I’ve always been drawn to the old Warren Buffett idea that one successful way of minimising risk through investing is to out money to work in businesses which have a substantial competitive moat of advantage. For Buffett that notion of a moat has very specific connotations but it speaks to a broader notion, that you should invest in businesses that have staying power, global scale, and substantial margins that are in turn based on some form of competitive advantage, be it brand or IP or tech based. This seems to me to be a sensible long-term strategy for participating in the upside of stockmarkets without taking too much risk. The key challenge is not to overpay for said stocks.
Various “experts” have come up with different ways of trying to find these businesses and then build them into a fund or an index. In terms of the latter outcome – an index – I wrote earlier this year about SocGen’s World Champions Index which is a way of capturing these wide moat businesses – you can read about this index in a Citywire article here: https://citywire.co.uk/funds-insider/news/david-stevenson-a-20-stock-portfolio-of-world-champions/a1312647
You can find out more about the index itself – the World Champions Index – here: https://sgi.sgmarkets.com/en/index-details/TICKER:SGIXWC/
Looking at the last factsheet the top five holdings in this index are as follows:
This ideas of scale champions has various rivals including the S&P Dow Jones Titans Index but the real grand daddy of this specialist space has to be the Morningstar Global Wide Moat index, which ahs been kicking around in the US market for a few years now. As we’ll discover it tries to take Buffett’s thinking and turn it into an actionable index which is then turned into ETFs via US firm VanEck. The latter has had a few ETFs in operation for a number of years now, with variations between global, international and US focused versions of the moat idea. Performance for the various ETFs, courtesy of data from www.etfdb.com, is in the table below. Overall, the idea seems to be effective and most of the time offers some advantage over a broad index such as the S&P 500 or MSCI World Index.
|ETF||YTD||1 yr||3 yr||5 yr|
|MOAT – VanEck Vectors Moat ETF||-3.65||10.35||40.18||83.9|
|MOTI – VanEck International Moat||-8.8||-1.54||-2.1||NA|
|GOAT – VanEck Global Moat||0.14||7.84||NA||NA|
|Van Eck Europe US MOAT||-5.35||8.45||36.54|
|S&P Global Titans Index||4.08|
VanEck in Europe has had a version of the index as an ETF since October 2015, ticker MOAT (for the US dollar version). Assets under management total around £180m and the fund has a TER of 0.49% pa. Top holdings include Veeva Systems (3.71%), Servicenow (3.39%), Amazon (3.33%), Facebook (2.95%), and Blackrock (2.82%).
VanEck have now added another version of the index, this time for a global mix of stocks: – the VanEck Vector Morningstar Global Wide Moat UCITS ETF (ticker GOAT) has just launched on the London Stock Exchange. The blurb for this new ETF says these moats “may include cost leadership, efficient scale, network effects, high switching costs and intangible assets. A Fair Value Estimate is also a determining factor for inclusion in the index.” According to VanEck the Morningstar® Global Wide Moat Focus IndexSM “has outperformed the MSCI World Index by 3.97 percentage points since its launch on 23 April 2018” and contains stocks from regions such as Europe, Japan, China and Australia. The underlying index is the Morningstar® Global Wide Moat Focus IndexSM (MSGWMFNU), “which is intended to track the overall performance of attractively priced global companies with sustainable competitive advantages according to Morningstar’s equity research team”.
The new ETF is fully replicating, excludes securities lending, and currently has a total expense ratio of 0.52 percent per year. The table below lists the main fund characteristics:
|ETF||VanEck Vectors Morningstar Global Wide Moat UCITS ETF (GOAT)|
|Index name||Morningstar® Global Wide Moat Focus IndexSM|
|Ticker LSE USD/ LSE GB||GOAT/ GOGB|
|Management company||VanEck Investments Limited|
|Investment manager||VanEck Asset Management B.V.|
|Index provider||Morningstar, Inc|
|Rebalancing||Half-yearly, quarterly staggered|
|Product structure||Physical (full replication)|
|Launch date||7 July 2020|
|Total expense ratio||0.52% p.a.|
|Appropriation of income||Re-invested income|
And which companies might find their way into this new fund – the table below has the current top 20 stocks for the US version of this GOAT ETF:
|All Fund Holdings as of 07/08/2020 for GOAT|
|Number||Holding||Ticker||Market Value||% of net assets|
|1||Gea Group Ag||G1A GR||$234,474.40||2.54%|
|2||Tencent Holdings Ltd||700 HK||$219,437.70||2.37%|
|3||Servicenow Inc||NOW US||$211,749.60||2.29%|
|4||Alibaba Group Holding Ltd||9988 HK||$205,529.36||2.22%|
|5||Microsoft Corp||MSFT US||$205,380.95||2.22%|
|6||Constellation Brands Inc||STZ US||$204,029.76||2.21%|
|7||Nabtesco Corp||6268 JP||$199,727.00||2.16%|
|8||Guidewire Software Inc||GWRE US||$199,328.88||2.16%|
|9||Salesforce.Com Inc||CRM US||$198,878.04||2.15%|
|10||Julius Baer Group Ltd||BAER SW||$198,081.81||2.14%|
|11||Amgen Inc||AMGN US||$195,988.61||2.12%|
|12||Alphabet Inc||GOOGL US||$193,964.40||2.10%|
|13||Nike Inc||NKE US||$193,232.20||2.09%|
|14||Emerson Electric Co||EMR US||$185,774.69||2.01%|
|16||Yum China Holdings Inc||YUMC US||$184,047.11||1.99%|
|17||Zimmer Biomet Holdings Inc||ZBH US||$179,212.44||1.94%|
|18||Cerner Corp||CERN US||$177,373.95||1.92%|
|19||Roche Holding Ag||ROG SW||$176,980.20||1.91%|
|20||British American Tobacco Plc||BATS LN||$176,792.16||1.91%|
In terms of portfolio composition the average market cap of a stock is a hefty $178 billion, with an average PE ratio of 22.2 – US stocks account for 64% of the index, China 7%, and the UK 6.6%. In terms of sector mix, healthcare stocks are the biggest weighting at over 20% followed by industrials at just under 16%, and Industrials at 15%.
