Morningstar says the index uses the firm’s proprietary methodology to identify companies with long-term, advantages, which allows companies to earn sustainable excess economic profits, as measured by the return on invested capital relative to the company’s cost of capital. [Morningstar ‘Wide Moat’ ETF Covers Firms with a Competitive Edge]
“Examples of competitive advantage include high switching costs, cost advantage, intangible assets, and/or network effects,” according to Morningstar. “The index contains the 20 most discounted companies that Morningstar’s equity analysts deem to have wide moats, which means that it generally contains firms that have been beaten down.”
- Switching costs. The cost of switching technologies to enter a specific industry may be too costly for a single start-up company, compared to established players in the field. For example, Oracle Corporation is a recent addition to the MOAT ETF’s portfolio.
- Cost advantage. Larger companies, like Intel or Wal-Mart, enjoy better economies of scale and low-cost resource base, allowing these firms to undercut the competition and bully new players out.
- Intangible assets. These assets include additional factors like brand recognition, patents and government backing. For instance, most investors would recognize Berkshire Hathaway.
- Network effects. This effect refers to the growing value of a service as more people utilize the network. MOAT includes growing communities like Facebook and eBay.
The MOAT strategy makes regular adjustments to holdings. As of June 21, the underlying index added Amgen, Franklin Resources, eBay, Facebook, Maxim Integrated Products, Oracle, Qualcomm and Schlumberger. While some of these stocks have been hammered, notably Facebook, Oracle and Qualcomm, it is interesting to note that Morningstar has kept its eye on these companies.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.