Incorporating economic moat analysis from Morningstar's equity team into our fund research provides a unique perspective.
Morningstar has an army of analysts delving into stocks, mutual funds, bonds, and exchange-traded funds, and monitoring the overall market and economy. The ability to cross-pollinate Morningstar's research and proprietary data points provides a unique perspective for analysis. Within the equity research team, categorizing a firm's economic moat is an important piece of the puzzle. On the fund research team, we aggregate the economic moats of stocks within a portfolio to generate portfolio "moat" metrics.
Morningstar launched economic moat ratings in 2002 based on Warren Buffett's thesis that firms with a competitive advantage (or a wide economic moat) are the same firms that can reward investors. Morningstar's economic moat ratings are straightforward: no moat (no competitive advantage), narrow moat, and wide moat (clear, distinct competitive advantage). The five distinct sources of economic moat are: network effect, switching costs, cost advantage, intangible assets, and efficient scale. A more detailed discussion of Morningstar's economic moat can be found here.
Morningstar's equity research team has found that wide-moat firms tend to outperform the broader market over time. In fact, as of mid-March 2013, the Morningstar Wide Moat Focus Index, launched on Sept. 30, 2002, has a 10-year annualized return of nearly 15%, compared with the S&P 500 Index's return of just under 9%. The Morningstar index holds 20 of the most undervalued wide-moat stocks, rebalanced quarterly.
To uncover whether a wide-moat portfolio might translate to strong performance in closed-end funds, we surfaced all of the equity CEFs with "wide" average economic moats. Table 1 lists these 10 funds and their Morningstar CEF category averages, along with various economic moat data points. They are ranked by the latest portfolio's percentage of wide-moat stocks. Average moat statistics further splice the data into five moat characterizations: none, minimal, narrow, moderate, and wide. Note that not all CEFs provide sufficient portfolio data from which to calculate moat statistics. It is likely that there are more than 10 CEFs with wide-moat portfolios.
Premium members of Morningstar.com can find these data points on each fund's Portfolio page, under "Premium Details." The data points are rescaled and only include rated stocks within the portfolio. Because most of the CEFs listed invest in concentrated portfolios of generally large-cap, well-known firms (even the MLP funds), most of the stocks in the funds' portfolios are assigned a moat rating. In general, turnover of these funds tends to be lower than their category averages and portfolios tend to be concentrated in 30 or so names.
Of note, Eagle Capital Growth GRF, Dow 30 Premium & Dividend Income DPD, and Dow 30 Enhanced Premium & Income DPO have many more wide-moat stocks than their large-blend peers (more than 70% versus 45%). The two Dow funds hold the 30 stocks from the Dow Jones Industrial Average, and because of their size and market prominence, all 30 stocks are rated by Morningstar's equity analysts and have been given an economic moat rating. The DJIA stocks tend to be household names and leaders in their industries, characteristics that can lead to favorable moat ratings.
Boulder Total Return BTF and Boulder Growth & Income BIF are interesting funds, earning their wide-moat rank mainly because of outsized positions in Berkshire Hathaway. In fact, 28% of Boulder Total Return's portfolio is in Berkshire Hathaway's A shares
Do Wide-Moat Stocks Translate to Better Fund Returns?
Have these wide-moat portfolios been able to outperform over the long term? Table 2 below shows that, yes, many have been able to do just that.
Over the latest three- and five-year annualized periods, all but three funds (Boulder Growth & Income and Eagle Capital Growth over three years and Foxby Corp FXBY over five) have beaten their Morningstar category averages, often by a fair margin. And, each fund has a Sharpe ratio that is equal to or higher than the category average (excluding Foxby). Finally, capture ratios look strong, especially on the downside. Each fund (again, excluding Foxby) has a lower downside capture ratio, indicating that when the market is down, the funds lost less than their category averages. Upside capture does not look as strong, with only one fund topping its category average (Dow 30 Enhanced Premium & Income). This means that many failed to capture as much upside in rising markets as peers. Certainly, the average moat metric is using only current portfolio data, but most of the funds listed in Table 1 have low turnover, adding to the likelihood that historical portfolios have been similarly moaty.
While a portfolio's "moatiness" is not a silver bullet, it's another tool that investors can use to learn more about a fund's equity holdings. Combined with historical returns, an understanding of the fund's process, and an investor's view on the market, Morningstar's economic moats can add color to fund analysis.
Click here for data and commentary on individual closed-end funds.