Wide Moat Investing

Heather Brilliant, CFA

May 2016

©2016 Morningstar, Inc. All rights reserved.

Morningstar Equity Research
Morningstar® Economic Moat™ Rating

Sustainable competitive advantages that allow a company to generate positive economic profits for
the benefit of its owners for an extended period of time.

Wide Narrow None

15% 45% 40%

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Morningstar Equity Research
Sources of Economic Moat

There are five sources of economic moats.

Intangible Switching Network Cost Efficient

Assets Costs Effect Advantage Scale

Wide Narrow None

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 Morningstar Equity Research
Measuring an Economic Moat

Duration of excess returns is far more important than absolute magnitude.

Return on Invested Capital (ROIC)

No Moat Narrow Moat Wide Moat Weighted

Average
Cost of Capital
Time Horizon: 10 Years 20 Years

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 Morningstar Equity Research
Why Moats Matter
Sustainable competitive advantage drives value creation.

Growth
Profitability
Competitive Advantage Invested Capital Economic Profit
Free Cash Flow

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Morningstar Equity Research
Why Moats Matter: Moats Increase Intrinsic Value

Wide Economic Moat Stage I Stage II STAGE III WACC

80.0%

60.0%

40.0%

20.0%

0.0%
2016 2021 2026 2031 2036 2041 2046 2051 2056 2061

Narrow Economic Moat Stage I Stage II STAGE III WACC

20.0%

15.0%

10.0%

5.0%

0.0%
2016 2021 2026 2031 2036 2041 2046 2051 2056 2061
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Morningstar Equity Research
Research Methodology

Our award-winning analysts rely on a proven methodology.

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Morningstar Equity Research
Examples of Wide, Narrow, and No Moat Companies

Intangible Switching Network Cost Efficient

Assets Costs Effect Advantage Scale
Coca Cola Oracle MasterCard Novo Nordisk Canadian National
It’s just sugar water, Switching from Each additional user of Entering insulin market Cost advantages,
but consumers pay Oracle’s tightly the MasterCard brand requires significant efficient scale, and
a premium integrated databases increases its value to upfront costs, and network effect form
could cause massive others. Novo controls more a steep barrier to entry
disruptions than 1/4 of the market.

Adidas Workday United Health FedEx Southern Company

Has strong and well- Switching costs with Sizable membership The high fixed-cost air Utilities have natural
recognized brand in initial product set, but and solid provider express segment geographic
athletic footwear. still need to see network allows firm to is still a large portion monopolies, but
success integrating a scale its fixed costs of revenue regulations
large number of restrain returns
products.

United Continental Macy’s Deutsche Telekom Alcoa Sprint

Name recognition Consumers easily Despite its scale, it has Low-cost bauxite Lacking scale versus
doesn’t result in pick and choose not been able to resources can’t offset AT&T and Verizon
sufficient pricing among many retailers generate returns above industry oversupply eliminates economic
power its cost of capital profit
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Morningstar® Economic Moat Trend
™

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 Morningstar Equity Research
Morningstar® Economic Moat™ Trend

Moat Trend is a detectable direction of change in the competitive position of

a company’s businesses.

g Positive Trend g Negative Trend

The underlying sources (or potential sources) The underlying sources (or potential sources)
of an economic moat must be materially of an economic moat must be materially
strengthening for an identifiable reason weakening or face a substantial
and identifiable threat that is growing

Positive Negative
Trend Trend Stable

No Moat Narrow Moat Wide Moat

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Morningstar Equity Research
Morningstar® Economic Moat™ Trend

A change in moat trend doesn’t indicate a change in moat rating. It’s an alert that competitive
advantages could extend further into the future, or dissipate sooner than we initially forecast.
Return on Invested Capital (ROIC)