More detail on the index methodology from Morningstar:
Download is available at PDF – http://morningstaradvisor.com/uploaded/pdf/widemoat.pdf
“A wide-moat company has a sustainable competitive advantage that enables it to keep
competitors at bay for an extended period of time. Morningstar has embedded the analysis of a
firm’s “moat” within its research process, and the resulting list of Wide Moat companies
includes what are, in our view, the highest-quality companies around. We’ve created the Wide
Moat Focus Index to allow investors to participate in the above-average profits that these firms
are expected to earn.
In determining the size of a firm’s economic moat, we begin with the premise that all highly
profitable firms attract competitors, and only firms that are able to keep competition at bay will
earn above-normal profits for a long time. An economic moat—or competitive advantage –
allows a company to fend off competitors and earn sustainable excess economic profits. We
look at return on invested capital (ROIC) relative to the company’s cost of capital to determine
profitability, because ROIC shows us the cash return on the capital invested in the business.
We think that ROIC is the best measure of economic profitability.
Of course, we have to examine ROIC relative to a firm’s cost of capital because money isn’t
free–those who have capital charge companies for the right to use it, and they charge some
companies more than others. A firm that operates pipelines or sells beer has a low cost of
capital because it has a stable business, so investors don’t ask for much in the way of returns.
A small semiconductor or biotech firm would have a very high cost of capital because it’s
entirely possible that investors might not get their money back, so they ask for a high return to
compensate for the higher risk. For example, an ROIC of 14% would be spectacular for a
pipeline company relative to its 8% cost of capital, but would barely clear the bar for a small
tech or biotech firm.
The first step is called “show me the money,” that is, we look at whether ROIC has exceeded
the firm’s cost of capital in the past. For companies that pass this test, the next step involves
further analysis by Morningstar analysts to determine if those high returns will continue. In this
step, Morningstar analysts must identify a clear competitive advantage for the company in
order to give it a moat rating. One or more of the competitive advantages listed in the following
table would qualify a company:
As an example, think about retailers and restaurant chains–switching costs for consumers are
extremely low, so companies in these industries need scale, a well-established brand, or some
other defensible advantage to give them a moat. Without some advantage, those high ROICs
could dissipate quickly–history is full of hot retail or restaurant concepts that have flopped as
quickly as they’ve become temporary hits, this is why only 40 of the 122 restaurants and
retailers we cover have narrow moats, and only five have wide moats
Wide or Narrow Moat
Finally, if we have evidence of solid returns on capital and confidence that those returns are
sustainable, we have to decide whether the firm has a wide or narrow moat. To rate a stock as
having a wide moat, we have to be very confident that the firm’s competitive advantage will
persist. This translates to the requirement that the company have the ability to generate ROIC
in excess of its cost of capital for at least 20 years. Thus, we’re pretty selective about this–only
about 10% of the stocks we cover receive wide-moat ratings.
Selection Committee Review
A Selection Committee makes the final determination of which stocks merit a Wide Moat
Rating. Only those stocks with one or more of the identifiable competitive advantages, as
determined by Morningstar analysts and agreed to by the Selection Committee, receive a Wide
Moat Rating. The committee meets on a regular basis and consists of Morningstar’s Director of
Stock Analysis and chief equities strategist.”
Recent additions to the Index from April
Stocks removed from the Moat index recently include Amgen, Bristol Myers Squibb, Cerner, Dominion Energy, Domino’s Pizza, and McDonalds, all of which failed the price to fair value screen plus United Health which failed the Moat test. These were all removed March 20th.
Stocks recently (April) added to the index include: Boeing, Blackbaud, Corteva, Constellation Brands, Bank of America, American Express and US Bancorp.
