Fri, 22 Mar 2013
Morningstar's Elizabeth Collins discusses the index's selection process and highlights one of the recent additions.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Elizabeth Collins. She's the director of basic materials research. She is also the chair of our economic moat committee, which helps vet companies to see what their economic moat ratings should be. We're going to talk about the Wide Moat Focus Index--what companies are coming in and which ones are coming out during this latest rebalancing.
Elizabeth, thanks for talking with me today.
Elizabeth Collins: Thanks for having me, Jeremy.
Glaser: Can you tell us a little bit about what this Wide Moat Focus Index is and how you decide what stocks go inside of it?
Collins: Sure, actually it's a rules-based index based on our analysts' moat ratings and fair value estimates. So basically every quarter, we look at our wide moat universe of U.S. stocks, and we figure out--we sort them based on which ones are trading at the cheapest basis based on our price/fair value estimate ratio. The fair value estimate is how much the analyst thinks the stock is worth, the price is how much the market currently thinks the stock is worth.
Glaser: How many companies are in the index and how often is it rebalanced?
Collins: All the time there's 20 companies in the index, but it rebalances once a quarter.
Glaser: And that goes to an equal weight or is it market cap weighted, how does that work?
Collins: Yes, it's equal weighted.
Glaser: So what's coming out for this most recent rebalancing?
Collins: This most recent rebalancing, what got kicked out of the index was St. Joe, Cisco, Oracle, and Northern Trust.
Glaser: Let's talk about St. Joe. Why did this company leave the index?
Collins: That's the company where we re-evaluated our economic moat rating back in late December, early January. And what happened was that we still think that the company has low-cost resources, and that's their acreage position for land development in northwest Florida. It's still the case that they have hard-to-replicate assets in Florida. But the fact that they are monetizing those assets very quickly, and reinvestment opportunities are kind of uncertain, prevents us from saying that they're going to be generating sustainable economic profits for two decades or more, which is the hurdle rate that we need to meet in order to award a company a wide economic moat rating.
So based on our re-evaluation and some debate, we decided to go with the narrow moat rating on St. Joe, and that removed it from our Wide Moat Focus Index.
Glaser: The other constituents that were removed--was that a matter of fair value cuts or moat changes, or was it just price appreciation?
Collins: Sure. For Cisco, Northern Trust, and Oracle that was all due to stock price appreciation since the last rebalancing.
Glaser: So, let's talk about valuations then. If we saw those appreciate as so did everything else, the market is at record highs according to some indexes. What's kind of that threshold that you need to hit for cheapness in order to be one of the top 20 cheapest wide-moat stocks right now?
Collins: Sure. Your point is very valid. Our wide moat universe has gotten more close to fairly valued recently. The cut-off point for the 20 cheapest wide moat stocks a year ago was a price/fair value estimate ratio of about 0.82. And at this last rebalancing, what we saw is that that has risen to a cut-off of a price/fair value estimate ratio of 0.89. So, that's not a very significant discount to fair value estimate for some of our higher- or medium-uncertainty companies.
Glaser: So given that it's gotten a little bit easier, according to these rules to get into the index, what was added in this rebalancing?
Collins: So, what was most recently added was C.H. Robinson, Caterpillar, General Dynamics, and General Electric.
Glaser: Let's take a look at C.H. Robinson. This is a company that maybe people aren't as familiar with. Why do you think this has a wide moat and why does it look slightly undervalued right now?
Collins: C.H. Robinson and its closest peers, I think, have a really great business model that exemplifies our wide economic moat and also the network effect, which is a very potent form of competitive advantage. Basically, C.H. Robinson is a third-party logistics provider. They are the middleman between companies that ship things--the shippers--and carriers--the truck providers, the people that drive around the products around in trucks. And their value proposition to both customers--the shippers--and carriers--the providers--increases the more carriers and customers that get added to the system. So, it's a potent network effect.
Glaser: How cheap does that look right now?
Collins: Like I said, most of the stuff that's in the index right now isn't trading at a screaming discount to our fair value estimate, but there are some concerns right now about C.H. Robinson with regard to margin compression. Part of this might be cyclical, might be a matter of the fact that the truckers are increasing their prices a little bit faster than C.H. Robinson has been able to. So to that extent, if C.H. Robinson can catch up, some of that pricing and margin power might be restored.
Glaser: Elizabeth, thanks for your thoughts on the index today.
Collins: Thanks Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.