Time Horizon: 10 Years 20 Years

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Morningstar Equity Research
Examples of Positive, Stable, and Negative Moat Trend Companies
Wide Moat
Salesforce.com
Switching costs continue to grow, as
companies increase their spending
with the firm faster than other
vendors.
3M
Ongoing investment in support of
intangible assets perpetuates a self-
sustaining new product development
cycle.
Wal-Mart
Shift to e-commerce will likely take
share and make large Wal-Mart stores
less productive at the margin.
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Narrow Moat
FedEx
Enjoying a strengthening network
effect, driving by growth, better
margins, and market share gains.
Ross Stores
Competition likely to increase, but
continued growing scale at Ross
should offset major threats.
Nasdaq
Still a major player, but competition in
the trading space remains fierce.
No Moat
Panera Bread
Increasing pricing power evidence of
an improving intangible asset.
Marathon Oil
High-quality U.S. portfolio increasing
in contribution, but the company’s
overall relative competitive position is
likely to remain unchanged.
Ford Motor Co
Excess capacity will probably become
even worse going forward given
minimal barriers to entry.
Moat Committee Members

Adam Fleck, CFA Gareth James Michael Holt, CFA

Consumer Technology Technology
Chicago Sydney Chicago

Allen Good, CFA Mathew Hodge Michael Waterhouse, CFA

Energy Materials Healthcare
Amsterdam Sydney Chicago

Alex Morozov, CFA Joel Bloomer Phil Gorham, CFA

Healthcare Consumer Consumer
Amsterdam Sydney Amsterdam

Dan Baker Matthew Coffina, CFA Rick Summer, CFA, CPA

Telecom Healthcare Technology
Hong Kong Chicago Chicago

Elizabeth Collins, CFA Michael Hodel, CFA Stephen Ellis

Materials Telecom Financials
Chicago Chicago Chicago

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Valuation

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 Morningstar Equity Research
The Effectiveness of Our Ratings Over Time

Aggregate Market Price to Fair Value

120%

110%

100%

90%

80%

70%
2002/06 2003/07 2004/07 2005/07 2006/07 2007/07 2008/07 2009/07 2010/07 2011/07 2012/07 2013/07 2014/07 2015/07

Data as of December 31, 2015

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Morningstar Equity Research
Aggregate Price to Fair Value By Industry

As of January 2016, Energy, Financial Services, and Industrials are among our most undervalued
sectors.
Undervalued Overvalued

Consumer Cyclical 108

Consumer Defensive 101
Utilities 96
Technology 95
Real Estate 92
Healthcare 91
Communication Services 90
Basic Materials 90
Industrials 88
Financial Services 77
Energy 74

70 75 80 85 90 95 100 105 110 115

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Morningstar Equity Research
Aggregate Price to Fair Value By Industry

Sector Valuations as of 30 Sept 2015: Financial Services, Energy, and Basic Materials were among
our most undervalued sectors.
Undervalued Overvalued
Financial Services 84
Energy 88
Basic Materials 89
Market Aggregate 91
Healthcare 91
Consumer Cyclical 91
Technology 92
Real Estate 92
Industrials 94
Consumer Defensive 96
Utilities 97
Communication Services 97

80 85 90 95 100 105 110 115 120

Data as of September 30, 2015

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Morningstar Equity Research
Aggregate Price to Fair Value By Industry

Sector Valuations from 30 Sept 2014: S&P declined more than 300 basis points after this period.

Undervalued Overvalued
Energy 92
Financial Services 96
Consumer Cyclical 98
Basic Materials 99
Market Aggregate 101
Consumer Defensive 101
Real Estate 103
Industrials 104
Utilities 106
Healthcare 110
Communication Services 110
Technology 110

80 85 90 95 100 105 110 115 120

Data as of September 30, 2014

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Morningstar Equity Research
The Effectiveness of Morningstar Ratings for All Stocks

From 2002-2015, 5-star rated stocks outperformed stocks of all other star ratings.

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Appendix
Morningstar Equity Research

Morningstar institutional equity research services

is a global and independent research provider.
Our long-term outlook and emphasis on economic
moats, or sustainable competitive advantages,
differentiate our research and have proven to
drive long-term outperformance.

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Morningstar Equity Research
Global Analyst Team

Our accomplished team of award-winning analysts apply one consistent methodology across our
global coverage universe.

Equity Analysts Companies Covered Globally

Methodology

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Morningstar Equity Research
Comprehensive Equity Coverage

Our coverage spans the globe and all major market sectors.

