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Best Ideas

A look at Van Eck's Wide Moat Focus exchange-traded fund.

Samuel Lee, 01/17/2014

Disclosure: Morningstar Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please go here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

I'm often asked about Market Vectors Wide Moat ETF MOAT. It puts me in a bit of a pickle. MOAT tracks the Morningstar Wide Moat Focus Index. Any recommendation to invest in it would be rightly perceived as coming from a conflicted party, hence the long disclosure prefacing this article. For what it's worth, I had nothing to do with MOAT's creation and am not compensated in any way by the exchange-traded fund's success or failure. I honestly think MOAT is an interesting strategy that deserves a hard look, and I also happen to be well-placed to do so in an insightful manner.

MOAT was launched in 2012, but the strategy was investable all the way back in 2007 via ELEMENTS Morningstar Wide Moat Focus ETN WMW. Its performance has been good.

Still, even six years of consistent performance is not enough reason to invest in an asset. Fixating on realized performance is a classic case of attribute substitution, in which the mind reflexively swaps out a hard question (“What is my forecast of future expected performance?”) with an easy one (“What was past performance like?”). Predicting future performance is hard and is better done by focusing on a strategy's process and fundamental characteristics rather than its historical returns. This is what I'll do in my analysis.

MOAT is a systematic best-ideas fund. Each quarter it buys and equal-weights the 20 wide-moat stocks trading at the deepest discounts to Morningstar equity analysts' estimates of fair value. The rationale for picking the most deeply discounted wide-moat stocks is that their future earnings are more predictable and therefore their fair values are likely to be less noisy than those of no- and narrow-moat stocks.

As reasonable as a strategy may sound, the devil is in the details. What the heck is a “moat”? How are “wide-moat” stocks identified? How is “fair value” calculated? And can combining the two be reasonably expected to add excess returns? Let's begin with the building blocks.

Moats
Warren Buffett likens an unusually profitable enterprise to a castle. An economic moat keeps competitors from hurting a firm's profit margins. Morningstar's equity team imitates Buffett. All the stocks they rate are assigned one of three moat ratings by a committee of senior analysts—wide, narrow, or none. Wide-moat stocks are those the committee believes will earn exceptional returns on invested capital over at least 20 years. No-moat stocks are those the committee believes will earn average or below-average return on capital. Narrow-moat stocks fall in between.

Buying companies with wide moats has worked out for Buffett, but to a skeptic like me it's not at all obvious it should continue to work, especially when there are legions of Buffett disciples.

Samuel Lee is an ETF Analyst with Morningstar.

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