Morningstar narrative for inclusions:
“Bank of America (BAC), one of the largest U.S. banks, has emerged from a decade of inefficient acquisitions with a leaner, more effective business model. The bank has effectively cut costs by selling off many risky business segments. The company has also increased its consumer loan standards, so most customers now have high average credit scores. Bank of America is also a top spender on technology compared with competitors, and we view this positively because we believe that banks will increasingly depend on technology innovations (like well-designed mobile apps and new functionality) to attract and maintain customers.
Analyst Eric Compton believes that large banks benefit from economies of scale, or cost advantages as a business segment grows larger. Bank of America is particularly well-positioned because it’s a top provider across many banking products, including credit and debit cards, brokerages, and consumer bank accounts, which can help the bank grow its assets more quickly. For instance, the bank has a Preferred Rewards program that offers customers savings if their total balance across products reaches a certain threshold. With this program, the bank gives customers incentive to use more financial products, reducing the amount it needs to spend to acquire new customers.
As customers use more of the bank’s offerings, swapping banks becomes more of a pain (in theory, anyway). As a result, the bank also benefits from switching costs, or the idea that customers will want to avoid the one-time inconveniences or expenses they face when they change products.
U.S. Bancorp (USB) also benefits from cost advantages and switching costs, says Compton. The bank gains cost advantages by minimizing costs. For instance, it runs physical branches relatively inexpensively, and its payments business, which helps businesses with tasks like accepting credit card payments, operates on a single platform with essentially zero costs per additional transaction. Finally, like Bank of America, Compton thinks that many U.S. Bancorp customers use many of its products, leading to a switching-costs advantage.
Analyst Colin Plunkett believes that American Express (AXP) will remain profitable over a long period given its historically successful commercial business segment, particularly business travellers who use company-issued cards. He argues that these are high-spending cardholders who stores want as customers, and stores can only acquire them by accepting American Express, which earns the company money every time a transaction is processed. As more stores accept American Express cards, cardholders can use their cards more, which helps American Express’ profits rise if transactions increase. Since entering the index, the stock’s price has further declined amid coronavirus concerns, but Plunkett believes this pressure is temporary and that financials will recover. While he believes the company’s revenue in 2020 will decline compared with last year, he expects revenue in 2021 to rebound nicely.
Analyst Seth Goldstein believes seed and crop chemical product producer Corteva’s (CTVA) advantage stems from its research-and-development spending to create proprietary products. Through this investment, the company maintains a portfolio of seeds and crops with patents, which legally prevent other companies from selling an invention for a specific time period. As a result, Corteva can sell the products at a higher price and protect its revenue, which is an example of an intangible asset. However, patents eventually lose their worth as they expire or a product loses effectiveness. But Goldstein believes Corteva is one of the best companies at developing new products given its vast experience in the field. As a result, he is confident that the company’s reinvestment in research and development will be effective in helping the company develop new patented products.
Analyst Nicholas Johnson recently upgraded alcoholic beverage producer Constellation Brands’ (STZ) moat to wide given the strength of its Mexican beer business, which generates approximately 80% of its profits. We believe this business segment has a strong brand given U.S. consumers’ increased affinity toward imported beer. Plus, the beer resonates with a growing U.S. Hispanic population. We think that the market’s overemphasizing the company’s noncore business segments, such as wines and spirits. In recent years, management has been selling off many of the low-margin and less-profitable products. Plus, Johnson believes the market is overly concerned about Constellation Brands’ acquisition of no-moat cannabis provider Canopy Growth given uncertainty in the cannabis industry; however, the acquired company represents a very small part of Constellation’s overall revenue.
Boeing (BA), which primarily manufactures airplanes, faces some challenges given the grounding of its 737 MAX aircraft, but analyst Burkett Huey argues that structural barriers to entry and under capacity in aircraft manufacturing will make it difficult for Boeing’s customers to switch to a different supplier. First, regulators have strict requirements to certify new aircraft that would likely delay a new competitor entering for years, so Boeing has a competitive advantage given its regulatory knowledge and key industry relationships. Second, while airlines could switch to Airbus, which is Boeing’s primary competitor, they would need to certify pilots and crews on these new airplanes. Additionally, both Boeing and Airbus maintain over five-year backlogs on popular 737 MAX replacements, so airlines could wait years for a new aircraft (or pay large fees to get one sooner). As a result, Boeing also benefits from switching costs.
In Boeing’s defense unit, deep relationships and knowledge of military aircraft manufacturing creates another advantage. Plus, Boeing produces so much for the military that the government would essentially need to overhaul its aircraft lineup, creating switching costs.
Blackbaud (BLKB) is the leading software producer in the social-good community, which includes nonprofits, foundations, and educational institutions. These organizations use this software to help with various tasks, including searching for charitable donors or managing grants and charitable campaigns. Analyst Dan Romanoff believes the company offers a robust suite of products that is more thorough than competitors’ offerings. Romanoff thinks the company benefits from switching costs because once customers start using Blackbaud’s software products, it’s expensive to switch to a new software and it takes time to train employees on it. Romanoff also believes that Blackbaud’s nonprofit customers are particularly sensitive to switching costs because they operate on tight budgets”.
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