Regional Coverage Market Cap Coverage Sector Coverage

Asia 136 ! Large-cap Stocks 731 h Cyclical
Australia/New Zealand 223 @ Mid-cap Stocks 409 r Basic Materials 133
t Consumer Cyclical 213
Europe 257 # Small-cap Stocks 317
y Financial Services 207
Latin America 32 The market caps were broken down by
the following breakpoints: u Real Estate 58
Middle East/Africa 46
Large cap: 10+ Billion USD j Sensitive
North America 763 Mid-cap:2-10 Billion USD
Small-cap: 0-2 Billion USD i Communication Services 60
Total Global Coverage 1,457
o Energy 123
p Industrials 191
a Technology 158

k Defensive
s Consumer Defensive 98

*Institutional coverage numbers d Health Care 133

Data as of September 30, 2015 f Utilities 83

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Morningstar Equity Research
Moat Rating Distribution

Our analyst coverage universe skews toward companies with economic moats, though in the overall
economy, most firms do not have an economic moat.

Morningstar Coverage Universe Moat Rating Distribution Wide Moat Narrow Moat No Moat

Analyst Coverage Quantitative Research Coverage

1%
15%
29%
40%

70%
45%

Data as of March 31, 2016

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Morningstar Equity Research
Moat Rating Distribution

Moats are not equally distributed across sectors. Highly commoditized or competitive industries
will have fewer companies with moats.

Wide Moat Narrow Moat No Moat

100%

80%

60%

40%

20%

0%
Basic Comm. Consumer Consumer Energy Financial Healthcare Industrials Real Technology Utilities
Materials Services Cyclical Defensive Services Estate

Data as of March 31, 2016

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Morningstar Equity Research
Moat Rating Distribution

The sources of competitive advantage are widely distributed across our moat companies.

Wide Moat Narrow Moat

70%

60%

50%

40%

30%

20%

10%

0%
Intangible Assets Cost Advantage Switching Costs Efficient Scale Network Effect

Data as of March 31, 2016

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Morningstar Equity Research
Morningstar® Economic Moat™ Trend Distribution

The number of companies with negative, positive, and stable moat trend ratings.

1,200
1,149
1,000

800

600

400

201
200
104

0
Negative Positive Stable

Data as of March 31, 2016.

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Morningstar Equity Research
The Effectiveness of Morningstar Ratings for All Stocks

The Morningstar Rating for Stocks shows significant predictive power in our regression analysis.

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Morningstar Equity Research
The Effectiveness of Our Ratings Over Time

Morningstar® Wide Moat Focus IndexSM vs. S&P 500

Wide Moat Focus S&P 500
7.00
6.00
5.00
4.00
3.00
2.00
1.00
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Trailing Annualized Returns (%)

Since
Inception
Index 1-Year 3-Year 5-Year 10-Year (09/30/2002)

Morningstar® Wide Moat Focus IndexSM 4.3 11.7 12.7 10.9 14.3

S&P 500 Index (cap-weighted) 1.9 11.8 11.6 7.0 9.2

Data from September 30, 2002 through March 31, 2016. Indexes are unmanaged and not available for direct investment.

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Morningstar Equity Research
The Effectiveness of Morningstar Ratings for Wide Moat Stocks

Wide Moat stocks sorted by Morningstar Rating for stocks vs. S&P 500

Trailing Annualized Returns (%)

Since
Inception
Morningstar Rating™ for Wide Moat stocks 1-Year 3-Year 5-Year 10-Year (06/26/2002)

QQQQQ 17.0 17.5 17.7 14.6 18.6

QQQQ -3.5 10.5 12.0 8.3 10.3
QQQ -3.5 9.0 11.1 7.6 7.6
QQ -0.2 7.5 11.2 7.4 8.9
Q -8.5 1.8 9.2 -3.7 -2.8

Morningstar Coverage Universe -3.3 8.89 7.8 9.0 —

S&P 500 Index (cap-weighted) 1.9 11.8 11.6 7.0 —

Source: Morningstar
Time-weighted returns through: March 31, 2016

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Morningstar Equity Research
The Effectiveness of Morningstar Ratings for All Stocks

All stocks sorted by Morningstar Rating for stocks vs. S&P 500

Trailing Annualized Returns (%)

