the pricing. And that will be a reason for us to sell today before that happens. And again that's the hardest part of this business: to see the future. But that's what we get paid to do.
Narrator: This strategy of paying a reasonable price to become the owner of a company with great competitive advantages has worked well over time.
No one knows for sure what is going to happen in the future. But at Morningstar, we firmly believe that buying and holding companies with sustainable competitive advantages is one of the best ways to stack the deck in your favor.
