Exchange traded fund investors who are seeking a way to diversify their investment portfolios can consider a timeless investment philosophy, driven by Morningstar’s forward-looking equity research, focusing on companies with a wide economic moat.
In the recent webcast, Morningstar’s Guide to Moat Investing, Brandon Rakszawski, Director, ETF Product Development, VanEck, underscored the uneven performance in the equity markets, with technology, consumer discretionary, and communication services sectors leading the charge, while sectors like energy, financials, and utilities languished.
At the end of August, Rakszawski noted that U.S. large-cap companies and, to a greater extent, U.S. tech companies were well overvalued according to Morningstar’s forward-looking rigorous valuation research. On the other hand, Morningstar’s wide moat focus investing philosophy systematically targets attractive valuation opportunities, and the Morningstar Wide Moat Focus Index showed that 10% of its holdings were undervalued as of the end of August 2020, compared to 8% as of the end of 2019.
Andrew Lane, Economic Moat Committee, Morningstar Indexes, explained that the Morningstar equity research process includes in-depth analysis to identify companies with sustainable competitive advantages, or moats, and those moat companies with attractive valuations. Specifically, the analyst conducts company and industry research on financial statement analysis, channel checks, trade show visits, industry and company reports and journals, conference calls, and management site visits. Analyst rates the strength of a company’s competitive advantage, or moat, by None, Narrow, or Wide Advantages that confer a moat through switching costs, intangible assets, network effect, cost advantage, and efficient scale. An analyst would then consider past financial results and focuses on competitive position and future prospects to forecast cash flows. Lastly, an analyst uses a discounted cash flow model to develop a Fair Value Estimate, which represents the intrinsic value of that company.
The resulting economic moat indexing methodology has helped investors generate consistent long-term outperformance. Specifically, over the past 5-year rolling periods, the Morningstar Wide Moat Focus Index has outperformed the S&P 500 Index 93% of the time.
“Batting average measures outperformance versus a benchmark. In baseball, it represents the percentage of a player’s hits to at-bats. When applied to investing, it indicates how often an investment strategy has outperformed a benchmark. The Morningstar Wide Moat Focus Index has had an impressive batting average against the broad U.S. equity markets, particularly over the long-term,” Lane said.
Lane explained that high profits attract competition, which can diminish future profitability, but economic moats keep competitors at bay and delay economic profit erosion. Competitive advantages, or moats, may potentially allow a company to generate returns on invested capital in excess of its weighted average cost of capital for extended periods. Furthermore, the history of outperformed has come with lower risk, compared to the S&P 500, helping investors enjoy improved long-term risk-adjusted returns.
According to Morningstar’s indexing methodology, there are five sources of economic moats: Intangible assets that include brand recognition to charge premium prices. Second, switching costs that make it too expensive to stop using a company’s products. Third, network effects that occur when the value of a company’s service increases as more use the service. Fourth, a cost advantage that helps companies undercut competitors on pricing while earning similar margins. Finally, an efficient scale associated with a competitive advantage in a niche market.
Rakszawski also pointed out that the moat investment methodology stands out against active strategies, providing investors with an actively managed investment style through a rules-based index fund, the VanEck Vectors Morningstar Wide Moat ETF (NYSEArca: MOAT), which implements Morningstar’s economic moat rating to identify strong companies with wide economic moats.
Financial advisors who are interested in learning more about economic moats can watch the webcast here on demand.