Since
Inception
Morningstar Rating™ for stocks 1-Year 3-Year 5-Year 10-Year (08/06/2001)

QQQQQ -11.5 11.9 8.0 13.5 10.9

QQQQ -4.9 6.7 6.8 8.1 10.8
QQQ -2.2 10.5 8.7 8.5 8.9
QQ -5.8 6.2 4.9 4.0 4.9
Q -8.1 7.4 4.6 10.6 8.8

Morningstar Coverage Universe -3.3 8.89 7.8 9.0 —

S&P 500 Index (cap-weighted) 1.9 11.8 11.6 7.0 —

Source: Morningstar
Time-weighted returns through: March 31, 2016

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Morningstar Equity Research
The Effectiveness of Morningstar Indexes and Portfolios

Morningstar Indexes and Portfolios vs. S&P 500

Trailing Annualized Returns (%)

1-Year 3-Year 5-Year 10-Year

Morningstar® Wide Moat Focus IndexSM 4.3 11.7 12.7 10.6

Morningstar Tortoise Portfolio 1.3 11.1 12.9 8.1

Morningstar Hare Portfolio 0.8 15.1 13.3 10.8

Morningstar Dividend Select Portfolio 12.7 11.8 14.4 —

Buy at 5-Star/Sell at 3-Star -12.9 1.6 3.6 7.5

Morningstar Large-Cap Blend Mutual Fund Cat. -2.2 9.2 9.0 5.5

S&P 500 Index (cap-weighted) 1.8 11.8 11.6 7.0

Source: Morningstar
Time-weighted returns through: March 31, 2016

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Morningstar Equity Research
The Effectiveness of Morningstar Ratings for All Stocks

Be careful with what you are measuring. The number of stocks in each star-rating buck fluctuate
from year to year.

1 Star 2 Star 3 Star 4 Star 5 Star

22 7 30 78 78 373 396 33 31 128 48 16 40 59

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Data as of October 31, 2015

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Morningstar Equity Research
Morningstar Rating™

We assign the Morningstar Rating for stocks by comparing the market price to our fair value
estimate, adjusted for uncertainty.

Q —175%+
—155%+
QQ —135%+
—125%+ —125%
—110% —115%
—105%
QQQ —95% —90% —85%
—80% —80%
—70%
QQQQ —60%
—50%

QQQQQ

Low Medium High Very High

Data as of September 30, 2015.

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Stewardship Analysis

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Morningstar Equity Research

The purpose of stewardship analysis is to

identify managers that are acting in the
best interest of shareholders. A focus on
capital allocation decisions best identifies
managers who focus on widening their
moats and improving shareholder returns.

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Morningstar Equity Research
Key Stewardship Considerations

A focus on capital allocation decisions informs the Stewardship Rating.

Investment Investment Execution Dividend and Management Financial Ownership

Strategy Valuation Buy Back Incentives Leverage Structure

Distribution of Poor, Exemplary, and Standard Stewardship Ratings Across Companies

1,400
1,227
1,200
1,000
800
600
400

92 137 200
0
Poor Exemplary Standard

Data as of March 31 2016

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Morningstar Equity Research
Examples of Exemplary and Poor Stewardship

Exemplary Stewardship Poor Stewardship

Deere AT&T
Stock ownership requirements for a broad set of employees, Poor capital allocation decisions, such as paying a premium
combined with disciplined investment processes and price for DirecTV, enacting a questionable strategic move
accretive share repurchases. into Mexico, and overpaying for operating assets.

Nike Carlsberg
Strong brand management, and executive focus on Shareholders face potentially substantial dilution in the event
maximizing returns on invested capital. of a major acquisition, owing to the Carlsberg Foundation’s
ownership of 75% of voting rights.

O’Reilly Automotive Zions Bancorp

Well-executed acquisitions that has transformed the firm into Growth at the expense of risk controls leading up to the
a highly profitable national player. 2008/09 financial crisis led to heavy losses.

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Morningstar Equity Research
Alphabet (GOOGL)

Alphabet – Conviction in growth potential allowed us to look past near term challenges and increase
our valuation.

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Morningstar Equity Research
General Electric (GE)

Focusing on the durability of GE’s economic moat allows us to see past near term concerns over
exposure to China and energy.

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