Investors can gain exposure to profitable companies that can maintain their high returns for an extended period through a targeted exchange traded fund strategy that specifically focuses on those with wide economic moats.
“Some firms generally stay very profitable for a long time by creating economic moats to protect profits,” Andrew Lane, Senior Equity Analyst and Chairman of Economic MOAT Commitee at Morningstar, said on the recent webcast, Combining Quality and Valuation – Surviving the Trump Era of Uncertainty. “Economic moats are structural competitive advantages that help companies generate high returns on capital for an extended period.”
Lane explained that companies exhibiting wide economic moats are positioned to sustain economic profits for at least 20 years, whereas companies with narrow economic moats would only be able to sustain profits for at least 10 years.
Moreover, economic moats are not equally distributed across the markets as some sectors show greater number of companies with wide economic moats. Lane warned that highly commoditized or competitive industries typically have fewer companies with wide moats. For example, the consumer defensive, healthcare and industrial sectors have a larger number of companies with wide moats, whereas the basic materials, telecom services and utilities sectors have fewer wide moat companies.
According to Morningstar’s indexing methodology, there are five sources of economic moats.
Intangible assets that include brand recognition to charge premium prices. Other characteristics include patents to protect procing power legally barring competition, and government regulatory licenses that hinder competitors from entering the market.
Switching costs that make it too expensive to stop using a company’s products. The value of switching exceeds the expected value of the benefit. For instance, razor and blade models entrench repeat consumables, and price is not the only determinant as there are indirect costs like hassle and distraction of using an alternative.
Network effect that occurs when the value of a company’s service increases as more use the service. As more customers use the good or service, the value for the good or services rises for both new and existing users. Furthermore, companies have the ability to increase the number of potential connections and grow exponentially.
A cost advantage helps companies undercut competitors on pricing while earning similar margins. Companies are able to sustainably lower costs than competitors. Additionally, wide moat companies with a cost advantage enjoy irreplaceable process advantages, superior locations, hard-to-amass scale or access to a unique asset.
Lastly, efficient scale associated with a competitive advantage in a niche market. A market of limited size is effectively served by a few companies where incumbents generate economic profits and newcomers are discouraged from entering due to lower profit margins.
Given these factors, Dan Lefkovitz, Content Strategist of Indexes at Morningstar, pointed out that Morningstar has been able to build a strategic beta index through the strong investment thesis of outperformance in companies with wide economic moats.
“We back each thesis with our extensive high-quality data and the body of research that emerges from the Morningstar Investment Research Ecosystem,” Lefkovitz. “We take a measured, disciplined approach to developing new index products that clearly defines the outcomes we want to achieve.”
For example, Brandon Rakszawski, Product Manager at VanEck, pointed to the VanEck Vectors Morningstar International Moat ETF (NYSEArca: MOTI) and VaneEck Vectors Morningstar Wide Moat ETF (NYSEArca: MOAT) as two popular ways to implement Morningstar’s economic moat rating to identify strong companies with wide economic moats.
Only “quality companies with attractive valuations are selected for Morningstar’s moat indices,” Rakszawski said.
The underlying Morningstar Moat Focus Indices target companies with a wide economic moat or sustainable competitive advantages and targets the most undervalued moat stocks, which have helped generate significant excess returns relative to the overall market.
The indexing methodology may help investors outperform the broader market.
“The Morningstar Wide Moat Focus Index has historically outperformed the broad U.S. equity markets and fund managers as represented by its Morningstar U.S. Funds Large Blend category average,” Rakszawski said.
Financial advisors who are interested in learning more about the current markets and an ETF strategy that implements Morningstar’s indexing methodology can watch the webcast here on demand.