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Beating the Market One Wide Moat at a Time

Morningstar's Wide Moat Focus Index shows how myopic markets have mispriced moats.

Pat Dorsey, 03/02/2011

Detailed analysis of competitive advantage and a steadfast focus on the long-term cash-generating ability of businesses are at the core of Morningstar's approach to equity investing, and so we spend a great deal of time thinking about economic moats and forecasting long-run cash flows. (Click here to learn more about how Morningstar analysts assign economic moat ratings to companies.)

But how can we have confidence that our approach adds value? After all, elegant theories are one thing, but generating excess returns in a very competitive marketplace is quite another, especially given the increased efficiency with which information flows between companies and investors.

To answer this question, we created an index several years ago called the Wide Moat Focus that holds the 20 wide-moat stocks trading at the largest discounts to our estimates of intrinsic value. If we have some skill at identifying businesses with competitive advantages, and if we have some skill at valuing the shares of those businesses, then a portfolio of cheap wide-moat stocks should outperform the market generally, and our wide-moat universe specifically.

I am happy to report that, so far, this has indeed been the case. A portfolio of the wide-moat stocks we view as being the most mispriced has generated substantially higher returns than both the S&P 500 and our overall wide-moat universe. I've summarized the performance data in the table below.

 Trailing Performance of Wide Moat Focus ( % )
 
2011 YTD
Trailing 1 Year
Trailing 3 Year
Trailing 5 Year

Since Inception
(10/1/02)

Morningstar Wide Moat Focus Index*
7.1
20.7
11.7
9.4 15.5
Morningstar Wide Moat Index **
5.2
24.0
5.7
5.2 10.6
S&P 500 Index
5.9
25.9
1.8
3.0 8.1
Data as of 2/15/11
* The wide moat focus index has been "live" as an ETN (ticker: WMW) since 11/01/07. It has an expense ratio of 75 basis points, so returns are somewhat lower. The three-year trailing return for WMW is 10.9%, and the one-year trailing return is 19.9%.
** The Wide Moat Index contains all U.S.-domiciled wide-moat stocks. It is equal-weighted and rebalanced quarterly.

While these results are obviously gratifying to those of us on Morningstar's Equity Research team, they also raise some very interesting questions. How is it that a group of well-known, (mostly) large-cap companies with substantial Wall Street analyst coverage can become mispriced with such frequency? How can a mechanical portfolio-construction process using well-known, (mostly) large-cap companies generate substantially higher returns than both passive indexes and the vast majority of active managers? (After lopping off a 1% hypothetical management fee, the Wide Moat Focus Index bests 95% of large-cap funds--and 90% of mid-cap funds--over the trailing three- and five-year periods, as well as since its late-2002 inception.)

I recently performed a comprehensive analysis of the Wide Moat Focus Index to examine these questions, and I'd like to share the results with you. Did the Wide Moat Focus simply take on more risk? Were excess returns generated from sector allocation or security selection? Is there a size or style bias to the index that would explain the performance data in the tables above?

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